Seritage Growth Properties — 2015 Form 10-K
Business context and reporting period. Seritage is a newly formed, self-managed retail REIT. It acquired a portfolio from Sears Holdings on July 7, 2015 and began operations that day; the reported period is July 7 through December 31, 2015, not a full fiscal year. The transaction involved approximately $2.7 billion and included 235 wholly owned properties and 50% interests in 31 joint-venture properties. At year-end, the portfolio totaled approximately 42.4 million square feet of gross leasable area.
Financial and operating results
- Revenue: $113.6 million, comprising $86.6 million of rental income and $26.9 million of tenant reimbursements.
- Profitability: GAAP net loss was $38.8 million; loss attributable to common shareholders was $22.3 million, or $0.71 per share. Results included $65.9 million of depreciation and amortization and $18.4 million of transaction-related acquisition expenses. Total NOI, a non-GAAP measure, was $89.5 million; FFO was $36.1 million and Normalized FFO was $62.0 million.
- Cash flow: The audited cash flow statement reports $17.7 million provided by operating activities, $2.73 billion used in investing activities and $2.78 billion provided by financing activities. The MD&A narrative separately cites operating cash flow of $13.7 million; this inconsistency should be reconciled.
- Debt and interest: Mortgage debt was approximately $1.16 billion gross ($1.14 billion net of deferred financing costs), all variable-rate. Loans are interest-only, mature in July 2019, and had a 4.96% weighted-average interest rate for the period. A 100-basis-point rate increase would raise annual interest expense by approximately $11.6 million, before mitigation. A four-year interest-rate cap had a $3.5% strike rate and year-end fair value of approximately $2.1 million.
- Liquidity: Year-end unrestricted cash was $62.9 million and restricted cash was $92.5 million. An additional $100 million future-funding facility was available subject to conditions and had not been drawn. Restricted cash included reserves for capital needs, property carrying costs and environmental matters.
- Portfolio and rents: Signed leases covered 99.5% of total portfolio GLA, including leases not yet open. Annual base rent was $202.9 million, or $5.13 per square foot. Sears represented 76.0% of annual base rent; third-party leases represented 24.0%. Sears accounted for 90.7% of leased GLA.
Material changes and strategy
There is no full-year prior-period comparison: Seritage had no operating business before the July 2015 transaction. The principal change was the creation of a large property platform funded through the acquisition, public and private equity proceeds, and mortgage borrowings. Management’s strategy is to recapture Sears space, redevelop or reconfigure properties, lease to third parties at higher rents and diversify tenants. The master lease permits recapture of approximately 50% of space at many properties and 100% at 21 identified properties, subject to terms and limits.
During the period, Seritage exercised 100% recapture rights at three properties and initiated five redevelopment projects with estimated total project costs of $64.2 million, including recapture termination fees. Of 15 projects acquired in various stages of development, seven were substantially completed; eight remained in development, with approximately $21.7 million yet to deploy at year-end.
Outlook, risks and unusual items
- Outlook: Management expects to grow NOI and diversify tenancy through redevelopment and leasing. The filing provides no specific earnings, revenue or NOI guidance.
- Tenant concentration: Sears Holdings remains the dominant tenant and revenue source. Its financial condition, ability to pay rent, lease termination rights and potential bankruptcy are material risks. Sears may terminate leases for qualifying underperforming properties, subject to fees and contractual limits; those rights could begin after August 1, 2016.
- Financing and covenants: Debt is secured by the wholly owned properties and Seritage’s JV interests. A debt-yield level below 11.0% or failure to meet tenant-diversification thresholds may trigger cash sweeps that restrict distributions and use of cash. Loans also restrict additional debt, asset transfers and certain leasing or redevelopment actions.
- Execution and property risks: Redevelopment entails construction, leasing, permitting, cost-overrun, vacancy and financing risks. Environmental exposures include former or existing automotive and fueling uses; Sears indemnities and a $12.0 million environmental reserve may not cover all liabilities. Management reported no known environmental issue expected to materially affect operations.
- Litigation: Sears shareholders have challenged the transaction, alleging an unfairly low sale price and flawed process, and seek unspecified damages. Seritage disputes the claims; management could not estimate a possible loss or range.
- Other items: The company recorded a $2.9 million fair-value loss on its interest-rate cap and $18.4 million of nonrecurring transaction expenses. Management intends to qualify as a REIT beginning with the 2015 tax year; qualification and distribution requirements are ongoing.
Important facts for investors to verify
- Reconcile the $17.7 million audited operating cash flow figure with the $13.7 million amount stated in MD&A.
- Track Sears’ rent-paying capacity, lease termination or recapture activity, and the pace and economics of third-party leasing.
- Verify redevelopment budgets, remaining capital requirements, leasing commitments, completion dates and realized returns.
- Review debt covenant headroom, variable-rate exposure, cash-sweep triggers, and the July 2019 maturity and extension conditions.
- Monitor the transaction litigation, environmental reserves and indemnity recoverability, and the company’s continued REIT qualification.