What's the idea?
Seritage ((NYSE:SRG) ($38.87))
A bet on SRG is a bet that it would be successful in replacing the current under-market rent paid by Sears (NASDAQ:SHLD) with other tenants that would pay market rent.
The thesis is three-fold:
- Sears is currently paying way below market rent @ $4.31 per square foot (PSF) while there are already third-party tenants paying $11.23 PSF. SRG is able to recapture 50% of each property leased to Sears or 22 million square feet (SF) across the portfolio under the master lease terms. SRG also has 21 properties that it can recapture 100% of from Sears. There are other special provisions in this, and it will be discussed down the road.
- SRG has 31 properties under joint ventures with GGP (NYSE:GGP), Simon Property Group (NYSE:SPG) and Macerich (NYSE:MAC). These JVs are supposed to help SRG realize value faster and gives the company the option to sell back the stake at a fair market price starting in early 2018.
- Seritage also owns all of the recapturing rights to Sears Auto, which the company has plans on making it into small platform stores. These are supposed to earn more PSF than what's being paid by Sears.
The question then to ask is how attractive are these locations to warrant higher PSF, and what are the risks for investors if Sears went under?
What's The Upside?
Let's assume that the bull case is fully realized, how much will investors earn buying it at today's price?
There are 21 properties that allow SRG to recapture fully with a total SF of 3,946,106 earning about $4.31 PSF. Let's say that SRG recaptures the whole thing and charges ~$18, which is the market rent, that would be an increase of ~$54 million in revenue.
Now let's assume that the JVs all go very well, and SRG retains the ownership stakes. The total SF for the JVs is 5.449 million. The JVs aren't earning anything yet, so if I assume $18 PSF, I would get an additional ~$49 million in revenue (50% stake).
Finally, the properties SRG can recapture only 50% of are roughly 214 with SF of 33.064 million. Because it would only be able to capture 50% of it, the SF affected here is 16.532 million. If I assume $18 PSF (rate at which SRG is charging now for tenants that are signed but not opened) for 16.532 million SF versus the current $4.31, there would be an increase of $226 million in revenue.
There is obviously capex associated with recapturing the property and redeveloping the properties, but this is just a simple exercise to see what the full realized value is in the ultimate bull-case scenario.
$226 + $49 + $54 = $329 million in extra revenue
G&A expense would likely remain modestly higher than the current $15 million. Let's assume $50 million in G&A. Real estate taxes and operating expenses would remain relatively stable.
$329 - $35 (extra G&A) = $294 million in EBITDA
$294 + $181 (current EBITDA) = $475 million in NOI
Interest expense would likely increase given the additional spending required to develop the project. Current interest expense is $58 million, and let's assume that the cost of redeveloping all of these properties would need another $1 billion. Interest expense would double to ~$120 million.
$475 - $120 = $355 million in OCF
Let's now assume that half of OCF would be able to be paid in dividend.
$355/2 = $177.5 million
There are 33 million shares outstanding or a "potential" dividend of $5.38 per share. If I apply a 5% dividend yield on this, it would imply a stock price of ~$107 per share.
Please excuse my rough estimates, but there are currently no estimates available to determine the exact costs needed to redevelop the recaptured leases.
If SRG was to move full force, under the master lease agreements, it can only recapture 20% of the total leases per year. Even in the scenario where the company did this on a full scale, it would still require five years + and this does not include the time it takes to build out the space, which could add another 2-3 years in the full realization of SRG's value.
How Do We Know If SRG Can Lease The Space Back Out @ $18 PSF?
SRG currently has tenants that are signed but not opened leasing the properties @ $18.95 PSF.
The tenant list is here:
To get a better understanding of SRG's real estate portfolio, let's look at the company's demographic breakdown:
SRG breaks down the attractiveness of the demographic surrounding its locations and the average household income. If the nearby population density is high combined with the higher-than-normal household income, this would imply that per square foot sales would normally be higher than other geographical regions. In turn, this would increase the demand for the mall space, which would demand higher PSF. One way to think this through is that the better the demographic of the region, the better the odds SRG can get the fair market rent.
Another factor that one needs to consider when investing in SRG is whether the company can simply just get rent above what Sears is currently paying. Given that the current rent is ~$4 PSF, it's not hard to envision the company can't rent it to another tenant at a higher price. Even if I assume a PSF of $8, which is below the current third-party tenant rate, SRG would earn almost doubled the current NOI.
One would need to make pretty bearish assumptions to convince themselves that SRG wouldn't be able to recapture the lease at a higher rate than what Sears currently pays.
What Are The Risks?
Investors are essentially getting paid 5% yield while owning the optionality of potentially market reverting rents. The master lease agreement expires after 10 years forcing Sears (if that's still the tenant) to pay market appraised rent. This means that the longest an investor has to wait is 10 years, because something will happen before then. The master lease also allows Sears to terminate a lease agreement if the store is operating unprofitably and would pay SRG a year's worth of rent in advance.
As a percentage of annual rent, Sears is 78%. This leaves investors to the risk of Sears potentially going under and dragging down the rental income. This is a big risk factor because it would mean an absent of rental income, and SRG still needs to pay interest expense + G&A cost and any capex it committed to developing other recaptured properties.
Other risk factors include the continued migration from physical retail sales to e-commerce thus reducing the demand for mall space. There's some cushion in this assumption as A-listed mall operators like GGP and SPG continue to enjoy strong demand for leasing space.
One last key risk factor is the possibility of Sears bondholders suing SRG for selectively picking the best real estate assets. In the event that Sears goes under, bondholders can point to the SRG deal as a way for shareholders to gouge the bondholders and leaving them with the crappy real estate assets. This could be a potential risk factor and one that I do not have the skills to handicap.
SRG owns a portfolio of promising real estate assets. It's hard to gauge at first the attractiveness of the assets, but through different lens of analysis, one can see the potential for value accretion through recapturing the leases. Given that SRG has already contracted out PSF rates of $18.95, it's hard to imagine that the probability of its attempt to recapture leases would yield PSF lower than what Sears currently pays.
There are obviously execution risks that are involved in this investment, but I feel that given the circumstances presented in this write-up, the odds of SRG getting higher than $4.31 PSF in future recaptured leases are high. I think investors are paid 5% yield while receiving the optionality of higher rent increases in the future. One must be cautious however as to the financial circumstances of Sears as it still presents 78% of SRG's rent. However, once SRG begins to recapture additional leases and diversify its tenant base, the risk of Sears become increasingly less.
SRG is a prudent risk worth taking.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SRG over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.