Seritage Growth Properties Makes Progress Despite Sears' Struggles

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2017 was the year of the store closure for Sears Holdings (NASDAQ: SHLD). The troubled retail icon slashed its store count by more than 25% last year, as management concluded that the company couldn't afford to keep operating loss-making stores.

This put pressure on Sears real estate spinoff Seritage Growth Properties (NYSE: SRG), which leases the majority of its space to Sears Holdings. The result was a big decline in profitability (by any measure) during the fourth quarter. Nevertheless, Seritage continued making progress last quarter toward its long-term goal of diversifying its tenant mix and boosting rental income.

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The bad and the ugly

In the fourth quarter, Seritage posted a net loss of $43.5 million or $1.27 per share, compared to a loss of $15.0 million ($0.48 per share) a year earlier. Funds from operations -- a metric that is more useful for judging REIT performance -- plunged to $0.20 per share from $0.62 per share in Q4 2016.

The big deterioration in profitability can be traced to a more than 20% year-over-year decline in Seritage's rental income. As part of Sears Holdings' downsizing initiative, the company has exercised its right to terminate the leases for many of the properties in Seritage's portfolio. Nearly all of these lease terminations had gone into effect by October.

In total, Sears Holdings has now terminated the leases for 56 properties. As a result, Seritage Growth Properties' portfolio was just 80% leased as of Dec. 31, down from being 90.2% leased just three months earlier and 99.2% leased at the end of 2016 (just before Sears Holdings began vacating space).

Leasing activity picks up speed

These numbers make it seem like the sky is falling. Yet it's important for investors to recognize that Seritage is in the early stages of a strategy to redevelop the majority of its properties to bring in new, higher-paying tenants.

Thus, leasing activity and redevelopment progress are arguably the most important performance metrics for Seritage Growth Properties today. From this perspective, Seritage had a relatively successful quarter and year.

During the fourth quarter, Seritage signed new leases for 872,000 square feet of space (more than 2% of its total square footage) at annual rents averaging $17.00 per square foot. This marked the second-best quarter in the company's history in terms of leasing activity.

For the full year, the company signed new leases on 2.6 million square feet of space at an average rent of $17.16 per square foot. This will bring in $44.7 million of annual rental income once all of the leases are in effect, up from $36.6 million in annual rental income from Seritage's 2016 leasing activity.

To look at Seritage's progress from another perspective, the REIT has begun redevelopment work on 63 properties since being formed in mid-2015. Management believes that when these projects are all fully stabilized, they will generate annual rental income of $157 million -- only $8 million of which will come from Sears Holdings. That's roughly equal to the total annualized rental income generated by Seritage last quarter across its portfolio of more than 200 properties.

The fundamental thesis hasn't really changed

Obviously, it's not ideal from Seritage's perspective that Sears dumped so much real estate -- and particularly low-quality real estate -- on it in the span of a year. Of the 36 properties that Sears Holdings decided to terminate between September 2016 and January 2017, Seritage had announced redevelopment projects for just 10 by the end of last year.

This highlights the difficulty of creating viable retail redevelopment projects in rural and/or low-income areas. However, in the long run, it may not matter much for investors.

First, the vast majority of the value of Seritage's portfolio comes from its top-tier properties. There are plenty more high-potential sites in the pipeline beyond the ones for which Seritage has already announced redevelopment projects. Second, Seritage ended 2017 with nearly $400 million of cash that can be used for redevelopment projects, which lessens its need to generate lots of cash flow internally in the near term.

A recent improvement in the retail climate should help Seritage Growth Properties accelerate its leasing and redevelopment activity. The stock has huge upside if management can make steady progress in this direction over the next few years. As a result, I began buying shares of Seritage Growth Properties a few weeks ago, and I am looking at the recent earnings-related pullback in the stock price as an opportunity to increase that position.

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Adam Levine-Weinberg owns shares of Seritage Growth Properties (Class A). The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.