Buffett's High Interest Rate Loan To Seritage

Summary

• SRG is up double digits on news of a loan from Buffett.
• We see this news as negative for SRG, given the high cost of debt.
• The hit to FFO will be sizable, and SRG is deeply overvalued.
• We are short SRG following this news.

This morning's Wall Street Journal included a headline "Buffett Bets On Former Sears Tracts", which refers to a loan Berkshire Hathaway (BRK.B) just made to Seritage Growth Properties (NYSE:SRG).

Whenever there is even a hint of Buffett betting on something, the market responds with a mandatory Buffett bump with SRG up double digits. As Buffett is already long SRG, some may have viewed this loan as doubling down.

Source: E-Trade streamer intraday 8/1/18

Despite the WSJ headline, I don't see this loan as Buffett betting on SRG.

This loan is profit-seeking in nature.

SRG's debt situation

Chris Hudgins, an analyst for SNL Financial, put out some particularly prescient analysis suggesting SRG was one of the most susceptible REITs to interest rate increases. Specifically, he cited that 90% of SRG's debt is variable rate and 100% of its debt is due in 2018 or 2019. Given that the 10-year Treasury yield spiked to over 3% today, now is not a great time to have short-term variable rate debt.

I believe Buffett smelled blood in the water and recognized this as an opportunity to make a loan that is likely to be highly profitable for Berkshire. Specifically, it is a $2.0B term loan facility consisting of $1.6B of initial funding and $400mm of additional capacity.

SRG is paying Berkshire 7% on the $1.6B and 1% on the undrawn portion. As of today, that represents an annual interest expense of $116mm. Prior to the Berkshire loan, SRG's liabilities were primarily mortgage loans as seen below.

Source: SRG supplemental

Importantly, SRG's annual cash interest expense was $60.9mm as seen below in SRG's supplemental.

Thus, the Berkshire loan, which replaces SRG's existing debt, increases SRG's annual interest expense from $60.9mm to $116mm.

That is a lofty price to pay for a slight extension of term. The facility only lasts until July 31, 2023, so SRG is paying through the teeth for what is still only a short to medium term loan.

Again, this is great for Berkshire as they will get an excellent return in any scenario except a near-term bankruptcy of SRG. I do not see how this is good for SRG.

The increase in interest expense of $55.1mm represents an extra cost of $0.99/share using a diluted share count of 55.7mm found in SRG's supplemental. Presently, Capital IQ consensus estimates which came out BEFORE the loan estimated SRG's FFO/share in 2018 at $1.39.

Source: SNL Financial

$0.99 per share is a huge hit to FFO which will likely only be partially undone by the loan amount being greater than the liabilities SRG is paying off.

SRG will net about $320mm of capital with which to redevelop, so I imagine that once this is spent it will pull FFO/share back up a bit. However, it is difficult to imagine $300mm of capital being able to make up the $55mm increase in annual interest expense. That would require one of the best cap rates in REIT history.

Valuation

Anyone with investing experience knows that equity must generate a higher return than debt due to its inferiority in the capital stack. Equity endures more risk, so it should generate a higher expected return to compensate investors for taking this risk. As of today, SRG violates this inherent law of finance.

Source: SNL Financial

Using an NOI cap rate, SRG is trading just south of 5% while peer mall REITs are trading at NOI cap rates north of 10%.

A <5% cap rate does not make sense when SRG's cost of debt capital is just above 7% as demonstrated by the new loan. I view this as gross overvaluation of the equity.

Summing it up

SRG was backed into a corner with substantial near-term debt maturities in a rising rate environment. They were likely going to have to refinance at a more expensive rate regardless of which route they chose and Berkshire was there to take advantage of the situation. This loan is good for Berkshire but represents crippling interest expense cost for SRG. I do not think SRG should have been up on this news, and it definitely should not have been up double digits. Given the market's knee-jerk Buffett bump, I initiated a short position in SRG on 8/1/18.

In my opinion, the greatest risk to a short position is the existing short interest at nearly 33%. There is a very real risk of a short squeeze here, so a short position requires ample liquidity to wait out a short squeeze if it were to happen.

I am personally short SRG and may trade it in the near term. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accept responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer's abilities as an investment advisor representative.

Disclosure: I am/we are short SRG. 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.