SRG - Seritage Growth Properties

[DooDiligence]

I'm new to this space & am interested in your thoughts on the following:

 

https://www.lowenstein.com/files/Publication/cf50b2ab-8d73-4835-920b-614a2e3f5802/Presentation/PublicationAttachment/68a5ceb7-9efc-4d2d-b7d9-d559c1168054/Will%20Innovative%20Moves%20Reverse%20the%20'Death%20Spiral'%20of%20Malls.pdf

 

I know that General Growth & Seritage are two different companies & was just wondering if mall operators were likely to start being their own customers more & more?

[SlowAppreciation]

A company developing property probably shouldn't have any free cash flow. I don't think the idea of free cash flow supporting development cost is necessarily the metric to consider. Look at a cable company. In fact, a case can be made that no cash flow is just fine during this phase of the process. But when the building is complete and the rents are coming in, you are in the harvesting phase and then FCF is most certainly warranted. What is important, of course, is to match development cost with resources on hand, or raising capital, or developing slowly enough to support the venture. I also don't think the dividend is warranted but it suggests they are not developing at top speed yet. I wouldn't be upset or surprised if the dividend was cut to zero during this process.

 

Yeah I think your comparison to cable companies is spot on. So probably best way of looking at SRG in the short-medium term would be to conservatively estimate out NOI, and then back into a NAV using comp cap rates?

[KJP]

A company developing property probably shouldn't have any free cash flow. I don't think the idea of free cash flow supporting development cost is necessarily the metric to consider. Look at a cable company. In fact, a case can be made that no cash flow is just fine during this phase of the process. But when the building is complete and the rents are coming in, you are in the harvesting phase and then FCF is most certainly warranted. What is important, of course, is to match development cost with resources on hand, or raising capital, or developing slowly enough to support the venture. I also don't think the dividend is warranted but it suggests they are not developing at top speed yet. I wouldn't be upset or surprised if the dividend was cut to zero during this process.

 

Yeah I think your comparison to cable companies is spot on. So probably best way of looking at SRG in the short-medium term would be to conservatively estimate out NOI, and then back into a NAV using comp cap rates?

 

How are you accounting for the money and time it will take to get to your stabilized NOI?

[SlowAppreciation]

A company developing property probably shouldn't have any free cash flow. I don't think the idea of free cash flow supporting development cost is necessarily the metric to consider. Look at a cable company. In fact, a case can be made that no cash flow is just fine during this phase of the process. But when the building is complete and the rents are coming in, you are in the harvesting phase and then FCF is most certainly warranted. What is important, of course, is to match development cost with resources on hand, or raising capital, or developing slowly enough to support the venture. I also don't think the dividend is warranted but it suggests they are not developing at top speed yet. I wouldn't be upset or surprised if the dividend was cut to zero during this process.

 

Yeah I think your comparison to cable companies is spot on. So probably best way of looking at SRG in the short-medium term would be to conservatively estimate out NOI, and then back into a NAV using comp cap rates?

 

How are you accounting for the money and time it will take to get to your stabilized NOI?

 

My model uses a bunch of different inputs/assumptions to play with so feel free to check it out. I'll be the first to admit it's still plenty rough around the edges, but I'm still new to valuing REITs so I'd love any suggestions/criticisms about the model, assumptions used, formulas, etc.

SRG.xlsx

[scorpioncapital]

This is the definition of investing: Laying out a dollar today in the hopes of getting back more than a dollar tomorrow.

[KJP]

A company developing property probably shouldn't have any free cash flow. I don't think the idea of free cash flow supporting development cost is necessarily the metric to consider. Look at a cable company. In fact, a case can be made that no cash flow is just fine during this phase of the process. But when the building is complete and the rents are coming in, you are in the harvesting phase and then FCF is most certainly warranted. What is important, of course, is to match development cost with resources on hand, or raising capital, or developing slowly enough to support the venture. I also don't think the dividend is warranted but it suggests they are not developing at top speed yet. I wouldn't be upset or surprised if the dividend was cut to zero during this process.

 

Yeah I think your comparison to cable companies is spot on. So probably best way of looking at SRG in the short-medium term would be to conservatively estimate out NOI, and then back into a NAV using comp cap rates?

 

How are you accounting for the money and time it will take to get to your stabilized NOI?

 

My model uses a bunch of different inputs/assumptions to play with so feel free to check it out. I'll be the first to admit it's still plenty rough around the edges, but I'm still new to valuing REITs so I'd love any suggestions/criticisms about the model, assumptions used, formulas, etc.

 

Thanks for posting this.  I may be misunderstanding your spreadsheets, but I don't think the changes in cash & cash equivalents on your projected cash flow statements match up with your projected balance sheets.

 

Also, I understand you to be projected SRG to recapture and re-rent at higher rates 2 million sq ft per year.  I also understand you to project $100 million per year in CapEx.  Can you explain the math behind the $100 million per year in CapEx in light of 2 million sq ft annual recapture and the maintenance CapEx needs of the other square footage? 

 

[SlowAppreciation]

A company developing property probably shouldn't have any free cash flow. I don't think the idea of free cash flow supporting development cost is necessarily the metric to consider. Look at a cable company. In fact, a case can be made that no cash flow is just fine during this phase of the process. But when the building is complete and the rents are coming in, you are in the harvesting phase and then FCF is most certainly warranted. What is important, of course, is to match development cost with resources on hand, or raising capital, or developing slowly enough to support the venture. I also don't think the dividend is warranted but it suggests they are not developing at top speed yet. I wouldn't be upset or surprised if the dividend was cut to zero during this process.

 

Yeah I think your comparison to cable companies is spot on. So probably best way of looking at SRG in the short-medium term would be to conservatively estimate out NOI, and then back into a NAV using comp cap rates?

 

How are you accounting for the money and time it will take to get to your stabilized NOI?

 

My model uses a bunch of different inputs/assumptions to play with so feel free to check it out. I'll be the first to admit it's still plenty rough around the edges, but I'm still new to valuing REITs so I'd love any suggestions/criticisms about the model, assumptions used, formulas, etc.

 

Thanks for posting this.  I may be misunderstanding your spreadsheets, but I don't think the changes in cash & cash equivalents on your projected cash flow statements match up with your projected balance sheets.

 

Also, I understand you to be projected SRG to recapture and re-rent at higher rates 2 million sq ft per year.  I also understand you to project $100 million per year in CapEx.  Can you explain the math behind the $100 million per year in CapEx in light of 2 million sq ft annual recapture and the maintenance CapEx needs of the other square footage?

 

No you're 100% right. I haven't setup all the formulas between the balance sheet and cash flows yet.

 

The understated CapEx is just me messing around with different inputs. But yes, the CapEx number should be a product of the estimated 2million sqft/yr and $100 sq/ft redevelopment costs. So yep, should be $200m/yr.

 

Other than that, any glaring errors/omissions? I feel like I'm not properly account for the JV income (just add to NOI?).

[SlowAppreciation]

Made some more updates to my model:

SRG.xlsx

[scorpioncapital]

I also think SRG is a play on the wildcard of much higher inflation than expected down the road. For example, one scenario is a long period of low rates like now, perhaps continuing forward for a while longer. This is a good environment for the redevelopment because you are getting nice new renovated properties at prices that - eventually, when the inflation comes will cost much more to build to maintain the high rental prices of properties of that "new" calibre. Conversely, if inflation does not happen, or not as quickly, then you can control the development cost nice and slow, and do it with lower wages. But I think this wildcard factor is one reason I do want some exposure to real estate. Between precious metals, art, TIPS, and businesses, real estate has shown to be a strong hedge of inflation. The low to high rent differential at SRG is icing on the cake for the low inflation scenario while possibly putting upward pressure on the share price if the history of the world repeats itself - namely higher inflation. Inflation is certainly not good, it is in fact, an economic failure, but people want pleasure today and pain tomorrow and some problems are so big that politicians may dictate to central banks to create it despite the fact that it will end badly.

[KJP]

Made some more updates to my model:

 

As you work toward connecting your projected cash flow statement to your projected balance sheet, you'll have to make some assumptions about where the capital is going to come from.  Once you decide that, you can then project actual interest expense (with an interest rate assumption), rather than using a percentage of revenue for interest expenses.  That will also help you understand how dependent the company is (or is not) on external funding sources and determine whether access to capital is a risk to your thesis.

 

SRG is a REIT.  Will the tax rules require it to start paying a dividend at some point?  If so, will that require additional external capital?

 

It also may be useful to try this exercise with another real estate company that has a long pathway for reinvesting capital into existing projects/assets, such as Howard Hughes, to see whether the returns and risks in SRG are attractive to you relative to other, similar investments.

 

[Mephistopheles]

Made some more updates to my model:

 

 

SRG is a REIT.  Will the tax rules require it to start paying a dividend at some point?  If so, will that require additional external capital?

 

 

 

Unfortunately, they already pay a dividend, even though they don't have to and even though they need all of the capital they can get. I think it's because the management owns restricted shares which they can't monetize for some time, except for when it pays dividends.

[KJP]

Made some more updates to my model:

 

As you work toward connecting your projected cash flow statement to your projected balance sheet, you'll have to make some assumptions about where the capital is going to come from.  Once you decide that, you can then project actual interest expense (with an interest rate assumption), rather than using a percentage of revenue for interest expenses.  That will also help you understand how dependent the company is (or is not) on external funding sources and determine whether access to capital is a risk to your thesis.

 

SRG is a REIT.  Will the tax rules require it to start paying a dividend at some point?  If so, will that require additional external capital?

 

It also may be useful to try this exercise with another real estate company that has a long pathway for reinvesting capital into existing projects/assets, such as Howard Hughes, to see whether the returns and risks in SRG are attractive to you relative to other, similar investments.

 

Also, what amount of maintenance CapEx is necessary, beyond the $200 million of recapture CapEx you include in  your model?

[HalfMeasure]

Made some more updates to my model:

 

Thanks for sharing. Just taking a look at the NOI valuation - not a REIT expert, but won't adding the cumulative discounted NOI from FY2017-FY2024 overstate the value of the assets as that NOI needs to be plowed back into redevelopment in order to reach terminal NOI? Wouldn't this be analogous to overstating a FCF valuation by not including growth CapEx during an abnormal growth period?

[SlowAppreciation]

Made some more updates to my model:

 

As you work toward connecting your projected cash flow statement to your projected balance sheet, you'll have to make some assumptions about where the capital is going to come from.  Once you decide that, you can then project actual interest expense (with an interest rate assumption), rather than using a percentage of revenue for interest expenses.  That will also help you understand how dependent the company is (or is not) on external funding sources and determine whether access to capital is a risk to your thesis.

 

SRG is a REIT.  Will the tax rules require it to start paying a dividend at some point?  If so, will that require additional external capital?

 

It also may be useful to try this exercise with another real estate company that has a long pathway for reinvesting capital into existing projects/assets, such as Howard Hughes, to see whether the returns and risks in SRG are attractive to you relative to other, similar investments.

 

Yeah I haven't seen too many SRG write ups that factor in additional capital needs (aside from the short ones). I do think they'll need to raise some money and don't really see how they won't be able to unless they can keep the $20+ leases coming. But if memory serves correctly, SNO are around $19/sqft now, which is actually down from a few quarters ago when it was $23/sqft. Could've just been one or two projects skewing it higher though.

[SlowAppreciation]

Made some more updates to my model:

 

Thanks for sharing. Just taking a look at the NOI valuation - not a REIT expert, but won't adding the cumulative discounted NOI from FY2017-FY2024 overstate the value of the assets as that NOI needs to be plowed back into redevelopment in order to reach terminal NOI? Wouldn't this be analogous to overstating a FCF valuation by not including growth CapEx during an abnormal growth period?

 

I'm also fairly new to REITs so take my model and everything I say with a grain of salt.... there are far more knowledgable people here who can probably better answer, but from what I've learned, there are 4 main ways of valuing REITs: NOI, FFO, AFFO and NAV.

 

Think of NOI as the same as EBITDA on the property level, but not on a company level. My understanding is that the whole point of NOI is to value the operating profit of individual properties, rather than that of the entire company. Took me a while to wrap my head around since I'm not a real estate expert, but that's my understanding of it at least.

 

FFO/AFFO are more or less variants of a DCF model, with certain charges included/excluded. If you're concerned about the treatment of growth CapEx, AFFO is probably going to be the best one. 

 

And NAV is sorta/kinda a variant of book value (though one based on current market values rather than historical cost) and can be calculated by taking NOI and dividing it by the comp cap rates. This will give you a rough idea of how much a buyer would be willing to pay for the property(ies).

 

(again, might want to wait for someone else here to chime in before taking anything I say as gospel)

[scorpioncapital]

All good points, one additional metric that is very important in investing is how much money do I get on my investment? While the initial yield may be lower, eventually it moves up or down to the ROIC. So for example, if Seritage invests $1 and earns $1.13 on that investment and Seritage current yield is 5%, then the next year the yield increases to 5.65%. You have a bond but with an expanding coupon. That coupon is part inflation protection and part real return. Eventually if all things are equal, an investor who is patient enough should be getting the full 13% return on purchase price after some number of years. But this is a good question...many stocks/companies start with a yield far lower than the internal return on capital. This may be because this is a cash-cow so has a base starting rate. Any other ideas why initial yields are never the return on invested capital - except possibly in a crash, when yields also dip but a long-sighted investor might assume it will normalize again in the future?

[SlowAppreciation]

All good points, one additional metric that is very important in investing is how much money do I get on my investment? While the initial yield may be lower, eventually it moves up or down to the ROIC. So for example, if Seritage invests $1 and earns $1.13 on that investment and Seritage current yield is 5%, then the next year the yield increases to 5.65%. You have a bond but with an expanding coupon. That coupon is part inflation protection and part real return. Eventually if all things are equal, an investor who is patient enough should be getting the full 13% return on purchase price after some number of years. But this is a good question...many stocks/companies start with a yield far lower than the internal return on capital. This may be because this is a cash-cow so has a base starting rate. Any other ideas why initial yields are never the return on invested capital - except possibly in a crash, when yields also dip but a long-sighted investor might assume it will normalize again in the future?

 

Yeah the more time I spend on it, the more I think you kind of have to look at SRG in stages. No one valuation model or method does it justice.

 

If you aggressively assume SRG redevelops 100% of the remaining 34.5m/sqft of their GLA at an average redevelopment cost of $100/sqft, then you're looking at an additional $3.4b capital outlay. If they can charge $15sqft across the portfolio, you're looking at a ~14%-16% yield at some later point ($470m NOI/$3.4b). Maintenance CapEx probably won't be huge at this point either.

 

The tricky part is figuring out if those assumptions are reasonable, and how long it will take to achieve them. And as you mentioned, am I okay with a 5% yield today that will expand over time?

[scorpioncapital]

From what I've observed the starting initial yield has two components:

 

1. Pure mispricing, misunderstanding of risk, etc.. where value investors make a living.

2. The real or perceived quality, safety, and long-term stability of the earning stream. Basically the higher the quality of the business, the lower the starting yield. Think maybe Coca Cola vs Dow Chemicals. Perhaps both make the exact same amount of free cash flow at some point in time but one may be cyclical, another less so. One might have less conviction that the earnings will be stable, not change, or materialize in 50 years, the other might not.

 

Seritage it's hard to say the quality of the earnings but if the value of the real estate is there and the land and development is good I can't see why it can't last a long time.

 

[KJP]

Any other ideas why initial yields are never the return on invested capital - except possibly in a crash, when yields also dip but a long-sighted investor might assume it will normalize again in the future?

 

The "initial yield" you appear to be referring to is the current earnings or FCF yield of the security at the investor's purchase price.  Holding future growth constant, that "initial yield" is inversely related to the company's anticipated future ROIC.  The reason for this is that the higher a company's future ROIC is -- i.e., return on incremental invested capital -- the more valuable its future growth is.  This is another way of saying that, holding growth constant, higher ROIC companies deserve higher P/Es.  The math behind this is laid out in many articles on ROIC and in McKinsey's Valuation treatise. 

[BTShine]

The company has stated they expect an 11-12% un-levered yield on future developments.  These developments will be levered at some point, which means they'll pay about 5% on the debt and see excess returns of 6 or 7%.  If they're doing this at $100/sqft on 2 million sq/ft of property each year, then we'd see about an extra $200 million in equity value created.  How? 

 

The two million square feet will see levered returns of around $14 million per year (as shown above).  With a conservative cap rate of 7% this means the value of this development is $200 million ($14 million / 7% = $200 million). 

 

With these round, yet fairly accurate numbers, we can assume every 1 million square feet that is redeveloped creates $100 million in value for SRG shareholders.  Spread over 55 million shares it's about $2/share. 

 

 

 

[muscleman]

http://www.debtwire.com/info/2016/12/16/sears-hit-cash-advance-requests-vendors/

 

In 3Q, Sears also terminated the leases of 17 underperforming stores owned by Seritage Growth Properties, a publicly traded REIT.

 

 

SHLD's market cap just crossed below 1bn. The pace of lease termination may accelerate.

[thinkpad]

hello

 

http://ir.seritage.com/file/Index?KeyFile=37276443

 

200m$ to fund redevelopment (debt issued by ESL)

 

 

[scorpioncapital]

Cool, but you know in math we have something called order of operations. Is there a reason you get a loan first instead of stopping the dividend and getting a loan? It's like a bathtub you are putting some water in but also taking some water out :)

[Mephistopheles]

Cool, but you know in math we have something called order of operations. Is there a reason you get a loan first instead of stopping the dividend and getting a loan? It's like a bathtub you are putting some water in but also taking some water out :)

 

From the 10-k:

 

In general, participating employees are required to remain employed for vesting to occur (subject to certain limited exceptions). Restricted shares that do not vest are forfeited. Dividends on restricted shares and share units with time-based vesting are paid to holders of such shares and share units and are not returnable, even if the underlying shares or share units do not ultimately vest. Dividends on restricted shares with performance-based vesting are accrued when declared and paid to holders of such shares on the third anniversary of the initial grant subject to the vesting of the underlying shares.

 

Unvested restricted shares at end of period

 

  221,484     $ 30.81  

[Foreign Tuffett]

In four months RBC has gone from initiating coverage on SRG as a "Top Pick" to downgrading it twice. That was fast.

 

I don't have access to the report, but my guess is that they are concerned about the risk of a SHLD bankruptcy.