For several years, Seritage Growth Properties' (SRG 3.70%) heavy debt load has been a significant risk for the Sears real estate spinoff's shareholders. When the COVID-19 pandemic hit in 2020, disrupting Seritage's redevelopment plans, that risk suddenly became acute, threatening the REIT's future.
Last week, Seritage Growth Properties took an important step on the road back to financial health by prepaying $160 million of debt. Nevertheless, it has a lot of work left to fix its balance sheet so that it can focus on executing its turnaround strategy.
Burning cash with no end in sight
Seritage has been burning cash consistently since the middle of 2018, as primary tenant Sears Holdings started closing stores much faster than the REIT could redevelop them for new tenants.
That said, prior to the pandemic, Seritage appeared to be on track to return to positive cash flow within a year or two due to a wave of scheduled tenant openings at redeveloped properties. Unfortunately, the pandemic pushed some of Seritage's tenants into bankruptcy and forced others to close stores or dial back expansion plans. Meanwhile, the REIT sold some rent-generating properties to raise cash.
As a result, by the third quarter of 2021, Seritage's in-place annual rent had receded to $92 million, compared to $108 million at the end of 2019. That caused adjusted funds from operations (FFO) to sink further into negative territory, declining from -$15 million in Q4 2019 to -$25 million in Q3 2021.
Making matters worse, Seritage's pipeline of signed leases for future openings shrank 66% over this period to just $29 million of annual base rent: not nearly enough to get the REIT back to breakeven FFO.
Chipping away at its debt
High interest expense is one of the biggest impediments to Seritage's efforts to return to positive FFO and cash flow. Cash interest expense for its term loan facility has totaled $116 million annually for the past few years. That alone makes it essential for Seritage to reduce its debt load as quickly as possible.
Furthermore, Seritage's $1.6 billion term loan matures in July 2023. In late November, the lender (an affiliate of Berkshire Hathaway) agreed to extend the maturity by two years -- provided Seritage reduces the balance to $800 million by next July. That makes debt reduction even more urgent.
On the bright side, Seritage has identified about 70 properties that it intends to sell. As of Sept. 30, 2021, it had $224.4 million of assets under contract for sale. On Dec. 31, it used some of its asset sale proceeds to make a $160 million debt prepayment. That will reduce annual interest expense by $11 million.
How much cash can Seritage raise?
Seritage appears to have completed one particularly large asset sale last quarter, selling a former Sears location in San Bruno, California (just outside of San Francisco) for roughly $128 million. The REIT still has other valuable sites in its disposition portfolio, including properties in San Jose and Westminster, California.
That said, most of the real estate Seritage wants to unload isn't worth much. For example, it recently sold a former Kmart in the Tampa suburbs for $6 million. That property is far more representative of what Seritage is looking to sell than the San Bruno site.
Seritage can certainly raise enough cash from additional asset sales to pay for its planned near-term redevelopment spending of approximately $250 million. It should also be able to cover its ongoing cash burn, which remains around $100 million annually, excluding capital expenditures. But after covering those costs, there probably won't be enough left to make a serious dent in Seritage's remaining term loan debt of $1.44 billion.
Seritage may hope to refinance some of its debt by using its best properties as collateral for mortgages. However, Berkshire Hathaway currently holds mortgages on all of the REIT's assets. Unless Berkshire agrees to more lenient terms, Seritage would need to raise enough cash to repay the term loan in full to tap the commercial mortgage market.
In short, Seritage still lacks a clear path to getting its debt down to a reasonable level relative to its annual rental income. Meanwhile, the slow pace of leasing over the past two years casts doubt on its ability to reach breakeven anytime soon. All things considered, investors can find much more attractive opportunities elsewhere in the REIT sector.