Seritage Growth Properties

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This is chapter six of a guide on REIT investing. Begin here.

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Seritage Growth Properies (SRG on Nyse) is a publicly traded, self-managed REIT engaged in the real estate property business. Seritage’s portfolio contains 235 properties consisting of 39 million feet of building space, which is diversified by location across 49 states and Puerto Rico. The portfolio consists of 84 properties operated under the Kmart brand, 140 operated under the Sears brand and 11 properties leased to third parties.

Under a master lease agreement, Seritage leases all but 11 of the properties to Sears Holdings under specific terms, including Seritage's right to recapture certain space from Sears Holdings at each property. In addition, Seritage has a 50% interest in 12 properties through joint ventures with General Growth Properties, 10 properties through joint ventures with Simon Property Group and 9 additional properties through investment in a joint venture with Mackerich.

Assets

The reported net value of the real estate is $1.7 billion. This includes $800 million in land and $829 million in buildings; the accumulated depreciation is $139 million and $223 million in current construction. The company held $214 million in cash and reported an investment in joint ventures of $283 million. Below, I write more about the value of the joint investments.

The portfolio of real estate consisted of 39 million square feet of gross leasable area, including 230 wholly owned properties across 49 states and an interest in 23 joint ventures. The properties total 35 million in SF and the joint venture total is 4 million SF. As of last year, 148 of the 240 wholly owned properties were leased to Sears Holdings and 72 properties were leased to both Sears Holdings and a third-party tenant. In addition, 22 of the 23 joint ventures are leased to Sears Holdings as well.

There were 31 vacant properties with a total of 7.3 million. The portfolio is 80% leased. Annual rent from California, Florida, New York and Texas was $52.37 million. There are 94 properties in these states and they attributed to 43% of the annual income. Real estate assets are recorded at cost, less accumulated depreciation and amortization.

Significant tenants

Sears Holdings occupied 24.2 million of the available 39 million SF. They represented about half of the annual income and 75% of the leased GLA, which does not include SF available in vacant properties.    

One hundred seventy-six of the 506 leases will expire in 2025, representing 76% of the leased GLA and half of the annual rent.

Liabilities

Reported total liabilities include both secure- and unsecured-liabilities of $1.45 billion. The secured liabilities: In July 2015 the company entered into a secured loan agreement that provided an initial loan of $1.2 billion. The loan matures in July 2019 and SRG has two one-year extension options. The pricing of the loan is based on the London Interbank Offered Rates (LIBOR) plus 470 basis points; payments are made monthly on an interest-only basis, according to SRG's most recent annual filing.

In other words, the cost of debt varies with the interest rate environment. The company paid an interest rate of 5.24% in 2016 and 6.03% in 2017. The collateral behind the loan is Seritage's wholly owned properties and its equity interest in the joint ventures. The unsecured liabilities include a $200 million term loan. The maturity of the loan is December 31, 2017 and the interest rate are 6.50%.

Income

Excluding the depreciation expense, the 2017 operating income was $148 million. After deducting for non-operating expenses and the interest expense, the net profit was $142 million.

Excluding the depreciation expense, the 2016 operating income was $147 million. After deducting for non-operating expenses and the interest expense, the net profit was $87 million. The difference in profit is the result of a gain on sale of real estate of $60 million.

Since REITs develop the properties they own, and those costs are capitalized (which means these expenses are not reported in the income statement), the REIT investor can find these expenses in the reported cash flow statement. In SRG's case, the company development of real estate had cost $243 million in 2017 and $66 million in 2016. So, while the company profited a total of $229 million in net earnings during those years, the cost of developing properties cost $309 million.

Expense

The typical operating expenses of a REIT are: real estate taxes, operating costs (such as utilities and janitorial), interest expense and general and administrative expenses. The non-operating expenses include litigation charges, provisions for doubtful accounts and acquisition-related expenses.

In 2017, SRG's operating expenses were $163 million and the non-operating expenses were less than $1 million. In 2016, operating expenses were $147 million and non-operating expenses were $19 million.    

The general and administrative expenses are often 15% to 25% of the REIT's operating costs, so further explanation of what this cost represents is warranted. The general and administrative expenses consist of personnel costs, including stock-based compensation, professional fees, office expenses and overhead. Read: everyone's salaries. The increase from $7.5 million to $27.9 million in 2017 was driven due to an increase in personnel resulting in more compensation.

Stock biography

SRG's stock began to trade on the New York Stock Exchange in July 6, 2015. In 2017, SRG stock traded as low as $39.8 and as high as $48.98. In 2016, the stock traded as low as $37.51 and as high as $56.47. In both years the company distributed a dollar of dividend per share.

Seritage has four types of common stock. There are 34 million Class A outstanding shares. Class B non-economic common shares are 1.3 million and class B non-economic shares are 1.5 million. There were 20.2 million in operating partnership units held by limited parties.

The Class B non-economic shares have voting rights, but do not have economics rights and do not receive dividends. The Class C non-voting common shares have economic rights but do not have voting rights. The Operating Partnership units are exchangeable for shares of Class A common stock on a one-for-one basis.

Risks

Seritage is highly dependent on Sears Holdings. To restate what was written in the asset section, 148 of the 240 wholly owned properties were leased to Sears Holdings and 72 properties to both Sears Holdings and a third-party tenant.  In addition, 22 of the 23 joint ventures were leased to Sears Holdings as well. Another fundamental risk to the REITs in general, and to Seritage in particular, is the reliance on capital markets. A rising interest rate environment will be detrimental to the business and to its future growth.

In addition, the company issued 2.8 million shares in Series A Cumulative Redeemable preferred shares. This negatively affects the common shareholder in two ways. First, the dividends distributed to preferred shareholders are senior to those of the common shareholders. In addition, the payment of preferred dividends may result in cutting the amount of the dividends for the common shareholders.

 Management

Benjamin Schall, boss of Seritage, is a veteran of retail REITs. Prior to Seritage, he served as Chief Operating Officer of Rouse Properties (RSE). Prior to that he was a Senior Vice President with Vorando Realty Trust (VNO).

His CFO is Brian Dickman. Prior to Seritage, Dickman was Chief Financial Officer at Agree Realty (ADC), and prior to that he was a real estate investment banker covering public REITs. Edward Lampert, Chairman and boss of Sears Holdings, sits on the board of directors, as does David Fawer, Senior Managing Director of Blackstone's real estate strategies.

Competitors

Throughout this chapter I will use Washington Prime Group (WPG), Pennsylvania Real Estate Investment Trust (PEI) and Brookfield Property REIT (BPR) as peer group comparisons. All REITs operate in the regional malls sector of the retail industry. And peer group market capitalization ranged from $630 million to $3 billion. SRG's market capital is $1.0 billion.

Ratios

Price to ffod ratio

While both SRG and WPG earned roughly $2.50 in FFO per share, SRG traded at 15 times while WPG traded at 2 times. And in 2017 both companies distributed $1 of dividend per share. And while BFS earned about twice the funds from operations per share compared to PEI, BFS traded at 16 times the FFO per share and PEI traded about 5 times the ratio. In short, capital markets value differently the earnings between firms.

But while WPG and PEI can be purchased at less than 5 times the funds from operations per share, which is about 60% less than the industry’s standard multiple of 16 times, neither stock is necessarily cheap.

WPG suffered significant losses in the portfolio and PEI vacancy is higher than the industry standard. Using the same logic, the stock of SRG and BFS is not necessarily expensive. While this is the initial clue of the stock market as to value of the companies, the ratio between price and FFO per share is only the starting point for the REIT investor.

Price to book value ratio

Between the four REIT companies, the discount to book value was as low as 81 cents to $1 of reported assets and as high as $1.17 for $1 of assets.

To calculate the book value per share, I used the reported equity balance and divided it by the number of outstanding, dilutive shares. The premium, or discount, is the stock price divided by the book value per share. For example, BFS book value per share is $64.30. And the stock traded at $52, so the reported price to book value ratio is 81 cents valuation for $1 of equity.

Back-of-the-envelope logic states that if a REIT is trading below its equity per share, if management is to sell the real estate assets and the associated portfolio, what will be left for the common stock holder will be more than the price of the stock. But reality is more complicated than that.

At times of duress the portfolio of real estate is often sold at a discount to the reported value. It is at that point that the common stock investor usually realizes that market values are truly estimates, while the reported liabilities are very accurate.

FFO to revenue ratio

As the below table demonstrates, PEI had the lowest FFO to revenue ratio, while WPG demonstrated the highest ratio in 2017. The industry average is between 35% and 50%. And there is little to say about any REIT that falls somewhere in that range. SRG, WPG and BFS demonstrated an adequate ratio, while PEI showed an inferior performance.

Often, future potential is associated with REITs that show an inferior operating expenses to revenue ratio in the present. There is more room for improvement, the logic goes, which may increase the price of the stock.

The theory behind this ratio states that the lower the ratio, the better and more efficient management is in managing the REIT. In other words, management is managing the general and administrative expenses better than peers; it uses less leverage and is in better control of the operating expenses.

Dividend yield ratio

Both SRG and BFS dividend yield is like what a typical community bank offers today for depositing your savings in a money market account. Given the current valuation of both WPG and PEI, the REITs, on paper, offer a double-digit dividend yield.

While enticing at first, as are most exciting things in life, the dividend yield typically does not last for very long. It should not surprise investors to see that WPH or PEI will cut their dividend rate in 2019.

As I wrote in the chapter on Valuation Methods, I place little value in the dividend yield ratio. First, dividends that are taxed as ordinary income are less advantageous compared to capital gains, especially if the investment is held in a taxable account. Second, if a company pays a hefty dividends to shareholders, it means that to grow its operations it will either (1) dilute current shareholder holdings by issuing more stock or (2) will use more leverage. And either (1) or (2) are not ideal.

Current assets to current liabilities ratio

Current assets are cash held by the REIT and receivable net of loss allowance. These exclude the value of the real estate investments and any intangibles, such as goodwill. Current liabilities include accounts that are payable in less than 1 year and any revolving lines of credit that renew every 12 months. SRG and PEI showed a higher positive net asset balance, while WPG and BFS showed a deficit account.

Financial theory states that if the working balance account (the difference between current assets and current liabilities) is positive, then the REIT can quickly pay all its outstanding debt and continue to operate, while a REIT that shows a negative account will surely cease it operations. But financial reality is that these ratios, in today’s capital market, are practically meaningless. REITs’ business does not erupt in 12 months, and there are ample numbers of places to borrow short-term funds. But, nostalgic as I am, I still like to quickly glance over this ratio.

Price Record

It takes little detective work to understand that the retail REITs, which specialize in shopping malls, are unfavored by capital markets nowadays. In the last month of 2018, all stocks are trading at the lower end. And this is a continuing trend. SRG traded between $40 to $49 in 2017, and now trades from $35. WPG traded between $7 to $10 in 2017, and now trades for $6. And BFS traded between $57 and $66 in 2017, and now trades for $52.

For any Amazon Prime member, the reason for the gloominess is apparent. The need to visit shopping malls has declined. And the traditional business model of commerce continues to be challenged by the behemoth e-commence website that now represents 50% of e-commerce sales and 5% of the overall U.S. retail market.

Disclaimer

First, I have been a shareholder of Seritage Growth Properties since June 2018, and on December 2018 I bought more shares of the retail REIT. I bought 500 shares in December, costing me roughly $18,000, and I will likely purchase more in 2019.

While I tried to describe the financial condition of Seritage from an objective perspective, not different from loving someone in life, where we often don’t see their bad parts, I may have missed out on significant risk factors.  

To state the obvious, my goal in writing this guide to REITs is not to entice you to buy shares in Seritage (nor in any other REIT, for that matter), but to share with you the depth of analysis and understanding required to buy REIT stocks. I also highlighted a few of the key financial items I look for prior to considering a REIT.

Buying a share in a company is the easy part. It is much more difficult to hold the stock when the rest of the market thinks differently of you. And it is even more difficult to admit that the initial hypothesis - in the case of Seritage, that future revenue will be four times higher - may be utterly wrong.

I would also like to tell you how I first learned about Seritage Growth Properties. In 2016, I read the annual letter that Bruce Berkowitz, the notable value investor, wrote to his shareholders. In it, he discussed his regretful purchase of Sears Company and then described a recent purchase in a somewhat unknown REIT, especially for those outside of the REIT industry. The more I read about the company, the more I liked his investment thesis.

Coincidentally, across from where I work there is now a vacant property, formerly occupied by Sears, which is owned by Seritage. The 110,000 SF 4-story former Sears is situated in one of the nicest shopping malls in San Diego.

And it does not take a genius to realize that if you parcel out the building into smaller units, there is much value to be realized. And since the master lease with Sears Holdings was signed over a decade ago, it was obvious to me that Sears must be paying below market rents.

Two months ago, Benjamin Schall, boss of Seritage, wrote a letter to shareholders. Schall knew that investors were skittish due to Sears Holdings filing bankruptcy and were concerned about the future of Seritage as its operations are highly dependent Sears. In his words: 

“We wanted to reach out to you to emphasize that Seritage is well positioned to navigate Sears Holdings’ bankruptcy filings. Almost 70% of our income on a signed lease basis is from diversified, non-Sears tenants on long-term leases at newly developed centers or actively under redevelopment. We have nearly $1 billion of cash and committed capital on hand after our recently closed term loan facility.”