Sears turning out to be wrong kind of anchor for Reit

Washington

INVESTORS, it seems, have come to see only the softer side of Sears Holdings' bankruptcy.

But there are signs that the likely demise of one of America's largest and oldest retailers could be a lot harder on the economy - and in particular on companies in the commercial real estate business, like banks and real estate investment trusts (Reits) - than markets are anticipating.

In October, Bank OZK disappointed investors with an unexpected 20 per cent drop in its earnings. A large portion of the drop came from US$45 million in losses on two loans, one of which was tied to a mall that has JC Penney and Sears as its two anchor tenants.

A report in October from S&P Global Ratings noted that Sears still had US$14 billion in revenue in the past 12 months and that going-out-of-business sales could drag down profits for nearby retailers, which includes most national chains, given that Sears is in malls across the country. The S&P analysts also said that the Sears bankruptcy would add to the challenges of second-tier malls, where Sears stores represent about 10 per cent of square footage and have been longtime tenants.

The mall owners will have to spend a considerable amount of money to be able to redevelop those spaces for new tenants, according to the S&P analysts. Nonetheless, the CMBX 6, an index of subprime commercial real estate debt that has about the most significant mall exposure that you can find, has fallen just 2.3 per cent since news first emerged that Sears was facing bankruptcy.

But where investors seem to be the most delusional is in the stock of Seritage Growth Properties, the real estate investment trust that was hived out of Sears three years ago and whose primary tenant remains the retailer.

Shares of Seritage have fallen 20 per cent since the early reports of Sears' pending bankruptcy proceedings. But at a stock price of just more than US$38, investors are still valuing the company at nearly US$1.4 billion. Its true value is most likely much lower.

In fact, the Sears bankruptcy and an ambitious redevelopment plan are likely to suck US$133 million a quarter out of the Reit's bank account.

Seritage says it has US$580 million in cash and an additional US$400 million in financing it can readily tap from a credit line from Berkshire Hathaway. But at that rate, Seritage will blow through nearly all of its cash within a year and its additional financing within two.

And that's if Sears is able to reorganise and emerge from bankruptcy with a good portion of its stores open. If Sears instead shuts down completely, Seritage and its shareholders could be wiped out sooner than that.

I came to that conclusion after modelling Seritage's likely cash flow for the next two years, based on its recent history and the company's projections. Seritage declined to comment on my calculations. Instead, a spokesperson emailed a statement that repeated Seritage CEO Benjamin Schall's recent remarks to shareholders. "Seritage is well positioned to navigate the Sears bankruptcy based on the fact that Sears now accounts for only approximately 30 per cent of our income on a signed lease basis and we have nearly US$1 billion of liquidity and committed capital as well as a track record of leasing redeveloped properties at an average of four times prior rents."

Schall's "well positioned" assessment is somewhere between best case and fantasy. Consider that 30 per cent figure. Seritage says that's the percentage of rent it receives from Sears "on a signed lease basis". The key is that last part. A good portion of those signed leases are not occupied or even generating any revenue and won't for a while. Seritage has not disclosed its third-quarter earnings yet, but my best guess is that more than 60 per cent of its revenue still came from Sears.

As for the rent comparison, that's not apples to apples. Sears does pay Seritage a lower-than-market rent for its properties, most likely because many have not been renovated in a long time. But in return for lower rent, Sears pays additional fees that cover a good deal of the operating expenses of the properties it rents, like utilities and upkeep. Non-Sears tenants cover some expenses, but much less.

A bigger problem for Seritage is the rate at which Sears has been shrinking. Annual rent from Sears shrunk to US$61 million last quarter from nearly US$89 million three months before. Based on that, Seritage is likely to generate US$50 million rent from Sears in the next year, along with US$25 million in fees. On top of that, Seritage gets US$61 million annually from other tenants, which it expects to increase US$20 million a quarter for the next two years.

That adds up to revenue of nearly US$190 million for the next year and US$260 million for the one after that.

Here's where things get messy. Seritage has US$100 million a year in operating expenses. As Sears exits properties, Seritage will have to cover more of its own property expenses, which will add up to an additional US$18 million in the next 12 months and as much as US$47 million the year after that.

On top of its day-to-day expenses, Seritage has an ambitious renovation and development plan, which it needs if it is to release all of those former Sears locations.

What's more, many of those signed but not yet occupied leases most likely require Seritage to make upgrades before the tenants move in. Seritage plans to spend US$880 million on renovations and development over the next two years.

Then there is some debt service. Seritage took out a US$1.6 billion loan in August from Berkshire Hathaway. That loan, which shareholders cheered at the time, has a 7 per cent rate and an annual interest payment of US$112 million. Some of that loan was used to pay off other debt.

Finally, Seritage has been paying US$55 million in dividends to shareholders for the past few years. It has hinted it would stop paying those if its profits no longer justified it, which they haven't for a while, but Seritage is still making the payments.

As much as Seritage would like to convince investors that it has distanced itself from Sears and its woes in bankruptcy, the retailer is still a significant anchor. Unfortunately, it's the kind that pulls everything down. WP