Seritage Growth Properties (SRG)

INTRODUCTION

In 2015, Sears Holdings faced the real threat of bankruptcy. In a move to raise much-needed cash, the struggling retailer spun off 266 store locations into a real estate investment trust (REIT), giving birth to a new, separate entity: Seritage Growth Properties (SRG). As part of the spin-off, Sears and SRG entered into a Master Lease Agreement (MLA) which required SRG to lease the stores back to Sears at rates far below market. 

Currently, SRG is unprofitable. But the MLA they entered with Sears contains hidden value for the REIT—and its shareholders—in the form of “recapture rights". These rights allow SRG to reclaim up to 50% of the gross leasable space currently occupied by Sears Holdings, and then re-lease it to new tenants at much higher rates. By reclaiming existing space—along with the adjacent land—from Sears, and then re-leasing it to new tenants, SRG stands to increase their average rent anywhere from 2x to 5x. 

In addition to the rent/sqft charged to new tenants, SRG’s value will also be determined by how quickly stores can be redeveloped, and the success of opportunities outside the core portfolio (i.e., the “adjacent lands”). Because each element can play out a number of ways, any valuation that relies too heavily on specific predictions is unlikely to be accurate. Instead, investors are best off looking a range of possible outcomes—from “worst case” to “best case”—and how they compare to today’s price. 

Even with pessimistic estimates, SRG is undervalued.

BUSINESS OVERVIEW

SRG’s portfolio consists of 266 properties. Of those, 31 are "Class A” (or "prime”) mall properties. The remaining properties are a combination of "Class B” mall anchors, 89 free-standing Sears Auto Centers, and the surrounding parking lots and land. Sears currently occupies 90% of SRG’s leasable space, at an average rent of $4.30/sqft. 

At a cursory glance, SRG might seem an unwise place to invest money: it offers below-market rents across its portfolio; mall attendance is declining; and its primary tenant, Sears, is on the verge of bankruptcy. 

And yet, four famed Buffett disciples—Eddie Lampert, Bruce Berkowitz, Mohnish Pabrai, and Guy Spier—have substantial positions in SRG. Even Buffett himself recently revealed an 8% ownership stake in the company. So what is it they see that the market does not? 

OPPORTUNITY

Today, only 10% of SRG’s space is occupied by non-Sears tenants, but because those tenants pay rents more in line with market averages, these leases bring in $56m (or 27% of SRG’s total revenue). As SRG recaptures additional space from Sears (which, as a reminder, they’re entitled to 50% of, per the MLA), their overall average rent will only increase—and revenue and profit along with it.

SRG’s portfolio is made up of three main property types—Class A mall stores, Class B mall stores, and Sears Auto Centers—all with differing redevelopment costs, prospective tenants, and expected rents. But even when using conservative estimates, the yield on investment across all of SRG’s core portfolio should approximate a very respectable 12%. 

The MLA also gives SRG the right to recapture 100% of the space at 21 high-value properties, which should command rents around $25/sqft (versus the $4.30/sqft that Sears pays). If exercised, average rents will net even higher.

Further, in many cases SRG also owns the adjacent land, which provides other development opportunities such as: adding space to auto centers to attract additional tenants (e.g., restaurants, banks); constructing new buildings on top of parking lots, and/or creating new mixed-use developments such as hotels, office complexes, apartment rentals, and open air “villages”. 

But even if investors were to ignore these other opportunities and solely consider SRG re-leasing 50% of the properties in their core portfolio, the stock still looks undervalued. 

VALUATION

Real Estate Investment Trusts are commonly valued using one of four methods: Net Operating Income (NOI), Funds From Operations (FFO), Adjusted Funds From Operations (AFFO), or Net Asset Value (NAV). While each method differs in how they handle certain accounting conventions, NOI, FFO, and AFFO are essentially just tweaked iterations of profitability; and NAV is a rough estimate of the value of the real estate less any outstanding debt. Importantly, by any of these measures, SRG appears undervalued.

At $44/share, SRG’s current price assumes slower-than-expected redevelopment, lower-than-expected rent, and zero opportunity outside the core portfolio. But the chance of SRG failing on all three counts is low. What’s more likely is that by 2025, SRG will have recaptured 50%+ of the space from Sears, and raised their average rent to somewhere in the $14/sqft range. In that scenario, investors would earn ~12% per year at today’s price. Even if they’re wrong—and SRG can only raise rents to, say, $8/sqft—they’ll still earn a solid (albeit not spectacular) ~6%. This implies a healthy margin of safety built into SRG’s stock price. 

Those estimates could also be over-conservative. If SRG can successfully recapture 100% of the space from Sears, increase rents to $16/share, and maybe have some success outside the existing core portfolio, investors could even stand to gain a remarkable 20%+ annually.

But the most likely outcome is probably somewhere between $8 - $16/sqft rents, 50% - 100% recapture rates, and maybe a few successful projects outside the core property portfolio. Therefore, it doesn’t seem unreasonable to expect a still wonderful ~15% annual return. 

CONCLUSION

It’s hard to pinpoint what SRG's proper valuation is with a high degree of certainty. However—and most importantly—we can be reasonably confident that it’s worth more than what the market thinks. If Sears can stay solvent for another 6-8 quarters and SRG delivers even the low-end estimates of recapture rates and rents, investors will do okay. If SRG delivers any upside, investors will do quite well.