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Why Did Buffett Buy This Sears-Focused REIT?

I find it perplexing that legendary investor Warren Buffett owns shares in a REIT that owns a large majority of buildings leased to Sears Holdings (SHLD).

In December 2015, Buffett disclosed an 8.02% stake in Seritage Realty Group (SRG) – a stake of ~2 million shares valued at roughly $70.6 million (as the time).

Sure, it’s pocket change for Buffett, worth $78.6 Billion according to Forbes, but the billionaire rarely invests in REITs and his strict “value investing” diet seems to be on the higher-end of the risk curve, much more speculative than his ordinary investing motif.

It’s hard to argue with Buffett though, shares in SRG have returned over 25% since he became a shareholder – a stake now worth close to $100 million.

But I am still confused that one of the wealthiest investors in America would roll the dice by betting on a REIT that is running out of money. That’s right, running out of money.

Sears is a Sinking Ship

Eddie Lampert is a “hedge fund titan” that is best known for his big bet in Sears in which has undertaken a key role as the CEO (since 2013) hoping to deliver outsized value by spinning off the retailer’s assets.

In 2015 he decided to create a REIT that serves like a bank – essentially obtaining $2.7 billion in capital for Sears in return for a promise to pay in the form of a large-scale sale/leaseback.

Billionaire Lampert (worth $2 Billion according to Forbes) and his hedge fund have essentially created a bank for Sears, except instead of securing the Sears-owned real estate, he has created a vehicle – Seritage Growth Properties– to generate liquidity (to keep Sears afloat). At the time of the SRG announcement Lampert said,

Today’s announcement demonstrates our ability to unlock a small portion of Sears Holdings’ vast and valuable real estate portfolio, and represents an important step in the continued transformation of Sears Holdings.

This week Sears reported widening fourth-quarter losses and plummeting same-store sales . The struggling retailer’s losses grew nearly 5% to $607 million in the fourth quarter, and same-store sales fell 10.3%.

Sears attributed its fourth-quarter sales declines to a “challenging” holiday season and highlighted the measures it’s taking to revive business. The company also highlighted the sale of its Craftsman brand to generate liquidity (for $525 million in up-front cash, with a further $250 million in three years, including additional payments based on several hurdles).

“The transaction delivered significant value for Sears Holdings, while facilitating the future growth of the Craftsman brand in and outside of our shopping platforms,” Sears CEO Eddie Lampert said in a letter to employees on the earnings results.

These moves seem to be more of a band-aid for Sears, assets are declining in value while long-term debt has risen from $2.2 billion to $4.2 billion. The company also hinted that it will likely close additional stores to cut costs. Sears chief financial officer Jason Hollar said

“We have a valuable real estate portfolio, which at the end of the fourth quarter comprised 1,050 leases with significant optionality, as well as 380 owned stores, many in prominent locations. We will continue to assess opportunities to right-size our store footprint and inventory levels aligned to our ongoing transformation to an asset-light integrated retail model.”

Sears is burning through cash, causing Fitch to ring alarm bells, while rating the company’s debt at “CC” and downgrading Sears Roebuck Acceptance Corp’s (SRAC) unsecured notes to “C.”

Fitch estimates that Sears stands to lose $1.0 billion in 2017 before pension obligations and capex, even with recent store closures, as same store-sales continue to fall by a high-single digit percentage after an 8% fall last year. Fitch expects total Sears cash burn of $1.8 billion in 2017, with a similar amount the following year. As Sears’ financial condition deteriorates further, the company will come under increased pressure to redevelop its space.

In the beginning of 2015 Sears announced a sell of 7 locations to CBL Properties (CBL) for $72.5 million at a 7.0% cap rate. Sears has more real estate it could sell, but a majority of buildings are pledged to the company’s pension.

So Why Would Buffett Invest In A Sinking Ship?

Seritage exists for the sole purpose of monetizing properties for Sears to survive. Lampert is the largest shareholder of Sears and Seritage, so he is essentially the Landlord and the Tenant. If it seems like a conflict of interest, it is.

In the fourth quarter Seritage reported operating FFO (Funds from Operations) of $0.54 per share, ample profit to cover the dividend of $.25 per share. However, liquidity and long-term performance are most troubling.

According to Floris van Dijkum, REIT analyst with Boenning & Scattergood, “SRG appears to be ramping up its development pipeline in order to maximize third party NOI before a potential bankruptcy event at SHLD. If all developments (including SNO tenancies) were to generate rent, third party income would be 36%, likely not yet sufficient to meet debt service payments.

The analyst points out that “both Macy’s and JC Penney’s have announced store closures that will compete for tenants with SRG. Should the company get into a liquidity squeeze, it could always look to sell its interest in JV assets to partners, likely at a discount.”

The best option for Seritage to fund growth may be a loan from billionaires’ Lampert or Buffett.

But Lampert (through ESL Holdings) has already loaned Seritage $200 million (at 6.5%) back in 2016 (matures December 2017) and Buffett has, up until now, been an equity investor in Seritage.

Why doesn’t Seritage raise equity?

Shares are trading at a 25% premium (to NAV), making it an opportune time to generate low cost equity to fund the Seritage re-development pipeline. Dijkum points out that “the current 30% short interest in SRG (the highest in the REIT industry, according to SNL) would provide a ready buyer pool for newly issued shares.”

History has shown that Lampert does not like raising equity, likely because it dilutes his ownership stake.

But he may have to, at year-end 2016, SRG had $52.0 million of unrestricted cash (total cash of $87.6 million) and approximately $80 million of undrawn funding remaining on its original $100 million facility. According to Dijkum “If all JV costs came due in 2017, SRG could have to spend a total $432 million on its existing pipeline, leaving just $5.4 million of excess cash.”

Fitch believes there’s a 40% chance that Sears could file bankruptcy in 2017 and if that occurs, Seritage will have to scramble.

Over the years I have learned that Buffett likes to be in control, and while his investment in Seritage is small, he is speculating that Sears will last a few more innings. Given the odds (of Sears survival) and the capital drain at Seritage, it may be a good time for Buffett to cash in his chips. Mr. Market is ignoring the most obvious catalyst – that Sears is likely to file bankruptcy – and Seritage management should be taking advantage of the premium valuation.

Clearly Buffett views Seritage as a value-add real estate play but he surely knows that Eddie Lampert is in control and value investors like Buffett should know that “he who has the gold, makes all of the rules”.

Disclosure: I own no shares on SHLD, SRG, or CBL. 

Written by: Brad Thomas

Original Article: 

Interest(s): Date: March 15, 2017