SRG – Seritage: No Returns For The Weary

Seritage Growth Properties (NYSE:SRG) has been an excellent example of a stock that had more hype than substance for the entire duration of its listing. When it first started trading, the focus was on the tiny holding by Warren Buffett. Never mind the fact that SRG’s primary tenant was Sears and most other mall REITs were trading at far lower valuations. The theory back then was that new tenants would give you 4-5 fold higher rent. Last year the redevelopment thesis was finally abandoned after spending over $1.2 billion in cumulative capex while watching EBITDA drop more than 90% from the start.

As one of the consistent skeptics on this experiment, we dismissed the idea that you were about to double your money by holding for Seritage to sell properties.

Even if you assume that the properties can be sold for $20 per share and the worst case is that it takes 1-2 years longer than the original plan, your net proceeds shrink dramatically with time. We don’t see the buffer here to play this, period. If we were forced to choose a long play here, it would be to buy the stock and sell the April 2023 covered calls.

Source: Bears Beat Back Bold Bulls

That skepticism has worked again.

We update the outlook on SRG and tell you whether you have some upside from these levels.

Q4-2022

The company led off the announcement with some positive results.

Since initiating our sale plan last year, we have made significant progress on dispositions, selling 65 wholly owned properties and eight joint venture assets for total gross proceeds of $739.7 million in 2022 and $238.6 million of asset sales year to date. We have used the sales proceeds to reduce the Company’s term loan balance to $800 million from $1.6 billion. We are building on our momentum with over $450 million of assets either under contract or with accepted offers.

Source: SRG Q4-2022 Press Release

Further down the press release was the grappling with reality.

Over the last several months, the Company, along with the commercial real estate market as a whole, has experienced and continues to experience progressively more challenging market conditions as a result of, among other things, the continued rise in interest rates, increases to required return hurdles for institutional buyers, availability of debt capital (including the willingness of commercial banks to lend in light of potential recession risks and balance sheet constraints), continued inflation resulting in higher construction and labor costs for development (which has the effect of, among other things, making cost estimates in development proformas more challenging), decreased demand for office development (with concerns about long term demand for office space including, but not limited to, continued work-from-home trends), and slowing rent growth expectations due to potential recession concerns. These conditions have applied and continue to apply downward pricing pressure on all of our assets. The assets we have sold to date have been those generally less impacted by these adverse market trends. In making decisions regarding whether and when to transact on each of the Company’s remaining assets, the Company will consider various factors including, but not limited to, the breadth of the buyer universe, macroeconomic conditions, the availability and cost of financing, as well as corporate, operating and other capital expenses required to carry the asset. If these challenging market conditions persist, then we expect that they will impact the Plan of Sale proceeds from our assets and the amounts and timing of distributions to shareholders.

Source: SRG Q4-2022 Press Release (emphasis ours)

This fits with our theory that the company would sell its easiest to sell assets first and the rising interest rates would dent all these imagined sales at 4% implied cap rates. What is working for the company is the big reduction in the cash burn rate. With the term loan facility down to $800 million, interest expense will drop 40% below 2022 run-rates and perhaps come in under $55 million. The other expenses seem manageable. The General and Administrative and preferred dividends will drain another $50-$55 million.

The offset here is the net operating income from properties of about $40-$44 million a year. So net-net we are looking at an annual run-rate of about $70 million cash burn at the operating level. The final number in this equation is the hardest to predict. The total capex. In 2022 this was about $125 million. A big improvement from over $300 million in 2020

Assuming SRG can limit this total to just $70 million in 2023, the total burn rate may be $140 million. That might sound small, but it is a third of the market capitalization.

Outlook

The market is frozen. You probably got this from management tone, but it is far worse. Office properties are suffering the worst with REITs like Vornado Realty Trust (VNO) trading at 60% discounts to consensus net asset value. Multi-family residential like AvalonBay Communities, Inc. (AVB) are trading 20% lower than their NAV. We will point out that these NAVs have been cut by 20-30% over the last 12 months. Our larger point is that while you may see few assets sell in this market, there is no line-up to buy SRG’s properties for development. Fully developed and perfectly functioning REITs with great properties are getting creamed. Development costs are still quite high and Broadmark Realty Capital Inc. (BRMK) which makes development and construction loans, albeit on a far smaller scale, has seen its model completely shattered. Any sane investors would consider taking a position in these REITs versus buying truckloads of properties going into a recession. We think this was the state before the regional banking crisis. Post that, commercial real estate will be half past dead.

Verdict

When we last wrote on this, our range for liquidation value ($10-$18) was a bit higher than the share price. As we have slid further down the rabbit hole we think even that level of optimism is unwarranted. We think the current range is likely to be $8-$14. So at $8.30 a share, sure, you can argue there is upside. But keep in mind that this is very poor related to the risks. At the midpoint you might make 35% from here. You would make a similar amount by buying AVB, if it just returned to its August highs.

AVB has an A rated balance sheet and you have a solid 4% yield here. There are many ways to make money in real estate today and SRG represents a poor choice with very limited upside and significant downside if things break. Last time we had suggested a covered call trade.

If you did that and closed things out today with the April $10 calls trading at 20 cents, you would be at about breakeven. A far better outcome than being down double digits of course. We don’t think covered calls make sense at this point. We would instead put Seritage Growth Properties 7% CUM PFD SR A (NYSE:SRG.PA) on our watch list and look to buy that on any market meltdown. The preferred shares have a solid yield and if you can pick them up near $20, you would have a compelling risk-reward.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.