SRG - Seritage Growth Properties

[peridotcapital]

 

Last quarter they signed new third party leases totaling 214,000 square feet. How on earth can SRG recapture 50% of all the Sears space over the next 18 months?

 

On an ABR basis, not a Sq Ft basis. If you're measuring on Sq Footage you're basically missing the entire investment thesis.

 

Exactly, but that's not what you said.

[Picasso]

SRG needs about $190 million of NOI to stay within their mortgage covenants.  It's not enough to simply cover their interest expense and overhead in the bear case. 

[glorysk87]

SRG needs about $190 million of NOI to stay within their mortgage covenants.  It's not enough to simply cover their interest expense and overhead in the bear case.

 

They don't earn $190mm of NOI now...

[Picasso]

Sorry, $125 million of NOI.  I had the wrong amount of mortgage debt. 

[peridotcapital]

Operating expenses plus interest is roughly at a $160M run-rate. At $20/sf they would need to lease about 8 million of space to third parties to get there. Halfway there already.

[CorpRaider]

Yeah I did a rough comp too (I mean rough w/r/t my computation) based on the NOI generated by 3rd parties and leases signed but not yet in force and came up with about half of the break even run rate needed.  At some point in the next couple of years it seems like Lampert will have set himself up a neat little sort of "hedged position" on the future of the SHLD (at least brick and mortar) retail ops.  Sort of fascinating for me follow (during breaks in flailing myself for owning GM and reading the WSJ month long expose on how shitty my BAC/the banking bidness is now).

[glorysk87]

One thing I am a little curious about, and something that IR wasn't able to answer, is why property operating expenses and taxes have both been increasing pretty significantly over the last few quarters.  Not sure if it's a function of the renovated properties or not, but in order to get an accurate NOI figure, we really need to know where property operating expenses and taxes cap out. Do they increase forever as properties are redeveloped or should that expense growth taper off at some point? Any ideas?

[peridotcapital]

One thing I am a little curious about, and something that IR wasn't able to answer, is why property operating expenses and taxes have both been increasing pretty significantly over the last few quarters.  Not sure if it's a function of the renovated properties or not, but in order to get an accurate NOI figure, we really need to know where property operating expenses and taxes cap out. Do they increase forever as properties are redeveloped or should that expense growth taper off at some point? Any ideas?

 

Since the tenants are paying them it should not really be material to SRG's NOI. The company's net property operating expenses have held steady at under $1 million per quarter during that time.

[glorysk87]

Since the tenants are paying them it should not really be material to SRG's NOI. The company's net property operating expenses have held steady at under $1 million per quarter during that time.

 

Oh man. I totally disagree. I think it's absolutely critical information when contemplating the downside risk.  If Sears goes bankrupt then SRG is responsible for all of those expenses that were previously being reimbursed by Sears.  So the big question is why are those expenses increasing drastically? If they're driven by the redevelopments then that's something we need to know. If not, then it's related to Sears and makes SRG's exposure to SHLD even more risky than it already was.

[peridotcapital]

Since the tenants are paying them it should not really be material to SRG's NOI. The company's net property operating expenses have held steady at under $1 million per quarter during that time.

 

Oh man. I totally disagree. I think it's absolutely critical information when contemplating the downside risk.  If Sears goes bankrupt then SRG is responsible for all of those expenses that were previously being reimbursed by Sears.  So the big question is why are those expenses increasing drastically? If they're driven by the redevelopments then that's something we need to know. If not, then it's related to Sears and makes SRG's exposure to SHLD even more risky than it already was.

 

Of course it's due to the redevelopments. If you make improvements to a building, or expand on existing lots, the county is going to reflect that in their assessments. All county property records are public record and most are archived online. Subdividing space also increases operating expenses. Also, don't forget that Seritage bought the properties from Sears so those transactions will help local governments get their assessments as close to fair market value as possible. Those higher tax payments will flow through over the first 12 months as the new assessments come out.

[glorysk87]

Of course it's due to the redevelopments. If you make improvements to a building, or expand on existing lots, the county is going to reflect that in their assessments. All county property records are public record and most are archived online. Subdividing space also increases operating expenses. Also, don't forget that Seritage bought the properties from Sears so those transactions will help local governments get their assessments as close to fair market value as possible. Those higher tax payments will flow through over the first 12 months as the new assessments come out.

 

Ok, property taxes show up in a different line item than property operating expenses. So taxes are not the thing I'm talking about here. I'm talking about ongoing, recurring property operating expenses which seem to be spiking upwards very quickly.

 

How does subdividing space increase operating expenses that significantly? That's what I'm trying to find out, and is a question that IR was not able to answer for me.

 

And in an investment that involves the potential bankruptcy of their main tenant, it is an absolutely integral piece of information.

[peridotcapital]

 

Ok, property taxes show up in a different line item than property operating expenses. So taxes are not the thing I'm talking about here. I'm talking about ongoing, recurring property operating expenses which seem to be spiking upwards very quickly.

 

How does subdividing space increase operating expenses that significantly? That's what I'm trying to find out, and is a question that IR was not able to answer for me.

 

And in an investment that involves the potential bankruptcy of their main tenant, it is an absolutely integral piece of information.

 

From the Seritage 10-K:

 

"Property operating expenses include: real estate taxes, repairs and maintenance, management expenses, insurance, ground lease costs and utilities."

 

I would expect that subdividing space would increase every cost listed there, except the in-place ground leases.

[glorysk87]

Yes, I understand they classify real estate taxes as an operating expense. My point is that on the income statement, real estate taxes are split out as their own line item. My concern lies with the specific line item "Property Operating Expenses".

 

As a percent of rental revenue, property operating expenses have risen from 6.8% just two quarters ago (3Q15) to 15.7% in the most recent quarter. That's a significant increase and something that definitely raises questions for me.  Maybe I'm dumb, but I can't seem to figure out how that much of a cost increase has resulted from a few redevelopments.

 

And even if that is the "right" level of operating expenses, then the redevelopments aren't adding nearly as much value as I would have thought, considering costs are flying upwards with the redevelopments.

[glorysk87]

Does anyone have any idea what an appropriate cap rate would be for Class B malls currently? I've dug through the supplementals and the conference calls of a bunch of different class B REITS (PEI, CBL, RSE, WPG) and it appears that none of them release cap rates on their properties/acquisitions/dispositions.

[Picasso]

It's all over the map since the lines on what denotes a "B mall" are pretty blurred. Cap rates can go anywhere from 7% to 18% on "B mall" transactions over the past year. BAM paid a 7% cap rate for RSE, PEI trades at around 7% as well, but certain disposals have been going at 15% or higher. Those disposals are more in the C mall category. It really depends on the demographics around some of the B malls.

[glorysk87]

15%? That's nutty. Rarely see transactions that high.

[AJB96]

After going through all the real estate investments Buffett has made, I believe his batting average in real estate is 100%. Below you will find that Buffett is attracted to assets with under market rent (Seritage Growth Properties and NYC real estate), merger arbitrage, liquidations as well as REITS that are simply very undervalued. Enjoy!

 

 

Past REIT investments by Buffett in the 1999 - 2000 time frame:

 

 

First Industrial Real Estate Trust:

 

Purchased by Buffett around December of 2001. See VIC report attached. It was just extremely cheap.

 

Here is my analysis of First Industrial Realty Trust. I wrote this when I was in 8th grade back in 2007 so please don't have high expectations.

http://alexbossert.blogspot.com/2007/07/reverse-engineering-of-warren-buffetts.html

 

http://www.wsj.com/articles/SB977873157860554052

 

http://www.bizjournals.com/southflorida/stories/2001/09/24/focus5.html

 

http://www.wsj.com/articles/SB945379359638447587

 

Laser Mortgage Management:

 

See Value Investors Club report. It was trading at a large discount to likely liquidation proceeds when Buffett purchased shares.

 

See page 150 in attached book "Trade Like Warren Buffett."

 

JDN Realty:

 

See Value Investors Club report.  This is interesting because fraud was uncovered. Buffett invested after the shares cratered on that news.

 

See page 151 in attached book "Trade Like Warren Buffett"

 

http://www.nashvillepost.com/home/article/20446872/buffett-takes-51-stake-in-jdn-realty

 

https://www.thestreet.com/story/916949/1/the-latest-in-buffetts-reit-buffet.html

 

PMC Capital:   

 

See Value Investors Club report.

 

http://www.crenews.com/general_news/general/warren-buffett-reports-holding-5.1-stake-in-pmc-capital.html

Burnham Pacific Properties

 

See attached Value Investors Club report. This is another liquidating REIT.

 

See page 153-4 in attached book "Trade Like Warren Buffett"

 

http://www.nytimes.com/2001/12/27/business/company-news-buffett-holds-5.1-percent-of-burnham-pacific.html

 

Baker Fentress & Co.

 

See the Value Investors Club report on Baker Fentress spin off BKR Capital

 

http://www.nytimes.com/1999/11/28/business/investing-a-quick-bet-perhaps-for-the-sage-of-omaha.html

 

http://articles.orlandosentinel.com/1999-08-20/business/9908190444_1_fentress-warren-buffett-tomoka

 

http://articles.orlandosentinel.com/1999-08-11/business/9908100468_1_fentress-buffett-tomoka

 

MGI Properties:

 

See page 154 in attached book "Trade Like Warren Buffett"

 

http://www.wsj.com/articles/SB910120794439808000

http://www.bizjournals.com/boston/stories/1999/03/29/daily8.html

 

Tanger Factory Outlets:

 

See page 151-2 in attached book "Trade Like Warren Buffett"

 

http://www.barrons.com/articles/SB924303618950490210

 

Aegis Realty:

 

http://boards.fool.com/new-york-march-14-bloomberg-billionaire-14564860.aspx

http://www.marketwatch.com/story/warren-buffet-files-a-5-percent-stake-in-aegis-realty

http://www.wsj.com/articles/SB98503199894924071

 

Town & Country:

 

http://www.forbes.com/forbes/1999/0531/6311280a.html

 

HRPT Properties Trust:

 

See page 152-3 in attached book "Trade Like Warren Buffett"

 

Purchase of New York real estate in 1993:

There are a lot of similarities to Seritage with this investment:

 

"Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20% of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere."

 

http://fortune.com/2014/02/24/buffetts-annual-letter-what-you-can-learn-from-my-real-estate-investments/

 

Other interesting reading:

 

Buffett's personal holdings over the years: http://secgems.com/c/0000315090/buffett-warren-e

 

This doesn't have to do with REITs. It's an analysis of Buffett's partnership investments:  http://bovinebear.blogspot.com/2015/04/warren-buffett-partnership-investments.html.

 

Link to the book: Trade Like Warren Buffett: http://www.mycfaspace.com/downloads/Trade_Like_Warren_Buffett.pdf

SRG_VIC_report_2.pdf

Burnham_Pacific.pdf

BKF_Capital.pdf

Laser_Mortgage.pdf

PMC_Capital_VIC.pdf

JDN_Realty_VIC.pdf

First_Industrial_VIC.pdf

SRG_VIC_Report.pdf

Trade_Like_Warren_Buffett.pdf

JDN_Realty_Corporation.pdf

[CorpRaider]

I remember him auctioning off a pick for charity one time that was PCL.  Maybe in the 90s?  Probably after they spun from whatever rail road it was.

 

 

Alex, would you recommend the Trade Like Buffett book?  Not a huge Altucher fan.  I mean he can be provocative but...

[glorysk87]

I've spent a healthy chunk of time analyzing this and have taken a position.

 

By my best and most conservative estimates, Sears would have to both declare bankruptcy and reject all of the leases in the portfolio within the next 6 to 8 quarters in order to put Seritage in a bad situation. And even then, as long as SRG could access external financing at a reasonable rate of funding, they should be able to survive without too much trouble.  Beyond 8 quarters, the company should be able to generate positive cash flow even if Sears suddenly disappears off the face of the Earth - the one large assumption here is that they're able to continue to recapture and redevelop properties at the same rate that they have been for the last few quarters.  If that suddenly drastically slows then it's a different story.  So that's the downside scenario.

 

The upside is massive, and I think will happen more quickly than most people expect. A complete turnover of the portfolio (meaning Sears completely gone and new tenants brought in) gets me a price target of ~$224 using an FFO model and $204 using an NAV model.  By my estimates this should take somewhere around 15 years, giving us an annual return of ~11%.  This doesn't take into account any rental inflation, any growth in the portfolio, or really any other sort of excess return that could be generated by the management team.  This is a pure, steady-state portfolio turnover.  So I think there's probably upside even to my estimates.

 

For anyone who is concerned about the near term Sears bankruptcy risk, it is somewhat cost effective to hedge a position in SRG by buying long-dated SHLD puts.  The Jan '18 expiration covers most of the risk, as by my estimates the risk should be greatly diminished past that point and an investment should no longer need a SHLD hedge after that date.

[peridotcapital]

I've spent a healthy chunk of time analyzing this and have taken a position.

 

By my best and most conservative estimates, Sears would have to both declare bankruptcy and reject all of the leases in the portfolio within the next 6 to 8 quarters in order to put Seritage in a bad situation. And even then, as long as SRG could access external financing at a reasonable rate of funding, they should be able to survive without too much trouble.  Beyond 8 quarters, the company should be able to generate positive cash flow even if Sears suddenly disappears off the face of the Earth - the one large assumption here is that they're able to continue to recapture and redevelop properties at the same rate that they have been for the last few quarters.  If that suddenly drastically slows then it's a different story.  So that's the downside scenario.

 

The upside is massive, and I think will happen more quickly than most people expect. A complete turnover of the portfolio (meaning Sears completely gone and new tenants brought in) gets me a price target of ~$224 using an FFO model and $204 using an NAV model.  By my estimates this should take somewhere around 15 years, giving us an annual return of ~11%.  This doesn't take into account any rental inflation, any growth in the portfolio, or really any other sort of excess return that could be generated by the management team.  This is a pure, steady-state portfolio turnover.  So I think there's probably upside even to my estimates.

 

For anyone who is concerned about the near term Sears bankruptcy risk, it is somewhat cost effective to hedge a position in SRG by buying long-dated SHLD puts.  The Jan '18 expiration covers most of the risk, as by my estimates the risk should be greatly diminished past that point and an investment should no longer need a SHLD hedge after that date.

 

I think a fully redeveloped share value in the $200 range that you put out there is entirely reasonable. The 15-year timeframe might be optimistic. Getting there would require both Sears and Kmart to be completely gone by then, and it would imply a redevelopment pace of roughly 2.4 million square feet per year (about 2.5 times their current run-rate). Given the secular trends in bricks and mortar retail (we have too many stores already), I think that is much more of a challenge than dealing with the Sears solvency risks. That said, it's pretty easy to see why Buffett liked this at $36 per share.

[Mephistopheles]

I've spent a healthy chunk of time analyzing this and have taken a position.

 

By my best and most conservative estimates, Sears would have to both declare bankruptcy and reject all of the leases in the portfolio within the next 6 to 8 quarters in order to put Seritage in a bad situation. And even then, as long as SRG could access external financing at a reasonable rate of funding, they should be able to survive without too much trouble.  Beyond 8 quarters, the company should be able to generate positive cash flow even if Sears suddenly disappears off the face of the Earth - the one large assumption here is that they're able to continue to recapture and redevelop properties at the same rate that they have been for the last few quarters.  If that suddenly drastically slows then it's a different story.  So that's the downside scenario.

 

The upside is massive, and I think will happen more quickly than most people expect. A complete turnover of the portfolio (meaning Sears completely gone and new tenants brought in) gets me a price target of ~$224 using an FFO model and $204 using an NAV model.  By my estimates this should take somewhere around 15 years, giving us an annual return of ~11%.  This doesn't take into account any rental inflation, any growth in the portfolio, or really any other sort of excess return that could be generated by the management team.  This is a pure, steady-state portfolio turnover.  So I think there's probably upside even to my estimates.

 

For anyone who is concerned about the near term Sears bankruptcy risk, it is somewhat cost effective to hedge a position in SRG by buying long-dated SHLD puts.  The Jan '18 expiration covers most of the risk, as by my estimates the risk should be greatly diminished past that point and an investment should no longer need a SHLD hedge after that date.

 

Thanks for sharing your opinion. How much are you counting for redevelopment spending in your estimate? Like on per sqft basis?

[Mephistopheles]

After going through all the real estate investments Buffett has made, I believe his batting average in real estate is 100%. Below you will find that Buffett is attracted to assets with under market rent (Seritage Growth Properties and NYC real estate), merger arbitrage, liquidations as well as REITS that are simply very undervalued. Enjoy!

 

 

 

Thanks Alex, some great reading material there !

[glorysk87]

 

Thanks for sharing your opinion. How much are you counting for redevelopment spending in your estimate? Like on per sqft basis?

 

I'm using $164 psf for redevelopment.

[glorysk87]

 

I think a fully redeveloped share value in the $200 range that you put out there is entirely reasonable. The 15-year timeframe might be optimistic. Getting there would require both Sears and Kmart to be completely gone by then, and it would imply a redevelopment pace of roughly 2.4 million square feet per year (about 2.5 times their current run-rate). Given the secular trends in bricks and mortar retail (we have too many stores already), I think that is much more of a challenge than dealing with the Sears solvency risks. That said, it's pretty easy to see why Buffett liked this at $36 per share.

 

Thanks for the input. I actually thought 15 years was relatively conservative.  A 15 year time frame assumes they can redevelop about 550k sq ft per quarter.  It is elevated from current levels but as they generate excess cash from the completed redevelopment properties it should allow them to plow more back in to additional redevelopments at a faster pace.

[moneyball]

 

Thanks for sharing your opinion. How much are you counting for redevelopment spending in your estimate? Like on per sqft basis?

 

I'm using $164 psf for redevelopment.

 

Is there a specific way you get to $164? It seems within reason. We would be looking at rents of $19.68 on new leases assuming yields remain ~12%. Though I think we may see costs that are elevated for a while as SRG continues to look at converting auto centers. Though they have been able to flip some of those at costs lower than  $164