SERITAGE GROWTH PROPERTIES SRG
February 09, 2016 - 11:12am EST by
Woodrow
2016 2017
Price: 38.73 EPS 0 0
Shares Out. (in M): 56 P/E 0 0
Market Cap (in $M): 2,153 P/FCF 0 0
Net Debt (in $M): 1,039 EBIT 0 0
TEV ($): 3,193 TEV/EBIT 0 0

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  • REIT
  • Warren Buffett Personal Account

Description

Thecafe provided a nice synopsis of  SRG in August, but I felt like this would be a good time for a more detailed update as more information on SRG has become available over the ensuing months. I apologize in advance if there is any duplication in the two write-ups, but I wanted my write-up to stand on its own.

 

Introduction

 

We believe Seritage Growth Properties (SRG) (“Seritage”) represents a compelling risk-reward that has been overlooked by the investment community.  Seritage was created in July 2015 through a spin-off from Sears Holdings (SHLD) (“Sears”) and a concurrent rights offering.  The Company’s assets consist of a selected group of 266 properties, the vast majority of which have been leased back to SHLD subject to a master lease at substantially below-market rents.  SRG’s objective is to re-develop this real estate and lease a majority of it to unrelated third-party tenants at materially higher rents, creating significant shareholder value.

 

The SRG opportunity exists because the Company is a recent spin-off with a lack of sell-side coverage and a weak initial investor relations effort.  SRG is also an “ick investment” that many investors have passed upon without serious diligence because they have soured on Eddie Lampert and SHLD.  We believe that this has created an opportunity to buy outstanding real estate assets at a reasonable price based on current earnings, when future earnings power will be materially higher.

 

Currently, 93% of Seritage’s square footage is leased to Sears Holdings at an average rent of $4.31 per square foot.  Over time, we believe that SRG will lease over 70% of the square footage to third-party tenants who will pay rents averaging closer to $18.00 per square foot.  We believe that this process will result in meaningful value creation for SRG shareholders, while simultaneously benefitting SHLD by providing a needed upfront cash infusion and rationalizing its store footprint to better suit SHLD’s current needs.  Meanwhile, as SRG leases SHLD space to third-party tenants, the share of rent paid by Sears should decline to around 10% of the total rent roll.

 

We believe that we are buying Seritage at a C Mall valuation, but the Company’s real estate is more reflective of an A Mall.  This hidden value inherent in Seritage’s real estate should become apparent through: 1) monetization of real estate in joint ventures (“JVs”) with A Mall REITs (Real Estate Investment Trusts); 2) rapid leasing of its portfolio of Sears Auto Centers at significantly higher rates of return; 3) generation of attractive returns on its standard re-developments due to strong retailer demand; and 4) receiving entitlements or partnering with non-retail real estate developers for longer-term projects to monetize SRG’s land.  While investors may currently be shying away from SRG with the view that it requires too long-term a perspective for the current market environment, we have identified strong 2016 catalysts, such as value creation in the JV assets and the releasing of the auto centers.  This will unlock value in SRG shares at a much faster pace than most realize.  Based on our analysis, SRG is worth $117.86 to $144.28 per share over time, representing 202% to 270% upside, as the Company executes on these opportunities.

 

High Quality Real Estate

 

We believe that misplaced focus on Seritage’s main tenant, Sears, has distracted investors from the fact that SRG owns a portfolio of extremely valuable real estate.  As investors understand the quality of the Company’s real estate, the Company’s valuation multiple should improve.  In a world where retailers face challenges from sluggish economic growth and e-commerce, REIT investors have narrowed their focus to property owners with high quality real estate.  The result of this shift is an extreme divergence of capitalization rates (“cap rates”) between A quality retail real estate where net operating income is growing and B quality retail real estate with the potential for shrinking income.  To this point, the top 50% of mall REITs in our comparable company table trade at an implied cap rate of 5.1% and the bottom half trade at a cap rate of 8.4%.  Similarly, the top half of shopping center REITs in our comparable company table trade at a 5.5% cap rate and the bottom half trade at a cap rate of 7.1%.

 

Moreover, there are signs that private real estate investors believe that the entire public retail REIT market is undervalued as several publicly traded REITs have recently been acquired.  Over the last six months, Blackstone acquired two portfolios of retail real estate from publicly traded REITs Prologis (PLD) and RioCan Real Estate Investment Trust (REI-U CN).  In December 2015, DRA Advisors acquired shopping center REIT Inland Real Estate (IRC), and in January, Brookfield Asset Management (BAM) announced an offer for Rouse Properties (RSE).

 

Despite investor interest, retail real estate still faces headwinds in the form of retailer bankruptcies and store closures from weaker retailers like Aeropostale (ARO), Chico’s (CHS), The Gap (GPS), and Pacific Sunwear of California (PSUN).  However, the demand for A retail real estate still exceeds supply, allowing for continued growth in rents and re-tenanting of underperforming retailers.  Fortunately, SRG’s portfolio consists primarily of high quality A real estate that it self-selected from a larger portfolio of Sears and K-Mart stores.  Since SRG plays a significant role in the value that SHLD investors will ultimately realize, we believe that the Company cherry-picked the better locations (39% of SHLD’s owned stores) from the broader portfolio.  Moreover, SRG has the opportunity to shape its portfolio based on what retailers want today, allowing it to avoid the underperforming retail tenants that plague its peers.

 

SRG’s real estate is extremely well-located.  When analyzing retail real estate, investors generally look for real estate in densely populated areas where the residents have high levels of disposable income.  SRG’s portfolio scores extremely well on both of these metrics.  According to data from Credit Suisse, Seritage’s average 10-mile population density is 694,000 and the average household income in these areas is $77,000.  This demographic profile is actually slightly better than that of A Mall portfolios like General Growth Properties (GGP), and just slightly worse than Simon Property Group (SPG).  GGP and SPG are both considered to be best-in-class mall REITs and trade for implied cap rates of 5.5% and 5.1%, respectively.

 

Retail real estate investors should be very familiar with the quality of SRG’s portfolio based on their investments in other publicly traded REITs, as 43% of SRG’s leasable square footage is in centers owned by publicly traded REITs.  SRG’s overlap tends to reside much more in high quality REIT portfolios than in those that own B Malls.  To demonstrate this point, we have done an implied cap rate analysis of the publicly traded malls in which SRG’s properties reside weighted by the number of properties that overlap.  Based on this analysis, SRG’s properties reside in REITs that trade at a weighted average cap rate of 5.7%, further demonstrating the quality of the portfolio.

 

Finally, SRG’s portfolio is attractive from a geographic footprint.  The Company derives 21% of its rental income on the wholly-owned portfolio from California, and the top five states (California, Florida, New York, Texas, and Illinois) represent 47% of rental income.  These states represent some of the more attractive areas for retail retailers, and SRG’s properties are clustered around major cities in these states.  Conversely, only 6% of the Company’s annual rental income comes from states in the bottom 20% of household income.  

 

As SRG begins to sign leases with national retailers at high rents and attractive rates of return, we believe that the market will recognize that SRG deserves a cap rate in line with the higher quality malls and shopping centers, not the lower quality ones.  While we believe that SRG will ultimately trade closer to the 5.1% cap rate at which the high quality mall peers trade, we have conservatively used a 5.7% cap rate to reflect the average cap rate of REITs where it has overlap.  We believe that SRG has an opportunity to deploy significant capital at a blended rate of return of at least 15%.  The wide gap in the rate of return that SRG can achieve on its investments and the cap rate at which it should trade will create substantial value for shareholders, as every dollar of capital deployed is worth 2.6x its original investment.  However, despite a value creation opportunity unparalleled in REITs, SRG shares do not even trade at a 5.7% cap rate on its current earnings level.  If the shares were to simply trade at this baseline level as opposed to their current 6.1% cap rate, they should appreciate by $4.15 per share or 11%.  Longer-term, we see the potential for the shares to triple as the Company executes on its redevelopment initiatives.

 

Warren Buffett Halo

 

With no sell-side coverage and a weak investor relations effort, SRG epitomized the definition of “under-the-radar” after its spin-off from Sears.  Few paid attention or conducted the significant amount of diligence necessary to understand the future SRG opportunity.  While many investors overlooked SRG, Warren Buffet did not and established a 2 million share position in December 2015.  We believe the Seritage opportunity is eerily similar to one of Buffett’s other successful real estate investments that he recently referenced in an annual letter. 

 

In his 2013 Annual Letter, Warren Buffett highlighted some investing lessons he has learned over the course of his career.  In this letter he used two illustrative examples, one of which was a commercial real estate property that he purchased in 1993.  This property was located near New York University (“NYU”) and was providing an unlevered yield of 10%, which was approximately 4% higher than the 10-year treasury yield at the time.  The largest tenant in the building occupied 20% of the space and paid rent of around $5.00 per square foot for nine more years, while other tenants averaged $70.00 per square foot.  Buffett stressed that the superb location, attractive yield, and obvious opportunity for future earnings growth made this investment the type of low-risk, high-return opportunity that investors should endeavor to uncover in the stock market.  In the first six years, Buffett was able to extract 150% of his initial investment in special dividends, and the property currently yields 35% on his original investment.  Buffett expects this property to be a “satisfactory [holding] for [his] lifetime and, subsequently, for [his] children and grandchildren.”

 

While we expect our investment in SRG to yield returns in a much shorter timeframe than Buffett’s NYU property, we agree with his sentiments on buying under-earning real estate at fair valuations based on its current earnings power.  In fact, SRG is valued much like Buffett’s NYU property with a current cap rate of 6.1%, essentially 400 basis points above the 10-year treasury yield.

 

However, one advantage that SRG has over Buffett’s previous real estate purchase is that it has the potential to be what he calls a “compounding machine.”  SRG has an opportunity to invest a large amount of capital at a high un-levered rate of return and the ability to finance that investment internally without diluting future shareholders.  SRG will generate substantial cash flows from its long-term leases.  It will have access to substantially more debt financing as its stable cash flows grow and will have opportunities to sell stabilized assets at attractive valuation levels with minimal tax leakage.  As SRG generates additional capital, it can reinvest at unlevered rates of return ranging from 12% to 22%.  We are optimistic that these traits will lead to even better returns for Buffett and other SRG investors. 

 

Master Lease Structure

 

In order to understand the Seritage opportunity, it is important to understand the Company’s master lease with SHLD.  This lease has a number of provisions that are extremely favorable for SRG, but poorly understood by the equity markets.  In the master lease, SRG’s properties are broken into four groups: Type I, Type II, Type III, and JV properties.  76% of the properties are Type II properties where SHLD is the primary tenant and SRG has the opportunity to recapture 50% of the available space from SHLD.  Conversely, there are 11 Type III properties, 4% of the total, where SHLD is no longer a tenant at the property.  Next, there are 21 Type I properties, 8% of the total, where SRG has the opportunity to recapture 100% of the available space.  These properties have the potential for a complete transformation.  There are 31 properties, or 12%, in JVs with GGP, The Macerich Company (MAC), and SPG where SRG controls 50% of the economics and the leases are typically structured like Type II properties.  Finally, SRG has the opportunity to recapture 100% of the space at Sears Auto Centers.  There are 164 Sears Auto Centers which represent approximately 9% of the total square footage.  SRG is responsible for all costs to redevelop SHLD space when a lease is terminated with the exception of any legacy environmental liabilities or costs.

 

The current master lease requires SHLD to pay an average triple net rent of $4.31 per square foot with 2% annual escalators.  Moreover, starting one year after the date of the spin, SHLD is permitted to terminate leases on unprofitable properties subject to a limitation of 20% annually.  If SHLD terminates its lease, it owes SRG one year’s rent as a termination fee.  As of April 30, 2015, 59 properties, or 22% of the total, are unprofitable and thus eligible to be terminated by SHLD in July 2016.  This structure provides SRG with a two-year window to re-lease these properties.  Finally, SRG owns all the land for its 266 properties, which averages 13 acres per site.  Therefore, Seritage has the opportunity to develop any vacant land or parking areas where it is currently receiving no rent from SHLD.

 

Joint Venture Opportunity

 

While the market may be skeptical about the quality of SRG’s real estate, purchasing patterns of the top mall owners suggest otherwise.  Before SRG was spun-off from SHLD, the Company entered into joint ventures with three A Mall REITs: GGP, MAC, and SPG.  These JVs were struck at implied values that are much higher than the price at which the market is valuing the rest of SRG’s real estate.  Recent commentary from SRG’s JV partners suggests that these investments are performing so well that we expect the Company’s success in its current JVs to spur other JVs in the near future.

 

These JVs highlight the value of SRG’s real estate and provide an opportunity for SRG to monetize that real estate value at far greater valuations, providing capital for future investment.  This should be an excellent proof of concept for SRG’s business model and allow SRG to pull forward some of the returns we expect in the future, resulting in potential value creation of between $27.19 and $35.26 per share, or 70% to 90% of the current share price.

 

While the JVs have the same structure as the rest of SRG’s properties according to the master lease, they were valued at higher levels and extracted higher rent levels for SRG from the onset.  The JV properties were valued at $27.7 million per property and $157.84 per square foot.  However, the market is valuing the non-JV properties at $11.8 million per property or $75.80 per square foot.  We believe that these premium valuations imbedded in the JVs provide a strong validation of the value proposition implicit in SRG shares.  Sophisticated REIT investors are paying 2.3 times more per property, and 2.1 times more per square foot than the value that the equity markets are ascribing to the remaining properties.  The JV investments are also valued at a substantial premium to the rest of the portfolio, at a 5.3% cap rate, despite the fact that they are projected to yield lower returns of 7-8%. 

 

Most importantly, SRG’s JV partners have been universally positive about the progress they have made around leasing up these properties.  On its Q3 2015 call, GGP stated that “the lease up [of Seritage stores] has been incredibly strong.  And we’re in entitlement to start to redevelop those assets.  And we hope that we can continue the process an additional …13 or 14 GGP Sears in the Seritage portfolio … So our hope is to be able to go back some time in 2016 to take down the next tranche of Sears’ assets that exist today within the Seritage portfolio.” GGP indicated on its Q4 call, that it anticipates half of the SRG stores will be in process in 2016 with the remainder in 2017.

 

SPG echoed that sentiment, saying “our progress is excellent with the Sears boxes at Seritage.”  In fact, they believe that demand is not a hurdle for redeveloping Seritage stores.  Instead, “the big unknown is how fast the Seritage things happen.  It's a joint venture, so, it's not just a question of how fast we can go, but also how fast Seritage can go and how fast Sears can go, which is clearly, we're trying to influence, but we don't have complete control on that. But we certainly have a lot on the drawing board to do there.” SPG reiterated its confidence on the Q4 earnings call, indicating that half of the SRG JV boxes would be in development during 2016 with tenants already secured and pro forma analyses completed.

 

MAC also has big plans for the SRG assets in its JVs, having already announced two Primark stores.  On the Q2 2015 call, they stated the following: “We're very pleased to have the opportunity to redevelop it and reposition those nine assets, and we anticipate over the next 60 days to 90 days that we'll be in a position to make more concrete announcements about what's happening within the Sears portfolio with us and the rationalization, but very happy with where we sit there.  And in particular, we could be seeing some pretty significant reconfigurations and re-merchandising and developments available to us at Cerritos and Washington Square, in particular both great centers, and centers where we have the ability to recapture over 200,000 square feet from Sears, and each of them Sears controls a 20-acre parcel of land that we are looking at various ideas for various expansions.” On its Q4 earnings call, MAC was less explicit about its timetable. We believe that this is due to the fact that MAC has fewer SRG boxes outside the JVs and is looking to maximize the potential of its existing JV assets rather than expedite their redevelopment.

 

What is most interesting about the SRG JVs is that SRG has an option to sell its 50% share of the JV back to mall owners in early 2018 at appraised value.  Therefore, we believe that SRG will make it a priority to complete the redevelopment of its JV assets over the course of 2016 and 2017.  Since the JV partners have all stated that demand for SRG locations is extremely strong, we believe that this timeline is realistic.  Moreover, when a SHLD store converts to a store that resonates with the modern consumer, there is a strong halo effect for the surrounding mall space.  In fact, GGP cited an example of a SHLD store that converted to a Nordstrom (JWN) store, which resulted in the entire mall enjoying a $200.00 per square foot boost in sales productivity.

 

We believe that the market is missing the magnitude of the value creation from SRG’s ability to redevelop its JV assets and sell the real estate back to its JV partners.  GGP has provided a number of data points that allow us to extrapolate the cost for these JVs to redevelop the SRG assets and the expected returns.  Based on this information, we have estimated that these JVs can ultimately generate NOI of between $81 and $101 million with a total incremental investment of between $299 and $408 million.

 

In Q2 2018, SRG will have the opportunity to sell its JV equity back to its partners for fair market value as determined by an appraisal.  We believe that leased space in Class A regional malls has been trading at a cap rate under 5.0% based on recent transactions.  Therefore, we have used a 5.0% cap rate for our valuation analysis.  This suggests a value of $734 million or $13.21 per share, net of SRG’s share of the redevelopment cost, more than double the value that the public markets are ascribing to these assets.  When SRG ultimately sells its 50% stake in these JVs back to its partners, we believe that they will add value of between $7.87 and $11.51 per share, or 20% to 30% of the current share price.    

 

While the market is clearly undervaluing the current JVs that SRG has struck with its partners, the future JV value is even more obscured.  GGP has suggested that it will explore a joint venture for the remainder of the SRG properties in its portfolio this year.  While one might assume that SRG and its JV partners cherry-picked the best assets for the initial JVs, we do not believe that this is the case.  Some of SRG’s best Type I properties located in California and Florida are currently located in GGP, MAC, and SPG malls.  These assets comprise 16% of future JV eligible square footage.  The original JVs valued SRG space at $158.00 per square foot.  If we apply this value to the future JV eligible assets, SRG’s share of future JVs would initially be $616 million or $11.08 per share, a value that is just over double the value implied by SRG’s current share price.  As SRG enters into future JVs, we believe that the Company has the opportunity to add value of $5.76 per share, or 15% of the current share price.

 

Longer term, SRG and its partners will create significant value by redeveloping these future JVs, and monetizing them by selling its remaining 50% share back to its partners for fair market value.  We calculate a long-term value of between $243.00 and $297.00 per square foot for future JVs, net of the additional capital SRG and its partners will invest in these assets.  Since SRG is currently trading at an implied value of $75.80 per square foot, the value created by the sale of future JV assets will be significant.  We estimate that this could be worth somewhere between $13.56 and $17.98 per share, or between 35% and 46% of the current share price. 

 

Finally, SRG has the opportunity to create joint ventures with other publicly traded companies in its portfolio.  For example, SRG has seven properties in Westfield (WFD AU) malls that could create substantial value in a JV format.  However, we have not included other potential JVs with mall owners outside of GGP, MAC, and SGP in our analysis.

 

Over time, as SRG begins to cash out of its JVs, this will create substantial liquidity for SRG and provide valuable capital to reinvest in its other properties.  Since SRG is able to sell its share in JVs at fair market value as determined by an appraiser, this is a much better method of generating cash than selling equity at an undervalued share price.

 

We believe SRG has the potential to create substantial short and long term value from JVs with other mall REITs.  In total this value creation could be worth between $27.19 and $35.26 per share, or 70% to 90% of the current share price.  As SRG executes on quickly redeveloping its current JVs and entering into future JVs, we believe that this value creation opportunity will become increasingly apparent to investors.

 

Sears Auto Center Opportunity

  

One of the most attractive and near-term opportunities for SRG is its ability to convert 100% of the current Sears Auto Center square footage into high value smaller retail space.  We believe that SRG’s leasing activity over the next twelve months will give investors a taste of the potential returns SRG can earn on its redevelopment plans.  Currently, SRG owns 164 properties with auto centers encompassing 3.6 million square feet of space.  More importantly, 89 of these auto centers, or 54%, are freestanding.  These freestanding auto centers are typically located in the out-lots of the mall or shopping center, high-traffic areas with great visibility and accessibility from the street.  Since most high quality malls and shopping centers are located in the most highly trafficked areas of their respective community, these locations have become extremely attractive for banks, fast casual restaurants such as Chipotle Mexican Grill (CMG) and Starbucks (SBUX), sit down restaurants, wireless retailers, and other fast growth concepts like Orvis and Jared.  In fact, one of our due diligence contacts called this aspect of SRG’s plan “free money” in the current environment.

 

This small shop space provides the opportunity to charge rents significantly higher than SRG will receive on its other real estate even though it currently receives the same $4.31 per square foot average rent as the rest of the portfolio.  While the capital costs for small shops may be higher, the higher rents will more than compensate, leading to materially higher returns.  In fact, in a recent presentation, SRG highlights a redevelopment of an auto center in Carson, California.  In this instance, SRG’s auto center was transformed into a mini mall with an Applebee’s, Smashburger, Jersey Mike’s, and Chick-fil-A across the street.  Consequently, SRG realized rents per square foot greater than $45.00 with lease terms of over ten years.  Based on conversations with industry experts, we estimate that a redevelopment of this type would have cost approximately $150.00 per square foot.  This yields a return of around 27%, above and beyond the rent SRG was achieving from SHLD.

 

With fast growth national retailers looking to secure high quality real estate, we believe that SRG will be able to turn over much of the auto center square footage in an expedited time frame.  Once the Company has example leases with these national retailers, we believe that SRG can negotiate multi-location deals.  Therefore, we would not be surprised if SRG can complete redevelopment of 70% of its auto centers within the next three to four years.  The other 30% will likely share a return profile in line with traditional redevelopments since they are part of the Sears box. 

 

While Seritage will not be able achieve high 20% returns on all deals, we believe that returns of 18-20% are readily available, given the quality of the real estate and the tenant demand.  Moreover, we estimate that SRG can add 10% square footage to the auto center footprint.  This would essentially add another restaurant box in one out of every four centers.  At a redevelopment cost of $150.00 per square foot, this implies a rent level of between $31.00 and $37.00 per square foot, well below the $45.00 per square foot that SRG has already achieved in its current redevelopments.  This opportunity alone provides the potential for $16.14 to $21.39 of upside for the shares, or 41-55%.  As investors understand the economics and timetable of this opportunity, we believe the value will begin to be reflected in the shares.

    

Core Portfolio Opportunity 

 

While SRG’s opportunity to redevelop its auto centers and JV assets have the potential to yield the highest returns in the shortest timeframe, most REITs would love the opportunity to redevelop high quality real estate at a 12% unlevered return or better.  Based on SRG’s current valuation, the market is clearly skeptical about the potential for 12% returns on SRG’s redevelopment.  We believe that this skepticism is based upon a poor understanding of SHLD’s business and the SRG master lease.  Over the next several quarters, as SRG begins to execute on its plan, sign leases and disclose the rates of return it is earning, we believe that investors will understand the long-term potential and the shares will appreciate materially.

 

One advantage of the SRG master lease is that while SHLD pays an average rent of $4.31 per square foot, different properties pay different rents based on the quality of the real estate.  For example, rents in California average $5.58 per square foot while rents in Alabama, Arkansas, and Mississippi average $2.96 per square foot.  Everything else being equal, SRG can achieve the same returns with rents that are $2.62 per square foot, or 19% lower, in poor southern states as in California.  However, everything else is not equal, as SRG is likely to spend less capital in order to lease its properties in lower rent states.  Also, SRG’s returns in higher rent states may subsidize returns in lower rent states in order to achieve its blended return targets.  For example, if we assume that SRG has equal square footage in properties that pay rents of $5.60 per square foot in rent and $3.00 per square foot in rent, its average rent per square foot is $4.30.  If we assume SRG spends $100.00 per square foot to develop the better space at a 13% return and $60.00 per square foot to develop the lower quality space at a 10% return, then the blended return is 12%.  This implies that SRG would need to achieve rent levels of $18.80 per square foot in its better real estate and $9.00 per square foot in its worse real estate.  We have talked extensively with contacts in the real estate world, and we believe these investment and rent expectations are quite reasonable.  In fact, SRG has achieved rent levels above $18.00 per square foot in Virginia Beach, VA and Thousand Oaks, CA.  Our contacts have labeled these locations as good, but not great, so they are hardly outliers.  In better markets like the King of Prussia Mall, SRG’s rents have topped $25.00 per square foot. 

 

Another interesting element of the master lease that investors do not comprehend is that Sears often achieves higher sales per square foot in lower quality real estate in Middle America as compared to high quality real estate in coastal markets.  SHLD has done a poor job attracting middle to high income consumers and thrives with low to middle income consumers who find their product offering more attractive.  According to the master lease, SHLD is able to exit 100% of its space in stores where it is unprofitable with a one year rent termination payment.  Therefore, we believe that SHLD will be more likely to exit stores with better real estate.  In these stores, SHLD pays higher rents per foot and employee wages are higher, but SHLD achieves similar or worse sales per square foot.  This suggests that SRG will redevelop a higher percentage of its better real estate at higher capital costs and returns.  This space will also be redeveloped sooner, as SHLD may force SRG to take this space back.  This dynamic further lowers the bar for returns and rent levels that SRG needs to achieve in its lower quality real estate.

 

Generally, secular trends in retail are moving in SRG’s favor as the retailers that currently have the most aggressive store growth plans are discount and junior anchor retailers, as well as movie theaters and fast casual restaurants.  In its typical Type II property, SRG has approximately 79,000 square feet per store to lease.  This works well as these retailers prefer larger footprint spaces that are ideal for SRG’s redevelopment plans.  SRG has already had success leasing its real estate to discount retailers like Forever 21, Nordstrom Rack, and Primark.  Since these discount retailers typically prefer footprints of 35,000-45,000 square feet, they can serve as an anchor tenant in SRG’s redevelopment project occupying 45-55% of the average square footage.  On the junior anchor side, SRG has signed leases with growing retailers like Dick’s Sporting Goods (DKS), DSW (DSW), The Fresh Market (TFM), REI, and Williams-Sonoma (WSM).  These retailers prefer spaces with 15,000-30,000 square feet, or 19-38% of the average property, which blends well with some of the larger size tenants.  Based on our channel checks, we believe that SRG can spend $75.00-$100.00 per square foot and achieve rent levels averaging $13.00-$18.00 per square foot for these tenants.  This yields a return of approximately 13% net of the average rent that SRG is receiving from SHLD.

 

In lower-end centers, SRG can cater to retailers like Burlington Stores (BURL) or Hobby Lobby.  These retailers like large footprints and can often absorb a full 80,000 square foot box.  Based on our channel checks, these retailers may only pay $8.00-$9.00 per square foot in rent, but they would typically be replacing a SHLD store paying closer to $3.00 per square foot and would require capital costs closer to $50.00 per square foot.  This yields a return closer to 11% net of SHLD rent and will be a substantially smaller piece of the capital committed by SRG.  However, these lower returns should be more than offset by higher returns in better real estate.

 

SRG can round out its redevelopment with growing fast casual restaurants like Bravo Brio Restaurant Group (BBRG), The Cheesecake Factory (CAKE), Outback Steakhouse, or Texas Roadhouse (TXRH).  These tenants prefer a footprint of around 6,000 square feet, or around 8% of the property.  Finally, movie theaters have also been making a push to expand in high quality malls and strip centers.  Larger movie theaters can occupy footprints of around 20,000 square feet.  Mall-based movie theaters and restaurants require substantially higher development costs per square foot but can compensate with higher rent per square foot.  Based on our channel checks, we believe that SRG can pay $150.00 to $200.00 per square foot and achieve rents of $25.00-$30.00 per square foot. This also yields a return of approximately 13%, net of the average rent that SHLD is currently paying.

 

Many of these restaurants and retailers also provide a good fit for freestanding units that allow SRG to create an open air mall within a mall.  This configuration allows SRG to maximize its excess real estate which averages 13 acres per site.  Since many SHLD stores were built in the 1960’s and 1970’s when malls required higher ratios of parking spots to retail space, SRG’s portfolio is generally over-parked which makes projects to add density feasible.  While new buildings require higher capital costs per square foot, SRG is currently receiving no rent on its excess land.  In its better centers, SRG can meet its 12% return threshold and still spend $47.00 per square foot more for new space since it will not be forgoing SHLD rents of $5.58 per square foot.  Based on our channel checks, we believe that SRG could build out a 20,000 square foot pod for several fast casual restaurants for $250.00 per square foot and achieve rents of $30.00-$45.00 per square foot.  This would yield an average return of 15% for SRG to compensate for the greater risk of a new building.

 

We believe that SRG can create significant shareholder value through redevelopment of its Type II properties at a return level over two times the cap rate at which we expect SRG to trade.  On average, we believe that SRG can redevelop its existing Type II and related real estate at a yield of 12-14% and a cost per square foot of $90.00.  We believe that these estimates are reasonable as they imply rent levels of between $15.00 and $17.00 per square foot, below the $18.00 per square foot that SRG has achieved in its early redevelopments.

 

Based on our calculations, we believe that SRG will have the opportunity to redevelop 12.3 million square feet of real estate.  This square footage estimate excludes the detached auto centers and JV properties discussed earlier, but includes real estate that we expect SHLD to give back and densification projects.  In total, this would cost SRG $1.1 billion, but would have the potential to add between $133 and $155 million of net operating income.   At the 5.7% cap rate at which we expect SRG to trade, this would create shareholder value of $22.07 to $29.08 per share, or between 57% and 75%.  Moreover, when combined with other initiatives, it could reduce SHLD’s percentage of the rent paid from 78% today to approximately 10% over time.

 

Major Redevelopment Opportunity

 

In the near-term, SRG has an opportunity to create meaningful shareholder value from its core strategy of re-leasing its below-market rent Sears’ stores to retailers who will pay market rents.  However, on a longer-term basis, SRG has a tremendous opportunity to create additional value through converting its most valuable real estate into large multi-use developments.  These projects could include luxury rental apartments, hotel and office complexes, or even condo development.  Most of these opportunities would be part of the Company’s Type I real estate portfolio.  The Company has several large plots of land with SHLD stores in areas that would interest any large real estate developer.  This inventory of potential mega-projects includes the following high profile locations: 30 acres in Hicksville, NY; 12 acres in the Aventura Mall in Miami, FL; 13 acres in the Southland Mall in Miami, FL; 19 acres in Town Center at Boca Raton, FL; 18 acres in the Orlando Fashion Square Mall; 22 acres in the Inland Center in San Bernadino, CA; 3 acres in Santa Monica, CA; and 14 acres in the Westminster Mall in Westminster, CA. This is just a sampling of over 20 pieces of irreplaceable real estate across the portfolio.

 

The first project that SRG has proposed is called “Esplanade” at Aventura in Miami.  SRG envisions an open air village including 250,000 square feet of retail and restaurants, 45,000 square feet of office space, a hotel, and a large parking structure.  This project is currently years from completion as it is in the entitlement phase. SRG will likely execute its plan on Esplanade through a partnership with a developer with expertise in the non-retail product types.  Other potential projects could include condo or apartment development in California.  As millennials have shown a preference to live closer to major metropolitan areas, the demand for high-end residential properties has exploded.  Based on our channel checks, a simple condo development on high quality real estate in California can be developed for $300.00-$400.00 per square foot depending on the finishes and could yield sale prices approaching $1,000.00 per square foot.

 

These opportunities are extremely difficult to quantify as partnership structures are uncertain and development will not begin in the near-term.  SRG will have to wade through entitlements with cities and other property owners in the area.  While we cannot put exact numbers on capital costs and returns, we expect higher capital costs per square foot and returns somewhere between the Type II properties and the auto centers.  It stands to reason that SRG will target higher returns on these projects as they are longer-term in nature, involve some of the Company’s best real estate, and are more complicated and riskier to execute.  We have estimated capital costs per square foot of $150.00-$200.00 per square foot and returns of 14-16%.  This should result in value creation of between $9.31 and $15.40 per share, or 24 to 40%.

 

While investors currently view the value created by these projects as beyond their investable horizon, they demonstrate that SRG will still have an opportunity to create shareholder value for years to come.  Indeed, one investment blogger dismissed the Seritage opportunity, saying “land is a rich man’s game.” However, as the development phase of these projects approaches, the market may be quicker to ascribe value to these projects than investors currently envision.

 

The Howard Hughes Corporation (HHC) spun out of GGP in November 2010 with an inventory of land for longer-term development projects.  At first, many investors dismissed it as too long-term.  However, HHC’s shares more than quadrupled over the ensuing four years.  HHC shares have generated a compounded annual return of 20% since the spin-off, a rate of return of over two times that of the Russell 2000 Index.  Unlike HHC, SRG presents a nice balance between near-term and longer-term opportunities to create value.

 

Conclusion

 

In summary, we believe that SRG’s stock has the potential to be worth $117.86 to $144.28 over time, representing between 202% and 270% upside to the current share price.  While it may take years for SRG to achieve these valuation levels, the annualized returns from the current share price should still be substantial.  If SRG takes five years to achieve the mid-point of our price target, the compounded annual total return will be approximately 30%.  Moreover, we believe that SRG has the opportunity to front-load returns for shareholders by focusing on its highest return opportunities first, including JVs, auto center redevelopments, and redevelopments of its higher quality Type II properties.  As investors digest the value creation from these projects, we believe that the shares will trade materially higher.

 

In this instance, we are obviously monitoring Sears Holdings and its cash burn and monetization opportunities.  We do not believe that Sears is likely to declare bankruptcy in the near future, putting the master lease structure at risk, and are comfortable that there is no fraudulent conveyance risk.  Over time, the SHLD risk should dissipate.  As SRG executes on this meaningful opportunity, it will only generate approximately 10% of its rent from Sears Holdings in the future.  

 

Important Disclaimers:

 

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control.  Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete.  We undertake no responsibility or obligation to revise or update such Statements. 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

1) Increased evidence of the pace of leasing of Autocenters and well-located Type II properties

2) Sucess at leasing and ultimately monetizing the JV portfolio

3) Sell-side coverage and better disclosures that make returns and opportunity more clear

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    Description

    Thecafe provided a nice synopsis of  SRG in August, but I felt like this would be a good time for a more detailed update as more information on SRG has become available over the ensuing months. I apologize in advance if there is any duplication in the two write-ups, but I wanted my write-up to stand on its own.

     

    Introduction

     

    We believe Seritage Growth Properties (SRG) (“Seritage”) represents a compelling risk-reward that has been overlooked by the investment community.  Seritage was created in July 2015 through a spin-off from Sears Holdings (SHLD) (“Sears”) and a concurrent rights offering.  The Company’s assets consist of a selected group of 266 properties, the vast majority of which have been leased back to SHLD subject to a master lease at substantially below-market rents.  SRG’s objective is to re-develop this real estate and lease a majority of it to unrelated third-party tenants at materially higher rents, creating significant shareholder value.

     

    The SRG opportunity exists because the Company is a recent spin-off with a lack of sell-side coverage and a weak initial investor relations effort.  SRG is also an “ick investment” that many investors have passed upon without serious diligence because they have soured on Eddie Lampert and SHLD.  We believe that this has created an opportunity to buy outstanding real estate assets at a reasonable price based on current earnings, when future earnings power will be materially higher.

     

    Currently, 93% of Seritage’s square footage is leased to Sears Holdings at an average rent of $4.31 per square foot.  Over time, we believe that SRG will lease over 70% of the square footage to third-party tenants who will pay rents averaging closer to $18.00 per square foot.  We believe that this process will result in meaningful value creation for SRG shareholders, while simultaneously benefitting SHLD by providing a needed upfront cash infusion and rationalizing its store footprint to better suit SHLD’s current needs.  Meanwhile, as SRG leases SHLD space to third-party tenants, the share of rent paid by Sears should decline to around 10% of the total rent roll.

     

    We believe that we are buying Seritage at a C Mall valuation, but the Company’s real estate is more reflective of an A Mall.  This hidden value inherent in Seritage’s real estate should become apparent through: 1) monetization of real estate in joint ventures (“JVs”) with A Mall REITs (Real Estate Investment Trusts); 2) rapid leasing of its portfolio of Sears Auto Centers at significantly higher rates of return; 3) generation of attractive returns on its standard re-developments due to strong retailer demand; and 4) receiving entitlements or partnering with non-retail real estate developers for longer-term projects to monetize SRG’s land.  While investors may currently be shying away from SRG with the view that it requires too long-term a perspective for the current market environment, we have identified strong 2016 catalysts, such as value creation in the JV assets and the releasing of the auto centers.  This will unlock value in SRG shares at a much faster pace than most realize.  Based on our analysis, SRG is worth $117.86 to $144.28 per share over time, representing 202% to 270% upside, as the Company executes on these opportunities.

     

    High Quality Real Estate

     

    We believe that misplaced focus on Seritage’s main tenant, Sears, has distracted investors from the fact that SRG owns a portfolio of extremely valuable real estate.  As investors understand the quality of the Company’s real estate, the Company’s valuation multiple should improve.  In a world where retailers face challenges from sluggish economic growth and e-commerce, REIT investors have narrowed their focus to property owners with high quality real estate.  The result of this shift is an extreme divergence of capitalization rates (“cap rates”) between A quality retail real estate where net operating income is growing and B quality retail real estate with the potential for shrinking income.  To this point, the top 50% of mall REITs in our comparable company table trade at an implied cap rate of 5.1% and the bottom half trade at a cap rate of 8.4%.  Similarly, the top half of shopping center REITs in our comparable company table trade at a 5.5% cap rate and the bottom half trade at a cap rate of 7.1%.

     

    Moreover, there are signs that private real estate investors believe that the entire public retail REIT market is undervalued as several publicly traded REITs have recently been acquired.  Over the last six months, Blackstone acquired two portfolios of retail real estate from publicly traded REITs Prologis (PLD) and RioCan Real Estate Investment Trust (REI-U CN).  In December 2015, DRA Advisors acquired shopping center REIT Inland Real Estate (IRC), and in January, Brookfield Asset Management (BAM) announced an offer for Rouse Properties (RSE).

     

    Despite investor interest, retail real estate still faces headwinds in the form of retailer bankruptcies and store closures from weaker retailers like Aeropostale (ARO), Chico’s (CHS), The Gap (GPS), and Pacific Sunwear of California (PSUN).  However, the demand for A retail real estate still exceeds supply, allowing for continued growth in rents and re-tenanting of underperforming retailers.  Fortunately, SRG’s portfolio consists primarily of high quality A real estate that it self-selected from a larger portfolio of Sears and K-Mart stores.  Since SRG plays a significant role in the value that SHLD investors will ultimately realize, we believe that the Company cherry-picked the better locations (39% of SHLD’s owned stores) from the broader portfolio.  Moreover, SRG has the opportunity to shape its portfolio based on what retailers want today, allowing it to avoid the underperforming retail tenants that plague its peers.

     

    SRG’s real estate is extremely well-located.  When analyzing retail real estate, investors generally look for real estate in densely populated areas where the residents have high levels of disposable income.  SRG’s portfolio scores extremely well on both of these metrics.  According to data from Credit Suisse, Seritage’s average 10-mile population density is 694,000 and the average household income in these areas is $77,000.  This demographic profile is actually slightly better than that of A Mall portfolios like General Growth Properties (GGP), and just slightly worse than Simon Property Group (SPG).  GGP and SPG are both considered to be best-in-class mall REITs and trade for implied cap rates of 5.5% and 5.1%, respectively.

     

    Retail real estate investors should be very familiar with the quality of SRG’s portfolio based on their investments in other publicly traded REITs, as 43% of SRG’s leasable square footage is in centers owned by publicly traded REITs.  SRG’s overlap tends to reside much more in high quality REIT portfolios than in those that own B Malls.  To demonstrate this point, we have done an implied cap rate analysis of the publicly traded malls in which SRG’s properties reside weighted by the number of properties that overlap.  Based on this analysis, SRG’s properties reside in REITs that trade at a weighted average cap rate of 5.7%, further demonstrating the quality of the portfolio.

     

    Finally, SRG’s portfolio is attractive from a geographic footprint.  The Company derives 21% of its rental income on the wholly-owned portfolio from California, and the top five states (California, Florida, New York, Texas, and Illinois) represent 47% of rental income.  These states represent some of the more attractive areas for retail retailers, and SRG’s properties are clustered around major cities in these states.  Conversely, only 6% of the Company’s annual rental income comes from states in the bottom 20% of household income.  

     

    As SRG begins to sign leases with national retailers at high rents and attractive rates of return, we believe that the market will recognize that SRG deserves a cap rate in line with the higher quality malls and shopping centers, not the lower quality ones.  While we believe that SRG will ultimately trade closer to the 5.1% cap rate at which the high quality mall peers trade, we have conservatively used a 5.7% cap rate to reflect the average cap rate of REITs where it has overlap.  We believe that SRG has an opportunity to deploy significant capital at a blended rate of return of at least 15%.  The wide gap in the rate of return that SRG can achieve on its investments and the cap rate at which it should trade will create substantial value for shareholders, as every dollar of capital deployed is worth 2.6x its original investment.  However, despite a value creation opportunity unparalleled in REITs, SRG shares do not even trade at a 5.7% cap rate on its current earnings level.  If the shares were to simply trade at this baseline level as opposed to their current 6.1% cap rate, they should appreciate by $4.15 per share or 11%.  Longer-term, we see the potential for the shares to triple as the Company executes on its redevelopment initiatives.

     

    Warren Buffett Halo

     

    With no sell-side coverage and a weak investor relations effort, SRG epitomized the definition of “under-the-radar” after its spin-off from Sears.  Few paid attention or conducted the significant amount of diligence necessary to understand the future SRG opportunity.  While many investors overlooked SRG, Warren Buffet did not and established a 2 million share position in December 2015.  We believe the Seritage opportunity is eerily similar to one of Buffett’s other successful real estate investments that he recently referenced in an annual letter. 

     

    In his 2013 Annual Letter, Warren Buffett highlighted some investing lessons he has learned over the course of his career.  In this letter he used two illustrative examples, one of which was a commercial real estate property that he purchased in 1993.  This property was located near New York University (“NYU”) and was providing an unlevered yield of 10%, which was approximately 4% higher than the 10-year treasury yield at the time.  The largest tenant in the building occupied 20% of the space and paid rent of around $5.00 per square foot for nine more years, while other tenants averaged $70.00 per square foot.  Buffett stressed that the superb location, attractive yield, and obvious opportunity for future earnings growth made this investment the type of low-risk, high-return opportunity that investors should endeavor to uncover in the stock market.  In the first six years, Buffett was able to extract 150% of his initial investment in special dividends, and the property currently yields 35% on his original investment.  Buffett expects this property to be a “satisfactory [holding] for [his] lifetime and, subsequently, for [his] children and grandchildren.”

     

    While we expect our investment in SRG to yield returns in a much shorter timeframe than Buffett’s NYU property, we agree with his sentiments on buying under-earning real estate at fair valuations based on its current earnings power.  In fact, SRG is valued much like Buffett’s NYU property with a current cap rate of 6.1%, essentially 400 basis points above the 10-year treasury yield.

     

    However, one advantage that SRG has over Buffett’s previous real estate purchase is that it has the potential to be what he calls a “compounding machine.”  SRG has an opportunity to invest a large amount of capital at a high un-levered rate of return and the ability to finance that investment internally without diluting future shareholders.  SRG will generate substantial cash flows from its long-term leases.  It will have access to substantially more debt financing as its stable cash flows grow and will have opportunities to sell stabilized assets at attractive valuation levels with minimal tax leakage.  As SRG generates additional capital, it can reinvest at unlevered rates of return ranging from 12% to 22%.  We are optimistic that these traits will lead to even better returns for Buffett and other SRG investors. 

     

    Master Lease Structure

     

    In order to understand the Seritage opportunity, it is important to understand the Company’s master lease with SHLD.  This lease has a number of provisions that are extremely favorable for SRG, but poorly understood by the equity markets.  In the master lease, SRG’s properties are broken into four groups: Type I, Type II, Type III, and JV properties.  76% of the properties are Type II properties where SHLD is the primary tenant and SRG has the opportunity to recapture 50% of the available space from SHLD.  Conversely, there are 11 Type III properties, 4% of the total, where SHLD is no longer a tenant at the property.  Next, there are 21 Type I properties, 8% of the total, where SRG has the opportunity to recapture 100% of the available space.  These properties have the potential for a complete transformation.  There are 31 properties, or 12%, in JVs with GGP, The Macerich Company (MAC), and SPG where SRG controls 50% of the economics and the leases are typically structured like Type II properties.  Finally, SRG has the opportunity to recapture 100% of the space at Sears Auto Centers.  There are 164 Sears Auto Centers which represent approximately 9% of the total square footage.  SRG is responsible for all costs to redevelop SHLD space when a lease is terminated with the exception of any legacy environmental liabilities or costs.

     

    The current master lease requires SHLD to pay an average triple net rent of $4.31 per square foot with 2% annual escalators.  Moreover, starting one year after the date of the spin, SHLD is permitted to terminate leases on unprofitable properties subject to a limitation of 20% annually.  If SHLD terminates its lease, it owes SRG one year’s rent as a termination fee.  As of April 30, 2015, 59 properties, or 22% of the total, are unprofitable and thus eligible to be terminated by SHLD in July 2016.  This structure provides SRG with a two-year window to re-lease these properties.  Finally, SRG owns all the land for its 266 properties, which averages 13 acres per site.  Therefore, Seritage has the opportunity to develop any vacant land or parking areas where it is currently receiving no rent from SHLD.

     

    Joint Venture Opportunity

     

    While the market may be skeptical about the quality of SRG’s real estate, purchasing patterns of the top mall owners suggest otherwise.  Before SRG was spun-off from SHLD, the Company entered into joint ventures with three A Mall REITs: GGP, MAC, and SPG.  These JVs were struck at implied values that are much higher than the price at which the market is valuing the rest of SRG’s real estate.  Recent commentary from SRG’s JV partners suggests that these investments are performing so well that we expect the Company’s success in its current JVs to spur other JVs in the near future.

     

    These JVs highlight the value of SRG’s real estate and provide an opportunity for SRG to monetize that real estate value at far greater valuations, providing capital for future investment.  This should be an excellent proof of concept for SRG’s business model and allow SRG to pull forward some of the returns we expect in the future, resulting in potential value creation of between $27.19 and $35.26 per share, or 70% to 90% of the current share price.

     

    While the JVs have the same structure as the rest of SRG’s properties according to the master lease, they were valued at higher levels and extracted higher rent levels for SRG from the onset.  The JV properties were valued at $27.7 million per property and $157.84 per square foot.  However, the market is valuing the non-JV properties at $11.8 million per property or $75.80 per square foot.  We believe that these premium valuations imbedded in the JVs provide a strong validation of the value proposition implicit in SRG shares.  Sophisticated REIT investors are paying 2.3 times more per property, and 2.1 times more per square foot than the value that the equity markets are ascribing to the remaining properties.  The JV investments are also valued at a substantial premium to the rest of the portfolio, at a 5.3% cap rate, despite the fact that they are projected to yield lower returns of 7-8%. 

     

    Most importantly, SRG’s JV partners have been universally positive about the progress they have made around leasing up these properties.  On its Q3 2015 call, GGP stated that “the lease up [of Seritage stores] has been incredibly strong.  And we’re in entitlement to start to redevelop those assets.  And we hope that we can continue the process an additional …13 or 14 GGP Sears in the Seritage portfolio … So our hope is to be able to go back some time in 2016 to take down the next tranche of Sears’ assets that exist today within the Seritage portfolio.” GGP indicated on its Q4 call, that it anticipates half of the SRG stores will be in process in 2016 with the remainder in 2017.

     

    SPG echoed that sentiment, saying “our progress is excellent with the Sears boxes at Seritage.”  In fact, they believe that demand is not a hurdle for redeveloping Seritage stores.  Instead, “the big unknown is how fast the Seritage things happen.  It's a joint venture, so, it's not just a question of how fast we can go, but also how fast Seritage can go and how fast Sears can go, which is clearly, we're trying to influence, but we don't have complete control on that. But we certainly have a lot on the drawing board to do there.” SPG reiterated its confidence on the Q4 earnings call, indicating that half of the SRG JV boxes would be in development during 2016 with tenants already secured and pro forma analyses completed.

     

    MAC also has big plans for the SRG assets in its JVs, having already announced two Primark stores.  On the Q2 2015 call, they stated the following: “We're very pleased to have the opportunity to redevelop it and reposition those nine assets, and we anticipate over the next 60 days to 90 days that we'll be in a position to make more concrete announcements about what's happening within the Sears portfolio with us and the rationalization, but very happy with where we sit there.  And in particular, we could be seeing some pretty significant reconfigurations and re-merchandising and developments available to us at Cerritos and Washington Square, in particular both great centers, and centers where we have the ability to recapture over 200,000 square feet from Sears, and each of them Sears controls a 20-acre parcel of land that we are looking at various ideas for various expansions.” On its Q4 earnings call, MAC was less explicit about its timetable. We believe that this is due to the fact that MAC has fewer SRG boxes outside the JVs and is looking to maximize the potential of its existing JV assets rather than expedite their redevelopment.

     

    What is most interesting about the SRG JVs is that SRG has an option to sell its 50% share of the JV back to mall owners in early 2018 at appraised value.  Therefore, we believe that SRG will make it a priority to complete the redevelopment of its JV assets over the course of 2016 and 2017.  Since the JV partners have all stated that demand for SRG locations is extremely strong, we believe that this timeline is realistic.  Moreover, when a SHLD store converts to a store that resonates with the modern consumer, there is a strong halo effect for the surrounding mall space.  In fact, GGP cited an example of a SHLD store that converted to a Nordstrom (JWN) store, which resulted in the entire mall enjoying a $200.00 per square foot boost in sales productivity.

     

    We believe that the market is missing the magnitude of the value creation from SRG’s ability to redevelop its JV assets and sell the real estate back to its JV partners.  GGP has provided a number of data points that allow us to extrapolate the cost for these JVs to redevelop the SRG assets and the expected returns.  Based on this information, we have estimated that these JVs can ultimately generate NOI of between $81 and $101 million with a total incremental investment of between $299 and $408 million.

     

    In Q2 2018, SRG will have the opportunity to sell its JV equity back to its partners for fair market value as determined by an appraisal.  We believe that leased space in Class A regional malls has been trading at a cap rate under 5.0% based on recent transactions.  Therefore, we have used a 5.0% cap rate for our valuation analysis.  This suggests a value of $734 million or $13.21 per share, net of SRG’s share of the redevelopment cost, more than double the value that the public markets are ascribing to these assets.  When SRG ultimately sells its 50% stake in these JVs back to its partners, we believe that they will add value of between $7.87 and $11.51 per share, or 20% to 30% of the current share price.    

     

    While the market is clearly undervaluing the current JVs that SRG has struck with its partners, the future JV value is even more obscured.  GGP has suggested that it will explore a joint venture for the remainder of the SRG properties in its portfolio this year.  While one might assume that SRG and its JV partners cherry-picked the best assets for the initial JVs, we do not believe that this is the case.  Some of SRG’s best Type I properties located in California and Florida are currently located in GGP, MAC, and SPG malls.  These assets comprise 16% of future JV eligible square footage.  The original JVs valued SRG space at $158.00 per square foot.  If we apply this value to the future JV eligible assets, SRG’s share of future JVs would initially be $616 million or $11.08 per share, a value that is just over double the value implied by SRG’s current share price.  As SRG enters into future JVs, we believe that the Company has the opportunity to add value of $5.76 per share, or 15% of the current share price.

     

    Longer term, SRG and its partners will create significant value by redeveloping these future JVs, and monetizing them by selling its remaining 50% share back to its partners for fair market value.  We calculate a long-term value of between $243.00 and $297.00 per square foot for future JVs, net of the additional capital SRG and its partners will invest in these assets.  Since SRG is currently trading at an implied value of $75.80 per square foot, the value created by the sale of future JV assets will be significant.  We estimate that this could be worth somewhere between $13.56 and $17.98 per share, or between 35% and 46% of the current share price. 

     

    Finally, SRG has the opportunity to create joint ventures with other publicly traded companies in its portfolio.  For example, SRG has seven properties in Westfield (WFD AU) malls that could create substantial value in a JV format.  However, we have not included other potential JVs with mall owners outside of GGP, MAC, and SGP in our analysis.

     

    Over time, as SRG begins to cash out of its JVs, this will create substantial liquidity for SRG and provide valuable capital to reinvest in its other properties.  Since SRG is able to sell its share in JVs at fair market value as determined by an appraiser, this is a much better method of generating cash than selling equity at an undervalued share price.

     

    We believe SRG has the potential to create substantial short and long term value from JVs with other mall REITs.  In total this value creation could be worth between $27.19 and $35.26 per share, or 70% to 90% of the current share price.  As SRG executes on quickly redeveloping its current JVs and entering into future JVs, we believe that this value creation opportunity will become increasingly apparent to investors.

     

    Sears Auto Center Opportunity

      

    One of the most attractive and near-term opportunities for SRG is its ability to convert 100% of the current Sears Auto Center square footage into high value smaller retail space.  We believe that SRG’s leasing activity over the next twelve months will give investors a taste of the potential returns SRG can earn on its redevelopment plans.  Currently, SRG owns 164 properties with auto centers encompassing 3.6 million square feet of space.  More importantly, 89 of these auto centers, or 54%, are freestanding.  These freestanding auto centers are typically located in the out-lots of the mall or shopping center, high-traffic areas with great visibility and accessibility from the street.  Since most high quality malls and shopping centers are located in the most highly trafficked areas of their respective community, these locations have become extremely attractive for banks, fast casual restaurants such as Chipotle Mexican Grill (CMG) and Starbucks (SBUX), sit down restaurants, wireless retailers, and other fast growth concepts like Orvis and Jared.  In fact, one of our due diligence contacts called this aspect of SRG’s plan “free money” in the current environment.

     

    This small shop space provides the opportunity to charge rents significantly higher than SRG will receive on its other real estate even though it currently receives the same $4.31 per square foot average rent as the rest of the portfolio.  While the capital costs for small shops may be higher, the higher rents will more than compensate, leading to materially higher returns.  In fact, in a recent presentation, SRG highlights a redevelopment of an auto center in Carson, California.  In this instance, SRG’s auto center was transformed into a mini mall with an Applebee’s, Smashburger, Jersey Mike’s, and Chick-fil-A across the street.  Consequently, SRG realized rents per square foot greater than $45.00 with lease terms of over ten years.  Based on conversations with industry experts, we estimate that a redevelopment of this type would have cost approximately $150.00 per square foot.  This yields a return of around 27%, above and beyond the rent SRG was achieving from SHLD.

     

    With fast growth national retailers looking to secure high quality real estate, we believe that SRG will be able to turn over much of the auto center square footage in an expedited time frame.  Once the Company has example leases with these national retailers, we believe that SRG can negotiate multi-location deals.  Therefore, we would not be surprised if SRG can complete redevelopment of 70% of its auto centers within the next three to four years.  The other 30% will likely share a return profile in line with traditional redevelopments since they are part of the Sears box. 

     

    While Seritage will not be able achieve high 20% returns on all deals, we believe that returns of 18-20% are readily available, given the quality of the real estate and the tenant demand.  Moreover, we estimate that SRG can add 10% square footage to the auto center footprint.  This would essentially add another restaurant box in one out of every four centers.  At a redevelopment cost of $150.00 per square foot, this implies a rent level of between $31.00 and $37.00 per square foot, well below the $45.00 per square foot that SRG has already achieved in its current redevelopments.  This opportunity alone provides the potential for $16.14 to $21.39 of upside for the shares, or 41-55%.  As investors understand the economics and timetable of this opportunity, we believe the value will begin to be reflected in the shares.

        

    Core Portfolio Opportunity 

     

    While SRG’s opportunity to redevelop its auto centers and JV assets have the potential to yield the highest returns in the shortest timeframe, most REITs would love the opportunity to redevelop high quality real estate at a 12% unlevered return or better.  Based on SRG’s current valuation, the market is clearly skeptical about the potential for 12% returns on SRG’s redevelopment.  We believe that this skepticism is based upon a poor understanding of SHLD’s business and the SRG master lease.  Over the next several quarters, as SRG begins to execute on its plan, sign leases and disclose the rates of return it is earning, we believe that investors will understand the long-term potential and the shares will appreciate materially.

     

    One advantage of the SRG master lease is that while SHLD pays an average rent of $4.31 per square foot, different properties pay different rents based on the quality of the real estate.  For example, rents in California average $5.58 per square foot while rents in Alabama, Arkansas, and Mississippi average $2.96 per square foot.  Everything else being equal, SRG can achieve the same returns with rents that are $2.62 per square foot, or 19% lower, in poor southern states as in California.  However, everything else is not equal, as SRG is likely to spend less capital in order to lease its properties in lower rent states.  Also, SRG’s returns in higher rent states may subsidize returns in lower rent states in order to achieve its blended return targets.  For example, if we assume that SRG has equal square footage in properties that pay rents of $5.60 per square foot in rent and $3.00 per square foot in rent, its average rent per square foot is $4.30.  If we assume SRG spends $100.00 per square foot to develop the better space at a 13% return and $60.00 per square foot to develop the lower quality space at a 10% return, then the blended return is 12%.  This implies that SRG would need to achieve rent levels of $18.80 per square foot in its better real estate and $9.00 per square foot in its worse real estate.  We have talked extensively with contacts in the real estate world, and we believe these investment and rent expectations are quite reasonable.  In fact, SRG has achieved rent levels above $18.00 per square foot in Virginia Beach, VA and Thousand Oaks, CA.  Our contacts have labeled these locations as good, but not great, so they are hardly outliers.  In better markets like the King of Prussia Mall, SRG’s rents have topped $25.00 per square foot. 

     

    Another interesting element of the master lease that investors do not comprehend is that Sears often achieves higher sales per square foot in lower quality real estate in Middle America as compared to high quality real estate in coastal markets.  SHLD has done a poor job attracting middle to high income consumers and thrives with low to middle income consumers who find their product offering more attractive.  According to the master lease, SHLD is able to exit 100% of its space in stores where it is unprofitable with a one year rent termination payment.  Therefore, we believe that SHLD will be more likely to exit stores with better real estate.  In these stores, SHLD pays higher rents per foot and employee wages are higher, but SHLD achieves similar or worse sales per square foot.  This suggests that SRG will redevelop a higher percentage of its better real estate at higher capital costs and returns.  This space will also be redeveloped sooner, as SHLD may force SRG to take this space back.  This dynamic further lowers the bar for returns and rent levels that SRG needs to achieve in its lower quality real estate.

     

    Generally, secular trends in retail are moving in SRG’s favor as the retailers that currently have the most aggressive store growth plans are discount and junior anchor retailers, as well as movie theaters and fast casual restaurants.  In its typical Type II property, SRG has approximately 79,000 square feet per store to lease.  This works well as these retailers prefer larger footprint spaces that are ideal for SRG’s redevelopment plans.  SRG has already had success leasing its real estate to discount retailers like Forever 21, Nordstrom Rack, and Primark.  Since these discount retailers typically prefer footprints of 35,000-45,000 square feet, they can serve as an anchor tenant in SRG’s redevelopment project occupying 45-55% of the average square footage.  On the junior anchor side, SRG has signed leases with growing retailers like Dick’s Sporting Goods (DKS), DSW (DSW), The Fresh Market (TFM), REI, and Williams-Sonoma (WSM).  These retailers prefer spaces with 15,000-30,000 square feet, or 19-38% of the average property, which blends well with some of the larger size tenants.  Based on our channel checks, we believe that SRG can spend $75.00-$100.00 per square foot and achieve rent levels averaging $13.00-$18.00 per square foot for these tenants.  This yields a return of approximately 13% net of the average rent that SRG is receiving from SHLD.

     

    In lower-end centers, SRG can cater to retailers like Burlington Stores (BURL) or Hobby Lobby.  These retailers like large footprints and can often absorb a full 80,000 square foot box.  Based on our channel checks, these retailers may only pay $8.00-$9.00 per square foot in rent, but they would typically be replacing a SHLD store paying closer to $3.00 per square foot and would require capital costs closer to $50.00 per square foot.  This yields a return closer to 11% net of SHLD rent and will be a substantially smaller piece of the capital committed by SRG.  However, these lower returns should be more than offset by higher returns in better real estate.

     

    SRG can round out its redevelopment with growing fast casual restaurants like Bravo Brio Restaurant Group (BBRG), The Cheesecake Factory (CAKE), Outback Steakhouse, or Texas Roadhouse (TXRH).  These tenants prefer a footprint of around 6,000 square feet, or around 8% of the property.  Finally, movie theaters have also been making a push to expand in high quality malls and strip centers.  Larger movie theaters can occupy footprints of around 20,000 square feet.  Mall-based movie theaters and restaurants require substantially higher development costs per square foot but can compensate with higher rent per square foot.  Based on our channel checks, we believe that SRG can pay $150.00 to $200.00 per square foot and achieve rents of $25.00-$30.00 per square foot. This also yields a return of approximately 13%, net of the average rent that SHLD is currently paying.

     

    Many of these restaurants and retailers also provide a good fit for freestanding units that allow SRG to create an open air mall within a mall.  This configuration allows SRG to maximize its excess real estate which averages 13 acres per site.  Since many SHLD stores were built in the 1960’s and 1970’s when malls required higher ratios of parking spots to retail space, SRG’s portfolio is generally over-parked which makes projects to add density feasible.  While new buildings require higher capital costs per square foot, SRG is currently receiving no rent on its excess land.  In its better centers, SRG can meet its 12% return threshold and still spend $47.00 per square foot more for new space since it will not be forgoing SHLD rents of $5.58 per square foot.  Based on our channel checks, we believe that SRG could build out a 20,000 square foot pod for several fast casual restaurants for $250.00 per square foot and achieve rents of $30.00-$45.00 per square foot.  This would yield an average return of 15% for SRG to compensate for the greater risk of a new building.

     

    We believe that SRG can create significant shareholder value through redevelopment of its Type II properties at a return level over two times the cap rate at which we expect SRG to trade.  On average, we believe that SRG can redevelop its existing Type II and related real estate at a yield of 12-14% and a cost per square foot of $90.00.  We believe that these estimates are reasonable as they imply rent levels of between $15.00 and $17.00 per square foot, below the $18.00 per square foot that SRG has achieved in its early redevelopments.

     

    Based on our calculations, we believe that SRG will have the opportunity to redevelop 12.3 million square feet of real estate.  This square footage estimate excludes the detached auto centers and JV properties discussed earlier, but includes real estate that we expect SHLD to give back and densification projects.  In total, this would cost SRG $1.1 billion, but would have the potential to add between $133 and $155 million of net operating income.   At the 5.7% cap rate at which we expect SRG to trade, this would create shareholder value of $22.07 to $29.08 per share, or between 57% and 75%.  Moreover, when combined with other initiatives, it could reduce SHLD’s percentage of the rent paid from 78% today to approximately 10% over time.

     

    Major Redevelopment Opportunity

     

    In the near-term, SRG has an opportunity to create meaningful shareholder value from its core strategy of re-leasing its below-market rent Sears’ stores to retailers who will pay market rents.  However, on a longer-term basis, SRG has a tremendous opportunity to create additional value through converting its most valuable real estate into large multi-use developments.  These projects could include luxury rental apartments, hotel and office complexes, or even condo development.  Most of these opportunities would be part of the Company’s Type I real estate portfolio.  The Company has several large plots of land with SHLD stores in areas that would interest any large real estate developer.  This inventory of potential mega-projects includes the following high profile locations: 30 acres in Hicksville, NY; 12 acres in the Aventura Mall in Miami, FL; 13 acres in the Southland Mall in Miami, FL; 19 acres in Town Center at Boca Raton, FL; 18 acres in the Orlando Fashion Square Mall; 22 acres in the Inland Center in San Bernadino, CA; 3 acres in Santa Monica, CA; and 14 acres in the Westminster Mall in Westminster, CA. This is just a sampling of over 20 pieces of irreplaceable real estate across the portfolio.

     

    The first project that SRG has proposed is called “Esplanade” at Aventura in Miami.  SRG envisions an open air village including 250,000 square feet of retail and restaurants, 45,000 square feet of office space, a hotel, and a large parking structure.  This project is currently years from completion as it is in the entitlement phase. SRG will likely execute its plan on Esplanade through a partnership with a developer with expertise in the non-retail product types.  Other potential projects could include condo or apartment development in California.  As millennials have shown a preference to live closer to major metropolitan areas, the demand for high-end residential properties has exploded.  Based on our channel checks, a simple condo development on high quality real estate in California can be developed for $300.00-$400.00 per square foot depending on the finishes and could yield sale prices approaching $1,000.00 per square foot.

     

    These opportunities are extremely difficult to quantify as partnership structures are uncertain and development will not begin in the near-term.  SRG will have to wade through entitlements with cities and other property owners in the area.  While we cannot put exact numbers on capital costs and returns, we expect higher capital costs per square foot and returns somewhere between the Type II properties and the auto centers.  It stands to reason that SRG will target higher returns on these projects as they are longer-term in nature, involve some of the Company’s best real estate, and are more complicated and riskier to execute.  We have estimated capital costs per square foot of $150.00-$200.00 per square foot and returns of 14-16%.  This should result in value creation of between $9.31 and $15.40 per share, or 24 to 40%.

     

    While investors currently view the value created by these projects as beyond their investable horizon, they demonstrate that SRG will still have an opportunity to create shareholder value for years to come.  Indeed, one investment blogger dismissed the Seritage opportunity, saying “land is a rich man’s game.” However, as the development phase of these projects approaches, the market may be quicker to ascribe value to these projects than investors currently envision.

     

    The Howard Hughes Corporation (HHC) spun out of GGP in November 2010 with an inventory of land for longer-term development projects.  At first, many investors dismissed it as too long-term.  However, HHC’s shares more than quadrupled over the ensuing four years.  HHC shares have generated a compounded annual return of 20% since the spin-off, a rate of return of over two times that of the Russell 2000 Index.  Unlike HHC, SRG presents a nice balance between near-term and longer-term opportunities to create value.

     

    Conclusion

     

    In summary, we believe that SRG’s stock has the potential to be worth $117.86 to $144.28 over time, representing between 202% and 270% upside to the current share price.  While it may take years for SRG to achieve these valuation levels, the annualized returns from the current share price should still be substantial.  If SRG takes five years to achieve the mid-point of our price target, the compounded annual total return will be approximately 30%.  Moreover, we believe that SRG has the opportunity to front-load returns for shareholders by focusing on its highest return opportunities first, including JVs, auto center redevelopments, and redevelopments of its higher quality Type II properties.  As investors digest the value creation from these projects, we believe that the shares will trade materially higher.

     

    In this instance, we are obviously monitoring Sears Holdings and its cash burn and monetization opportunities.  We do not believe that Sears is likely to declare bankruptcy in the near future, putting the master lease structure at risk, and are comfortable that there is no fraudulent conveyance risk.  Over time, the SHLD risk should dissipate.  As SRG executes on this meaningful opportunity, it will only generate approximately 10% of its rent from Sears Holdings in the future.  

     

    Important Disclaimers:

     

    Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control.  Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete.  We undertake no responsibility or obligation to revise or update such Statements. 

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    1) Increased evidence of the pace of leasing of Autocenters and well-located Type II properties

    2) Sucess at leasing and ultimately monetizing the JV portfolio

    3) Sell-side coverage and better disclosures that make returns and opportunity more clear

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