Seritage Growth Properties Preferreds: Attractive Current Yield + Capital Appreciation Opportunity

| About: Seritage Growth (SRG)

Summary

Seritage Growth Properties, the real estate spin-off from Sears, has been misunderstood by investors and has been under forced selling pressure by a mutual fund liquidation.

The Seritage preferreds are attractive on a relative and absolute basis and should trade at a substantially lower dividend yield given the asset quality.

As Seritage continues making progress and recapturing Sears real estate and redeveloping it, the preferreds offer a nice dividend and should appreciate over time.

Overview:

Given the recent rebound in many mall REITs and the strong underlying fundamentals of the asset base at Seritage Growth Properties (NYSE:SRG), the Seritage Preferred Stock is an attractive investment on both a relative and absolute basis. The current yield is very attractive, and I believe purchasing the preferred stock now will likely result in underlying capital appreciation as well as the market realizes that Seritage's preferred stock is currently being valued at an unwarranted discount to similar instruments outstanding at other mall REITs. As a reminder, Seritage consists of Sears' (NASDAQ:SHLD) legacy real estate assets and was formed in 2015 and subsequently spun-off to shareholders of Sears. The stock was initially somewhat controversial given there were concerns that if Sears were to go bankrupt soon after Seritage was spun-off, there could be fraudulent conveyance risk related to the bankruptcy and Seritage could have exposure on that front. Given it has been over three years since the spin-off, this risk has all but gone away given three years is an important legal timeline for any potential fraudulent conveyance claim - i.e., given Sears is still not bankrupt, it would be quite difficult to argue a fraudulent conveyance claim that Sears was effectively insolvent at the time it originally spun-off Seritage. One reason the Seritage capital structure has been under pressure of late is that Bruce Berkowitz is in the process of liquidating his mutual fund and he was a large shareholder of both Sears and Seritage - this wind-down is quite close to completion at this point and this selling pressure should have abated.

Berkowitz Liquidates Hedge Fund That Owned Sears Holdings Shares

Another interesting dynamic is that Warren Buffett personally invested ~$70mm in Seritage common stock around the time of the spin-off - this is notable because it is one of the few personal investments Buffett has made in recent years - said differently, he likely finds Seritage to be quite an attractive investment to bother with investing in it personally.

Forbes Welcome

Characteristics of the Preferreds:

The Seritage preferreds have a 7% coupon which is an ~7.5% current yield. They offer a cumulative dividend yield which means that if Seritage becomes non-current in its dividend payments on the preferred, the company will eventually have to pay dividends that have been in arrears.

Comps:

Some comparable mall REIT preferreds trade at much tighter dividend yields than the Seritage preferreds which implies solid upside for the Seritage preferreds. For instance, the Simon Property Group preferreds yield ~5.9% and the GGP preferreds yield ~6.45%; while there is probably some discount warranted for Seritage given the Sears exposure, they should likely trade in the mid to 6% dividend yield range, which would imply potential upside of 10-15%+.

Confusion Around Seritage's Earnings:

The primary investment thesis underlying Seritage common stock is that as Sears winds down, the real estate will be redeveloped and leased at market rates which are orders of magnitude higher than the legacy rental rates Sears is paying. The company is moving as quickly as possible to recapture the buildings leased to Sears and to invest in the properties and then re-lease them at market rates. Given REITs are valued on Funds from Operations, this poses a challenge for Seritage because Funds from Operations will actually decline on a short-term basis as Seritage takes Sears properties offline to redevelop them and then eventually re-lease them. This is increasing the economic value of Seritage and the long-run earnings power of the business but looks bad on the current operating metrics which REIT investors tend to focus on. Additionally, Seritage has actually been moving more quickly than expected on the recaptures, the Funds from Operations metrics look even worse than people were expecting.

Risks:

  1. Rising interest rates - this is certainly a concern in investing in these preferreds, but given they trade at a relatively large spread to treasuries, any potential move in interest rates should not have too big an impact on these
  2. Exposure to malls - many investors are concerned about exposure to malls given all of the negative news flow and trends over the last few years; that being said, performance of late has been much better than expected

Catalysts:

  1. Continued progress at Seritage in recapturing real estate from Sears and redeveloping it

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.