Formed at the initiative of Edward Lampert, the Sears chairman and chief shareholder pilloried by the press and his former partners alike over the failure of the iconic retailer, Seritage stands out as a fitting platform to redevelop a vast portfolio of prime but underexploited real estate assets.
The company popped on investors’ radar for a first time in 2015, when Warren Buffett privately bought shares on the open market; for a second time earlier this year, when Sharon Osberg, Mr. Buffett’s long-standing bridge partner, joined the board after a $2 billion loan granted by Berkshire; and then for a third time not long ago, as woes surrounding Sears’ bankruptcy have escalated into a full-blown investigation on asset sales, spin-offs and other dealings orchestrated by Mr. Lampert during his tenure.
The investment thesis is here remarkably straightforward: as the retailer liquidates its money-losing brick and mortar operations, Seritage recaptures the stores; once redeveloped, commercial space formerly leased by Sears at $4 per square foot is re-leased at an average of $17 per square foot to a diversified group of retail and lifestyle tenants – a spectacular uplift that paves the way for splendid value creation over the next decade.
There would be plenty to comment about the projects already undertaken or completed but, to cut a long story short, from the get-go management has been incredibly successful in converting the timeworn properties into pristine venues. The good news is that the court-driven reorganization of Sears should accelerate the recapturing process; the bad news, of course, is that Seritage may lose a good chunk of its rental income (30%) while its main tenant winds down at forced march.
Short-term pain, long-term gain: here is the kind of trade-off that should naturally arouse the curiosity of placid investors who believe in patient capital and delayed gratification.
In effect, Seritage owns 248 properties, totaling 39 million square feet across the United States, of which 36.4 million belong to the company once subtracted the partners’ interests in 26 joint ventures. A good half of the annual base rent is sourced from the “best” states: California, Florida, New York, Illinois and Texas.
Running a graceless back-of-the-napkin valuation, we know the company still leases 12.4 million square feet to Sears; let’s assume things will get slow and ugly there, and count these for zero. That leaves 24 million square feet open to new tenants, of which 6 million have already been re-leased, while the remaining 18 million square feet sit idle or are undergoing redevelopment; the company has 88 projects completed or commenced, so transformation is well under way.
Should we capitalize the new average rent of $17 per square foot over ten years – a conservative yardstick in every respect – the value of total leasable space reaches $4.1 billion. Once subtracted the $1.7 billion in debt – preferred shares included – net asset value gets to $2.4 billion.
The company holds a 64% interest in the operating partnership, and Mr. Lampert’s hedge fund a 36% interest. Net asset value attributable to shareholders thus ends up at something like $1.5 billion, or roughly $41 per share for a current quote of $38, but we have counted the twelve million square feet leased to Sears for zero.
The margin of safety is substantial, for all this soon-to-be-vacated space seemingly comes as a free call option. Absent a nuclear winter on commercial real estate, the opportunity to prosper out of Sears’ demise appears startling, if not too good to be true.
The key issue, of course, boils down to securing the necessary funding to proceed. Recent examples have shown it costs about $200 per square foot to redevelop to modern standards: in this regard, the 18 million square feet refitted – or currently being refitted – would amount to at least $3.5 billion in capital spending, pretty much the capitalization of Seritage’s total debt and equity.
Once included the additional 12.4 million square feet occupied by Sears, the bill jumps to $6 billion for a complete refitting – admittedly no small change. Things could take an unpleasant turn if such funding failed to line up, but with $1 billion at hand, modest leverage and ample latitude to monetize individual assets or some of its stakes in the joint ventures, Seritage seems adequately geared to withstand the downfall of its largest – albeit fast-diminishing – tenant, and redevelop profitably.
It may take time indeed, but isn’t the big money made in the waiting, rather than in the buying or the selling?
(Long SRG at an average price of $38 a share.)