Description

I am recommending a short of Seritage, as I believe a restructuring event will occur at one of its debt maturities in either July 2023 or July 2025 and that the equity will receive little or no recovery.

 

Part 1: Intro      

 

Seritage has been written up no fewer than seven times on this board, including twice on the short side. Since the last writeup in November 2018, the company’s primary tenant Sears declared bankruptcy and exited all of its Seritage locations. Subsequently, Seritage’s stock price plummeted at the onset of COVID, and it remains ~75% below both its immediate post-spinoff and YE19 prices. For anyone unfamiliar with Seritage’s backstory, I included a brief timeline in this writeup as an appendix. With $1.44b of debt outstanding in the form of a July 2023-maturity 7% fixed rate term loan held by Berkshire Hathaway and a ~$685mm market cap (including unconverted OP units in the share count), Seritage now trades as a levered play on new CEO Andrea Olshan’s plans for a mostly vacant real estate portfolio.

 

Seritage has been in violation of financial metric covenants in the term loan since 2019, and it won’t be able to cure these any time soon. These financial covenant violations are not considered events of default – so by my read Berkshire couldn’t accelerate the debt even if it wanted to – but Berkshire does now have veto rights over any property sales or new JVs, along with mortgage liens on all of Seritage’s wholly owned properties. Under a loan modification executed in November 2021, Seritage can extend the term loan for two years after the initial maturity date of July 31, 2023 provided that it has paid the loan down to $800mm by the initial maturity. Seritage took the first step towards meeting the extension requirement with a $160mm paydown on 1/4/22, which appears to have been funded with a few Q4 asset sales including the sale of a single empty mall box in San Bruno, CA for $128mm.

 

I started doing work on Seritage late last year due to both the hiring of Olshan and some increased disclosure about the company’s development and disposition plans. Given the leverage profile, I figured it might be interesting as either a long or a short. When Sears was still in occupancy, this company was incredibly hard to value – I don’t think prior management had any real plans for redeveloping the majority of these boxes. As of 21Q3, the company has finally divided the 170 remaining assets into four post-Sears business plans:

 

Retail: Currently 80%+ leased and positive cash-flowing.

Premier Mixed Use: 7 high-end development projects on Seritage’s most valuable land. 3 of these are complete or close to it, and 4 are still in the planning phase.

Residential: Vacant boxes set to be torn down and redeveloped as apartment buildings.

Other: Mostly vacant sites that are slated to be sold off to pay down debt.

 

I ultimately found Seritage to be an attractive short for two main reasons:

 

     1) The majority of Seritage’s assets are one-off mall anchor boxes, which are very challenged from a liquidity perspective. As Seritage has sold assets, the portfolio concentration has shifted from ~48%/52% mall/freestanding at spinoff to 60%/40% today due to the lack of buyers for the mall boxes. B and C malls themselves went no bid even before COVID, and there have been minimal recent trades of even A-malls. Additionally, because Seritage’s boxes are fractions of malls and not malls themselves, I think the majority of Seritage’s assets have only one possible buyer – the owner of the adjacent mall (data on Seritage’s previous property sales strongly support this). If Seritage were forced to sell these mall boxes, either today or at debt maturity, they would likely only clear at a deeply distressed price, far below the already-low prices where a few similar mall boxes have previously traded.

 

     2) The 3 Premier mixed use developments that Seritage is close to completing – Santa Monica, Westfield UTC, and Aventura – have been flops, sitting mostly vacant today. Before Seritage, nobody I know of had ever attempted to redevelop and try to lease a fraction of a high-end mall when the rest of the mall is owned by a top mall operator. The 2 Premier projects already open to tenants have revealed that this concept was poorly conceived, and all indications point to the 3^rd such project struggling as well. I think all three of the close-to-complete Premier properties will fail to stabilize at much above 50% occupancy, and the only possible buyer for these properties is the owner of the rest of the mall, who is fully aware they’re the only buyer. Any trades of these assets should also be at a deeply distressed price.

 

Estimating distressed prices is difficult, so I value Seritage’s assets based on what I call an “appraisal” valuation. The assumptions in this appraisal valuation are 1) valuing every mall box based on the very limited transaction comps available (in reality, there’s massive adverse selection in that the few mall boxes have already traded are the highest quality); and 2) valuing the 3 mostly-complete Premier mixed-use developments as if they’re fully stabilized and cash-flowing.

 

Even in this generous appraisal value scenario, I’m shaking out to a gross asset value slightly below SRG’s current enterprise value, suggesting all the upside is already priced into the stock. Needless to say, owning illiquid, hard-to-value, negative cash-flowing assets with maturing secured debt usually doesn’t lead to great outcomes for equity holders. The mall boxes and 3 Premier projects are a majority of Seritage’s assets, so it doesn’t take very aggressive discounts to their appraised value to cause the equity to be a full wipeout. Ultimately, I think Berkshire has the best chance at maximum recovery on its term loan by selling these assets off over a long period of time, and so I expect that, whether the eventual restructuring event occurs in July 2023 or 2025, the Seritage equity will receive minimal recovery.

 

Finally, I was finishing this writeup last week and saw the headline that Seritage has engaged Barclays and is, “open to full sale or asset disposal”, with Lampert stepping down as Chairman. I think this is just more evidence supporting the short thesis. Even before the announcement, Seritage was already selling all the assets it could find liquidity for. Westfield, which owns a national portfolio of high-quality malls (as opposed to single boxes), has been publicly trying to sell its US malls for over a year and hasn’t completed a single transaction. Outside of Eddie Lampert doing something that is not in his economic interests, there is not a buyer for Seritage as a whole, and I would expect the few buyers that find pieces of Seritage attractive to hold out until the debt maturities in order to buy at a cheaper price.

 

 

Part 2: Real Estate Private Markets for B and C Rated Malls

 

The most important metric in assessing the health of a mall is tenant sales productivity per square foot, and a B-mall is defined as one doing less than $500 PSF in tenant sales. Since before COVID, the private markets for both real estate equity and debt have treated B and C malls as toxic assets. Every investor in any position in the capital structure of a given B-mall is asking an existential question of whether the mall will continue to exist in 5-10 years, and nobody seems to have a convincing answer.

 

The last wave of institutional buying of B-malls occurred in the early 2010’s, when a few firms including Starwood and KKR attempted to aggregate one-off undermanaged B-malls, improve operations, and either IPO or sell at a portfolio premium. These firms were largely successful at improving operations and cash flow, but during their hold periods cap rates for B-malls blew out, erasing any equity value above the mortgage debt they’d taken on. From conversations I’ve had with folks at these firms, they consider themselves lucky to have returned ~1.0x from a combination of hold period cash flow, refinances, and outparcel sales. The prevailing sentiment in real estate private equity with respect to investing in malls is “never again”.

 

I recently had a call with one of the top mall brokers in the country, and one story he told made the B-mall cap rate widening story particularly salient to me. To paraphrase, he said, “I talked to a hedge fund looking at a high-yielding note in the 65-75% LTV corridor (based on an appraisal) of a B-mall refinance loan to one of the top mall operators [Simon or Brookfield]. The fund had done a lot of work going through the rent roll and understanding the competitive centers in the market. I told them I agreed with all of the analysis they had done, but based on the cap rate where I could list the mall today and actually get bids, I thought their note was closer to 110%-120% LTV.”

 

In addition to the capital markets challenges, one anecdote I’ve heard from some former mall investors is that trying to lease a one-off mall or a small portfolio of malls is very challenging. The typical A- and below mall is a fairly commoditized product, and there are more mall locations in a typical MSA than the average tenant needs to be at. Given the national leasing platforms of the large mall operators like Simon and Brookfield, it usually makes the most sense for tenants to just pick the closest mall owned by a big operator. On one hand, the big operators have standardized lease language and a single point of contact for many different MSAs, and on the other hand tenants don’t want to risk their relationships with the big operators to sign a lease with a single local owner. This is a large part of why there’s relatively little private ownership of malls compared to other types of real estate – the major private mall owners left are generational family real estate firms that own irreplaceably located malls, such as Bal Harbour Shops owned by the Whitman family and the Caruso malls in LA.

 

Today, the only national buyers of B-malls are firms like Namdar Realty and Kohan Realty that are essentially doing a run-off analysis. These companies buy dying malls at high teen to low 20’s cap rates (~5x cash flow), slash operating expenses to the bone, play hardball with municipalities to reduce property taxes, and ultimately try to recoup their initial investment through the first few years of cash flow from the tail end of expiring leases. If these firms can sell some number of their sucked-dry malls to developers after getting their initial investment back from cash flow, the strategy as a whole should deliver attractive returns. Needless to say this is not for the faint of heart.

 

The commercial mortgage markets are essentially shut to B- and C- malls, even for the best operators. Historically, Simon and GGP financed many of their lowest-quality malls with non-recourse CMBS debt. In retrospect this was a great decision, as now that these loans are coming due Simon and Brookfield can selectively default on the worst assets, offloading massive losses to bondholders with minimal consequences to the parent. For example, Simon gave up on Independence Mall outside Kansas City, MO in Feb 2018, and a CMBS trust sold the property in 2019 for just $50mm net of expenses, resulting in a $150mm loss on the $200mm initial loan. This 25% recovery is probably a best case outcome for the dozens of other B malls that have been taken over by CMBS servicers since 2020. Most of these have absolutely no bid and will languish in special servicing for several years before resulting in zero or even negative recovery after servicer advances and expenses.  

 

Admittedly, I’m less knowledgeable about the macro trends around e-commerce. I don’t think Amazon is going to drive every small retailer in the country out of business. However, the U.S. remains by far the most heavily retailed country in the world, with ~23 SF per capita compared to ~5 SF per capita in other developed countries. An oversupplied real estate market is a nasty thing. Because redevelopment is so expensive it often makes more sense for landlords to wait around for tenants, and meanwhile property cash flows decline as expiring above-market leases roll down. During the decade beginning in 1981 the square footage of commercial office space doubled in the United States, driven by tax incentives and lack of market information among other factors. This gave way to a massive real estate crash in the early ‘90’s. In 1991, Sam Zell famously coined the phrase, “Stay alive ‘til 95,” to describe underwater owners trying to stave off foreclosure in hopes of a better day. The prediction turned out to be accurate. In other words, it took four years to bounce back from this mostly supply-driven real estate downturn – demand for office space was not secularly impaired during this time period. Given how dramatically demand for mall space and department store boxes in particular have declined, I expect the current mall downturn to last quite a long time even if brick-and-mortar retail starts to mount a comeback.

 

Finally, a number of structural considerations make the cash flow from malls especially risky:

 

1.       Co-Tenancy / Sales Kickout Risk: Almost all mall tenants have termination options in their leases tied to the overall health of the mall, called co-tenancy provisions. These are usually tied to some combination of 1) a certain number of anchor boxes being occupied, 2) one or multiple specific anchor tenants being in occupancy, and 3) the overall occupancy of the mall. Additionally, some tenants have sales kickout clauses in their leases, which give a tenant the ability to break their lease if sales fall below a certain level. These are two of the biggest contributors to the mall “death spiral”, where B and C malls quickly empty out after falling into the 75-85% occupancy range.

 

2.       Anchor Risk: The traditional mall model used large anchor department stores to drive foot traffic, making smaller inline tenants viable. These department stores have been decimated by e-commerce. Many anchor tenants have gone out of business, and the few left continue to close stores. Most malls have one or more vacant anchor boxes and even the best malls often struggle to re-lease them.

 

3.       Non-Owned Anchor Boxes / REAs: Many anchor tenants own their own boxes (i.e. Seritage). This can significantly depress the redevelopment value of a mall as it can take years for a developer to assemble all the owned parcels. Additionally, in malls where anchor boxes are separately owned, there are usually reciprocal easement agreements (REAs) governing the various parcel owners. REAs include various use restrictions and purchase options that can further impair the redevelopment value of a mall.

 

 

Part 3: Historical Asset Sales

 

To understand the investment sales market for Seritage’s mall boxes, I put together a list of all of Seritage’s past property sales. Using Real Capital Analytics and CoStar, I was able to pull the buyer and purchase price for the ~85% of transactions where that data was available.

 

The properties that Seritage has sold so far skew heavily towards freestanding boxes. At spinoff in 2015, Seritage had 129 wholly-owned freestanding properties – it now has 61 wholly owned freestanding properties and 3 in JV’s. On the other hand, Seritage started with 106 wholly-owned mall properties and 31 JV mall properties – it still has 85 wholly-owned mall properties and 21 in JV’s.

 

For purposes of understanding the portfolio concentration I treat each JV property as half of a wholly-owned property (trying to weight by square footage is a bit of a moving target because of the redevelopment, but doesn’t produce significantly different results). Using this methodology, Seritage has sold 52% of its original freestanding boxes, but just 21% of its original mall boxes. This shifted the portfolio concentration from 52% freestanding boxes at spinoff to 40% today. Additionally, the proportion of B and C mall boxes increased from 39% of the portfolio at spinoff to 49% today.

 

Digging further into the mall sales reveals a huge asterisk: The vast majority of Seritage’s mall box sales have been to the owner of the adjacent mall. Seritage has realized liquidity on its mall boxes 40 times on 38 different assets (two assets were first contributed to JV’s and later fully sold). Of these 40 transactions, there were only ten where I couldn’t verify that the buyer owned the adjacent mall. One of these was the formation of a JV with Invesco to redevelop a box at Westfield UTC, which is so different in quality from the rest of the portfolio that I ignore it completely. The remaining nine transactions resulted in $90mm of proceeds to Seritage at an aggregate valuation of $66 PSF.

 

I thought it was worthwhile to understand each of these nine third-party mall box transactions. Two are obvious outliers. First, Seritage redeveloped a box at The Oaks Mall in Gainesville, FL, leased it to University of Florida Health, and sold the stabilized property in Aug 2019 for $20.0mm or $143 PSF. Second, Seritage sold an 80% interest in an ultra-infill mall box at Southbay Pavilion in Carson, CA (LA MSA) to NewMark Merrill in Sept 2020 at a valuation of $27mm, or $148 PSF. Excluding these two, the remaining seven transactions resulted in $49mm of proceeds at $43 PSF. Further, included in those seven remaining third-party mall box transactions are two sales to a known run-off mall buyer of boxes at Brookfield B-malls with near-term debt maturities – I anticipate this buyer will be making a play for the rest of the mall. Finally, another one of the seven third-party sales just didn’t have any public information.

 

I believe many of Seritage’s adjoining mall owners either 1) just have no desire to put incremental capital into their malls by buying the Seritage box, or 2) knowing they’re the only buyer, will wait until Seritage runs into distress to get the box at the lowest possible price. Thus, I’d expect the 60% of Seritage’s portfolio currently comprised of mall boxes to face severe liquidity challenges.

 

 

Part 4: In-Place “Appraisal” Valuation

 

I was able to match each Seritage box with its adjoining mall and then pull the Green Street rating for each mall. Results are in the table below broken out by segment. Again, the fact that ~half of Seritage’s properties are B/C mall anchor boxes struck me as very concerning given how negatively the real estate private markets treat B/C malls.

 

I was also able to approximate property-level revenues and expenses for each segment. In the Press Release for 21Q3 Earnings, Seritage provides NOI for each segment, but not revenue. I took rental revenue from the I/S and allocated it to each of the wholly owned segments by their leased SF. Unfortunately I wasn’t able to estimate revenue for the JV properties, although none of the JV segments are stabilized so they can’t be valued based on current income anyways.

 

 

 

 

Part 4Ai: Wholly-Owned Retail Valuation

 

The 38 wholly-owned properties Seritage lists as “Retail” are 82% leased in aggregate, and generating $45.6mm of annual NOI. 19 of the 38 properties are freestanding retail, averaging 89% occupancy, and the other 19 properties are mall boxes averaging 76% occupancy. The occupancy difference is a hint that the freestanding and mall box properties have very different risk characteristics. I valued the two segments separately. To split NOI between the two, I allocated revenue by leased SF and allocated expenses by total SF, which resulted in an almost exactly 50/50 split: $22.8mm of NOI for each of the freestanding and mall box sub-segments.

 

To value the freestanding properties, I applied a 7.0% cap rate to the $22.8mm of total NOI. Some of these properties are in decent markets – North Miami, FL; Lombard, IL; Austin, TX; and Riverside, CA – but some of the others are in very tertiary markets, such as Merrillville, IN; Kearney, NE; and Anderson, SC. I’d expect the adequately located properties to trade in the high 5%’s to mid 6%’s cap rates, while I could see the tertiary properties trading well into the 8% cap rate range. The rent rolls for these properties aren’t particularly impressive, with a lot of chunky exposure to movie theatre, gym, and other non-credit tenants. For example, a few of these properties are fully or majority leased to At Home, a budget big box furniture retailer taken private by Hellman & Friedman in mid-2021. At Home’s CCC rated bonds trade at close to 10% yield or ~85 $Px after being issued at par last June. Despite the generally ugly nature of the real estate and tenancy, most of the freestanding properties should work as class B/C retail longer-term. A 7.0% cap rate on $22.8mm NOI results in $326mm of value, or $148 PSF.

 

The mall boxes are much more fundamentally challenged and difficult to value. Just 5 of the adjoining malls are GSA A-rated, with 11 B-rated and the remaining 3 C-rated. If it’s difficult to compete with the big mall operators to sign tenants to a single mall in a given MSA, I don’t envy the task of having to compete for leases at a single box in a mall owned by someone else. On the capital markets front, I’d expect Seritage’s mall boxes to have similar or worse liquidity than the adjoining malls.

 

I value the stabilized mall boxes at a 12.5% cap rate, which works out to $182mm of value or $66 PSF. Allocating a 15% cap rate to the B and C mall leased SF leaves a 7.1% cap rate on the A mall SF. The implied cap rate on Simon’s pre-COVID acquisition price for Taubman was 6.2%, which should be a hard lower bound on the A-mall cap rate. 12.5% for all of the stabilized mall boxes is undoubtedly a punitive cap rate, but, right or not, the private markets treat every B-mall today as a future redevelopment play. Frankly I struggle to think of a buyer for these boxes even at that level.

 

For the A mall boxes, assuming a buyer pays a 7% cap rate or ~150 PSF, the space needs to work as retail at the end of the current tenants’ leases in order for any return math to work. I doubt any mortgage lender would touch a single mall box, so, assuming a 5 year remaining lease term, the 7% unlevered cash yield only nets the buyer’s basis down to ~$100 PSF by the time the tenant rolls (obviously ignoring cost of capital). A $100 PSF basis is far too high for redevelopment to be profitable. Likely the only buyer who would pay close to $150 PSF for one of these A-mall boxes is the owner of the adjoining mall.

 

For the B/C mall boxes, even at a 15% cap rate (~$55 PSF) I struggle to come up with a buyer profile. I don’t think these properties would work for the run-off buyers unless they were also trying to assemble the other mall parcels. With a single box, there aren’t any common area maintenance costs to cut, and a buyer would have much less leverage with the municipality to reduce property taxes. Additionally, depending on how many years of lease term remain, I don’t think a 15% unlevered cash yield would net down a run-off buyer’s basis far enough to give them the exit optionality they look for. A 15% cap rate might work for a developer buying one of these boxes as a covered land play, although there are plenty of cheaper vacant B-mall boxes available that can be redeveloped immediately. These are toxic assets and I think there’s real downside to even a $55 PSF aggregate valuation.

 

Combining the freestanding and mall box segments, my overall valuation for Seritage’s stabilized retail properties works out to a 9.0% blended cap rate, or $508mm of value at $102 PSF.

 

 

 

Par 4Aii: JV Retail Valuation

 

                Seritage lists 21 JV properties under its stabilized retail segment. These are essentially all A-/B+ mall boxes owned in 50/50 JV’s with the owner of the rest of the mall – 5 at Brookfield malls, 5 at Simon malls, and 7 at Macerich malls. “Stabilized” is a bit of a misnomer for these properties, as they’re currently 32.5% leased and generated just $4.3mm of annualized NOI in Q3 2021.

 

I think these are some of the most challenged assets in Seritage’s portfolio. The mall owners have an obvious incentive to shift prospective tenants to spaces where they can capture 100% of the leasing economics instead of just 50%. In most of these malls, the Seritage JV box is the only one that’s vacant. Simon seems to be the least bashful about this dynamic: all five of the Seritage JV boxes in Simon malls are completely vacant, compared to Brookfield JV properties at 43.7% leased and Macerich at 34.8%.

 

The best comps for these JV stakes are previous JV transactions between Seritage and the mall owners. In 2017, Seritage sold its 50% JV interest in seven boxes back to GGP for $190mm ($243 PSF, likely skewed upwards by the box at A++ rated Oakbrook Center), sold its 50% JV interest in five more boxes back to Simon for $68mm ($162 PSF), and contributed 50% stakes in five wholly-owned boxes to a new JV called GGP II for $57.5mm ($98 PSF). In a possible sign of deteriorating values after the Sears bankruptcy, Seritage sold back its remaining 50% interest in two of the GGP II boxes in 2020 for just $54 PSF.

 

To account for the A-/B+ quality of these properties I appraise them at $150 PSF, which works out to $252mm of total value or $126mm at-share for Seritage. In reality, I think there’s no liquidity for Seritage’s 50% stakes except from its partners, who also happen to be its biggest competitors. Given the mall owners know they’re the only buyer, I’d expect that they will hold out for the lowest possible price and thus not be a buyer until/unless Seritage runs into distress. Hastening this possible distress seems to be in the mall owners’ best interests.

 

 

 

Part 4Bi: “Mostly-Complete” Premier Properties

 

High-end retail has always been one of the most volatile but potentially lucrative types of commercial real estate. Seemingly minor details can cause massive value swings for luxury retail properties. For example, in Manhattan ground floor retail, a corner space can command 2-3x the rent PSF as a non-corner storefront in the exact same building. High-end mall rents can show even greater variation between heavily trafficked primary locations and those awkward off-center storefronts that seem to have a new tenant every couple years.

 

Because of the idiosyncratic risks of luxury retail properties, I did a deep dive on the leasing history, physical layout, and competitive dynamic for each of the three in-progress Premier properties, including visiting the Westfield UTC asset in person. You can read my full analysis in Appendices 3 (Santa Monica), 4 (Westfield UTC), and 5 (Aventura). To summarize, I think all three of these properties are failed concepts that will eventually need to be reimagined by a more experienced developer or operator.

 

·         Santa Monica (50/50 Invesco JV): The Santa Monica Asset, known as “Mark 302”, is the only one of these three Premier properties that isn’t directly adjoined to a mall. Instead, it sits across the street from Macerich’s Santa Monica Place, which as of 21Q3 is just 62% leased and struggling to backfill former Bloomingdales and ArcLight Cinemas anchor spaces. Seritage began redeveloping Mark 302 in 2018 into 51k SF of office space and 56k SF of retail, but has not yet signed a single lease in four years since development started and over a year since completion. For appraisal purposes I value this property at the reported JV total cost of $145mm, which represents a very high basis of $1,368 PSF. Assuming a 5.0% cap rate and 100% occupancy, the property would need to lease at a rent of $68.40 NNN, generating $7.25mm of NOI, to justify this $1,368 PSF valuation. In reality I don’t see Mark 302 leasing up any time soon.

 

·         Westfield UTC (50/50 Invesco JV): This completed project is 226k SF of retail and office space in the much larger A+ open air mall Westfield UTC. Seritage’s space opened in October 2021 and is less than 20% leased. Based on my walk through the property, I see most of Seritage’s storefronts here as awkward, hard-to-lease spaces that are essentially dead on arrival. This is the first high-end fractional mall redevelopment project Seritage (or anyone) has completed, and clearly Westfield is dominating Seritage at attracting tenants. As the owner of the rest of the mall, Westfield is the only logical buyer of this asset. However, Westfield in early 2021 announced that it would be disposing all of its US malls, so I find it unlikely that Westfield will want to throw more money at Westfield UTC unless it gets very favorable economics. I value the Westfield UTC asset at Seritage’s estimated cost basis of $165mm, or $729 PSF. The stabilization assumptions behind this value are 90% occupancy, 75% NOI margin, a 6.5% cap rate, $70 PSF gross rents, and $10.7mm of NOI.

 

·         Aventura: Aventura Mall is one of the top malls in the country, doing well over $1b in annual sales productivity. A 2018 appraisal for a $1.75b CMBS refinance of Aventura Mall valued it at $3.45b, or greater than Seritage’s entire enterprise value. Seritage broke ground on its Aventura site, called Esplanade at Aventura, over four years ago in 2017, and it expects to finally finish base building work in Q4 2022. The property is currently ~50% pre-leased, but ~80% of that pre-leasing is to anchor tenants Industrious and Pinstripes, which are likely paying low rents (if any at all in Industrious’ case). To my knowledge, Esplanade has not signed any traditional retail tenants, just a few restaurants. I value Esplanade at Aventura by assuming Seritage cuts rents to ~$100 PSF net, a 20% discount to rents at the rest of the mall, and manages to lease the property to 90% occupancy. At a 5.0% cap rate, this property is worth $388mm, or $1,800 PSF. In reality, the extremely savvy owners of Aventura Mall, Turnberry and Simon, know that nobody else would try to compete with them at their trophy Aventura property by buying Esplanade. I expect Turnberry and Simon to compete Esplanade at Aventura into the ground on the leasing front and then try to scoop up Esplanade as cheaply as possible in a liquidity event for Seritage.

 

 

 

Part 4Bii: Other Premier Projects

 

     Seritage’s four other premier projects exist only in renderings – the sites themselves are either vacant land or empty boxes. Due to either site specific issues or lack of funding from Seritage, these projects are all in some form of development limbo, and none is likely to be anywhere close to producing cash flow by Seritage’s debt maturities. On the positive front, because these sites are ‘blank slates’ they should generally have a larger buyer pool than the three other half-baked Premier projects.

 

·         Park Heritage Dallas: Valley View Mall in Dallas has been in various stages of demolition since 2012, and was finally torn down completely in 2019. The site of the former mall totals 450 acres owned by various developers, with Seritage’s portion comprising 23 acres of the total. Per SRG’s 21Q3 earnings release, “the Company completed the first phase of its infrastructure work at its Park Heritage project in Dallas, Texas, and expects to complete the second and final phase by the second quarter of 2022.” A June 2021 article reports that the hold-up was due to a lack of a sanitary sewer line. Seritage doesn’t have the development chops or capital to compete with the other developers here, but they should be able to sell the site fairly easily.

 

·         Town Center at Boca Raton: This is a Simon A+ mall with six anchor boxes, including a Macy’s, Saks, Nordstrom, Bloomingdales, and Neiman Marcus, along with the vacant Sears. Simon sued Seritage in Oct 2019, claiming that Seritage’s filing plans for various non-retail uses at the site triggered an option in a 1985 REA allowing Simon to buy the Sears box based on an appraisal value. There’s been no update on the property in the two years since. As with many of Seritage’s mall boxes, Simon is the only rational buyer for this site.

 

·         Overlake Plaza: This is a freestanding retail strip in Redmond, WA. Seritage has engaged in various property swaps here with Regency Centers, which controls a section of the retail, and it’s tough to decipher exactly which company owns what. The Sears box is still standing and I didn’t find any word on redevelopment plans moving forward.

 

·         Hicksville Shopping Center: This is a freestanding site in Long Island adjacent to B-mall Broadway Commons. The exec leading the project left Seritage in April 2021. Reportedly the company is “reviewing its Hicksville project” in light of the reorganization, “to ensure it is consistent with market conditions, our own realigned goals and business objectives, and reflects our discussions with community and government leaders.”

 

Lacking any more detailed information I aggressively value each of these properties at $50mm, or $2.3mm per acre. The only other vacant sites Seritage has sold close to that dollar amount were on valuable land in Honolulu ($47mm) and the San Francisco Bay Area ($128mm). In reality, the Town Center at Boca Raton site is worth whatever Simon is willing to pay for it, so $200mm for the four should account for any surprise to the upside on an individual parcel.

 

 

Part 4C: Residential Valuation

     SRG’s first residential project, Avalon Alderwood Place in Lynnwood, WA, is slated for completion in Q2 2022. This property has been held in a 50/50 JV with GGP/Brookfield since spinoff. Given that residential development will be the business plan for 35 of SRG’s remaining 170 assets, I was surprised to find almost no disclosure about the Alderwood project in SRG’s public filings. I had to look in the 10K of AvalonBay (AVB), a ~$40b EV REIT which owns ~80k apartment units, to find, “We have a 50.0% interest in… a joint venture to develop, own, and operate Avalon Alderwood Mall … expected to contain 328 apartment homes when complete.”

 

     The original Alderwood JV with GGP was 50/50, so I expect that Seritage owns at most 25% of the current JV. Seritage could have been diluted further if it was unable to fund its share of the $110mm ($336k per unit) of additional project costs reported by RCA. Also per RCA, the contribution value of the empty Sears box to this undisclosed new JV was a measly $3.4mm, or $11k per buildable unit. No news article mentions Seritage as a JV partner, although multiple mention Brookfield and AVB.

 

     This first project is an example of how little value Seritage brings to the world of multifamily development. SRG is 1) not a very good development partner, with minimal in-house development, property management, or leasing expertise, and with just one project under its belt as a minority JV partner. Without development expertise, Seritage will have to pay fees and promote to a partner on all of its residential projects. SRG is also 2) not a very good capital partner, given its obvious corporate-level leverage problems.

 

     The only thing Seritage really brings to the table in these residential JV’s is the land itself. While the US is experiencing a lack of housing supply especially in suburban areas, I find it hard to believe that developers are so desperate to build apartments adjoined to malls that they would give excessively favorable JV economics to Seritage. Additionally, Berkshire will have to release its mortgage lien on any wholly-owned properties before construction loans can be taken out on the sites.

 

     I assume Seritage’s residential land overall is worth $20k per buildable unit, which a friend in the real estate business described as generous. SRG’s 21Q3 press release reports that it contributed sites in West Covina and Riverside, CA to residential development JV’s at an aggregate contribution value of $15.9mm, or $21.3k per buildable unit. These look like some of the better sites in the residential category, so the $21.3k per buildable unit should be an upper bound on valuing the rest of the properties. Assuming mid-rise density of 25 apartments per acre on the 474 acres of residential land results in 11,850 buildable apartments, or $237mm of current land value at $20k per buildable unit. Of course, this valuation rests on the assumption that all the residential sites are actually developable as apartments, which is likely not the case considering almost 75% of the sites are mall boxes.

 

     To value the Lynnwood project, I assumed back of the envelope $2,000/mo market rents, 95% occupancy, 75% NOI margin, 4% cap rate, and 25% equity ownership for Seritage with no mortgage debt. This values the apartment building at $428k per unit or $35.1mm for Seritage’s stake.

 

 

 

Part 4D: Other Valuation

 

On SRG’s website, the About Us section lists, “…Approximately 10.0 million square feet of GLA or approximately 850 acres to be disposed of.” This ties to the 69 properties totaling 10.3mm SF and 844 acres in Seritage’s “Other” segment as of 21Q3. In aggregate, these properties are 18% leased and generating $3.9mm per year of negative NOI on $31mm of allocated revenue. It appears Seritage’s strategy is to sell the Other assets to pay down debt.

 

One argument I’ve heard Seritage bulls champion is that, since previous property sales have almost all been above book value, if you extrapolate some market/book value ratio to the rest of the portfolio there’s “tremendous value” to be unlocked. I think this is a huge mistake, and that there is enormous adverse selection in the assets that Seritage has not already chosen to sell or redevelop. The Other assets aren’t working as stabilized retail, apparently can’t be redeveloped as residential, and have not yet found buyers during the last two years of Seritage funding themselves mostly from asset sales. This is truly the bottom of the barrel of the original 266-asset Seritage portfolio.

 

I expect that a significant number of the Other properties have a negative NPV today – it will both cost more to tear down the Sears box and take more time to negotiate a development plan with stakeholders than is justified by the value of anything that can be built there. For example, one of the Other properties is a mall box connected to what was formerly known as Panama City Mall in Panama City, FL. In late 2018 the mall was hit by Category 5 Hurricane Michael, sustaining heavy damage. Longtime mall owner Hendon Properties decided not to rebuild, stating, “It is with a heavy heart we announce our decision to keep Panama City Mall closed for the foreseeable future… Unfortunately, the order of magnitude to rebuild comes at too great a cost. It is economically unfeasible to rebuild as the cost far exceeds the repaired value of the mall.” As of Feb 2022, the mall is still sitting vacant. The Seritage box at this mall has a book value of $4.3mm as of YE20.

 

I Google mapped each of the properties in the Other segment and would encourage others to do the same. There are a couple of well-located properties, a number in secondary markets, and a significant majority of properties in very tertiary locations. Some of these tertiary locations include: Anchorage, AK; Yuma, AZ; El Centro, CA; Webster City, IA; Paducah, KY; Lafayette, LA; Madawaska, ME; Manistee, MI; Sault Ste. Marie, MI; Columbus, MS; Olean, NY; Toledo, OH; and many others (admit it, you had to think twice about a few of those state abbreviations). By my count, 3 of the Other properties are located in primary locations that could have significant land value, 18 are located in secondary locations near real population centers, and the remaining 48 are in tertiary locations outside the top 50 US MSA’s.  

 

The risk to the short thesis for this segment is any upside surprise from selling the primary and secondary boxes. Additionally, I expect the most valuable properties to be the most liquid and thus the first to sell, which could make the unsold properties look more valuable than they really are. This was demonstrated when Seritage sold an Other property in San Bruno, CA to a lab office developer for $128mm in Nov 2021. I talk more about this sale in the Appendix, but I believe it was a true one-off transaction located in one of just 2-3 life science markets in the country that could support that kind of land valuation. The other primary tier boxes I identified are in San Jose, CA and Westminster, CA (LA MSA). In a demonstration of how hyperlocal the life sciences market is, I don’t believe the San Jose property would work for a lab conversion even though it’s just a 45-minute drive from San Bruno. It’s anyone’s guess what these two properties are worth, although given they’re both mall boxes they might not have any buyer at all due to REA restrictions.

 

Of the 18 secondary market boxes, 7 are freestanding and 11 are B-mall boxes. Just two of the 18 are greater than 50% occupied, and both of those are single tenant At Home’s. 8 of the 18 boxes are completely vacant. Again, it’s anybody’s guess what these are worth. The better ones have already started to sell – in Nov 2021 Seritage sold a mall box in Montclair, CA to adjacent mall owner CIM for $10mm / $57 PSF along with another mall box in Chula Vista, CA to adjacent mall owner Brookfield for $19.3mm / $88 PSF.

 

I estimate the Other segment as a whole is worth $30 PSF, or $309mm. There’s not a lot of science to this, except that I think the Other properties should be worth less overall than the Residential ones. The $30 PSF valuation implies the Other properties are worth $366k per acre, compared to $500k per acre for the residential land. If you assume half the tertiary Other properties are worth nothing, that implies ~$55 PSF of value on the rest of the Other segment. This is in the same ballpark PSF as my “stabilized” B and C mall box valuation, which intuitively makes sense as a buyer would be looking at any in-place lease at these properties as a run-off.

 

 

 

Part 5: Full Portfolio Valuation & Short Thesis

 

 

 

Adding up each segment I’m coming to a valuation of $1.96b. This is right on top of the $2.19b of current enterprise value: $1.44b term loan + $70mm pref + $685mm market cap (made up of 43.6mm Class A shares and 12.4mm unconverted OP Units both at $12.23/sh), assuming all the ~$160mm cash on the B/S is essential to SRG staying in business. [For simplicity, I include the Other properties known to have been sold after 3Q21 (San Bruno, Montclair, and Chula Vista) in the valuation calc at $30 PSF instead of their higher actual sale values, accounting for the sale proceeds by giving credit for the full $160mm term loan paydown in my EV calc] For the equity to be mispriced you have to believe some combination of the following:

 

1.       The three completed premier projects will not stabilize: $543mm of the valuation, a bit less than Seritage’s total equity value, is comprised of stabilized valuations for the three partly-completed premier projects: $72.5mm of at-share value / $1,368 PSF for Mark 302 in Santa Monica, $82.5mm of at-share value / $729 PSF for Collection at UTC, and $388mm of value / $1,800 PSF for Esplanade at Aventura. If you believe the competitive dynamics at these properties are too great for Seritage to overcome, any haircut to get to a distressed value translates to ~1 for 1 downside to the stock price. My estimate here is ~50% downside, which still values the properties at a weighted average ~$637 PSF and Aventura at $900 PSF.

 

2.       Many of the mall boxes won’t have a buyer at any price: $657mm of the valuation comes from non-premier mall boxes. This breaks down into $182mm / $54 PSF coming from the 76% occupied “stabilized” boxes; $126mm at share / $150 PSF of 33% occupied JV boxes at Simon, Macerich, and Brookfield malls; $174mm coming from 25 vacant sites to be redeveloped as multifamily; and $175mm / $30 PSF in 17.6% occupied “other” properties. In its entire history, Seritage has sold just nine mall boxes to third parties at an aggregate $90mm ($66 PSF) of proceeds, making the adjacent mall owner the only buyer for Seritage’s boxes in most cases. My base case here is also ~50% downside to the $657mm valuation.

 

3.       Development land is one of the first asset classes to go no-bid in any kind of macro event: Excluding the 3 in-progress premier projects, $746mm of the valuation comes from development land currently generating negative cash flow. This is comprised of the entire value of the Residential and Other segments, in addition to $200mm from the 4 wholly-owned premier sites that have yet to break ground. Since land is priced based on expectations of future cash flow, land is one of the first asset classes to go no-bid in a negative macro scenario, which would cause major issues for Seritage depending on the timing of the event.

 

If you believe, as I do, that the first two points are correct, the equity today should be fully out of the money. I view the third point as a bit of an added bonus that makes the Seritage short a nice portfolio hedge.

 

 

 

Part 6: Rough Cash Flow Projections

 

                As a last analysis, I did some back of the envelope math on Seritage’s cash flow position leading up to the debt maturities. Apart from property level revenues and expenses, the company has four main needs for cash over the next 1.5 or 3.5 years:

 

1.       Interest & Pref Dividends: Seritage pays a 7% fixed coupon on its $1.44b term loan and the same 7% rate on its $70mm preferred shares. The company capitalizes ~25% of its cash interest expense under development spending, but the full coupon must be paid each period unless Seritage wants to start accruing additional interest at the penalty rate of 9%. This cash interest expense and pref dividends would be $105.7mm annually at the current loan amount, dropping to $60.9mm annually assuming Seritage can pay down the loan to $800mm. In both scenarios, interest alone would be greater than the $46mm of NOI currently generated by the stabilized retail segment, not even accounting for the $18mm of negative carry from the Premier, Residential, and Other segments. Assuming $1.12b average loan balance over the next 1.5 years results in $125mm of total interest cost leading up to the initial debt maturity.

 

2.       Debt Paydown: $640mm in the next 1.5 years to extend the term loan.

 

3.       G&A: As far as I can tell this comprises tenant improvements, leasing commissions, property-level maintenance CapEx, and all corporate overhead. CRE is generally valued on “above the line” NOI, but leasing turnover costs and maintenance capex obviously must be paid. The G&A line item has actually grown as the portfolio has shrank, and has not been below $25mm annualized no matter what period you look at for the last four years. I assume $25mm of annual cash G&A expense going forward (maybe a bit high, but it won’t really move the needle on total cash needs).

 

4.       Development CapEx: Finally, Seritage will need to pay for the additional base building work and first-gen TI/LC’s for its Premier projects, most importantly Esplanade at Aventura. I assume $50mm additional base building work and $21.5mm of TI/LC’s at Aventura, ignoring lease-up costs on the other two for simplicity.

 

Adding those four uses of cash I’m estimating $874mm of total cash needs for Seritage to be able to extend its term loan in July 2023. I find it unlikely that Seritage can meet these obligations, but I will try to imagine a scenario where the company does.

 

Selling the entire Other segment at my appraisal valuation of $309mm obviously will not be enough. The next best candidate for sale is the Residential segment, which is generating $12mm per year of negative carry and will require hundreds of millions of dollars of building work and years of development headache before producing any cash flow. Selling this segment at my appraisal value (maybe to AvalonBay, whose CEO is former Seritage CEO Ben Schall) will generate another $237mm of proceeds, still well short of the $874mm. Selling the four Premier development sites still in planning could generate another $200mm, which gets to $746mm of sources of cash. Depending on the assumptions you make on stabilized retail NOI, cash already on the B/S, and how quickly Seritage can eliminate the negative carry from the properties it sells, in this scenario Seritage might get into the ballpark of being able to meet the cash requirements to extend the term loan.

 

     Even in this farfetched scenario, the remains of Seritage would essentially become a “pure-play fractional mall REIT”, which probably wouldn’t be a viable concept. At this point Seritage still has the $46mm of stabilized retail NOI. Assuming all 3 in-progress Premier projects stabilize, Westfield UTC and Mark 302 together would add $9mm of NOI at-share, and Esplanade at Aventura would add another $19mm NOI. This gives Seritage $74mm of property-level NOI vs $61mm of pref dividends and interest, leaving just $13mm for leasing costs, redevelopment CapEx, and all corporate overhead. This reduced-size version of Seritage probably would not generate any cash without further asset sales, would still be over-levered with the $800mm remaining term loan, and now couldn’t even claim the possibility of “redevelopment upside”. The two year extension would give the market for mall assets a bit more time to thaw, but I think the ultimate outcome would still be minimal recovery for the equity.

 

 

 

 

 

Appendix 1: Company Timeline/Overview

1.       July 2015: Sears under Eddie Lampert spins out Seritage, a REIT comprised of 235 wholly-owned Sears properties and 31 Sears properties owned in 50/50 JVs with Simon, Macerich, and GGP. A rights offering to existing Sears shareholders along with ~$1.2b of CMBS debt is used to acquire the properties for $2.7b. Substantially all of the properties are then leased back to Sears under a master lease agreement. The master lease agreement has various termination options for both Sears and Seritage, ostensibly to allow Seritage to begin redeveloping the portfolio as Sears closes locations.

2.       November 2015: Warren Buffett files a 13G disclosing that he owns 2.0 million shares of Seritage in his personal account, good for ~8% of outstanding shares at the time (not including OP Units), but still likely just a $60-$90mm total investment. Buffett appeared with the same number of shares on every proxy filing up until 2021, when he was diluted below 5.0% ownership due to OP units being converted to common shares. Buffett hasn’t made any filings since this initial 13G and it’s unclear if he still owns his shares today, although, if he does, the shares would have a market value of less than $25mm.

3.       August 2018: Seritage refinances its CMBS and other debt with a $1.6b initially-funded term loan provided by an insurance unit of Berkshire Hathaway. This transaction results in ~$250mm of net proceeds to Seritage after existing debt paydowns, and also frees up ~$175mm of restricted cash that had been reserved for leasing costs under the CMBS loan docs. The new term loan also includes a $400mm future funding component to be released to Seritage if it achieves $200mm in revenue from non-Sears tenants.

4.       October 2018: Sears Holdings files for Chapter 11 bankruptcy.

5.       February 2019: Sears rejects the Seritage master lease in bankruptcy, and executes a new master lease at 48 of Seritage’s wholly-owned properties and 3 JV properties. Seritage announces it will suspend its common dividend. From 2018 to 2019, Seritage’s consolidated rental revenue from Sears will drop from $152mm to $51mm.

6.       April 2019: The Sears Estate sues ESL and other parties including Seritage, claiming that a number of transactions leading up to the Sears bankruptcy constituted fraudulent transfers, including the Seritage spinoff. The litigation remains ongoing as of 21Q3 (This writeup does not discuss the fraudulent transfer claim, which has already been discussed at length on VIC).

7.       February/March 2020: Peak COVID fear hits the U.S., causing Seritage’s stock price to drop from ~$40/share to ~$7/share in a month.

8.       May 2020: Seritage executes the first amendment to its Berkshire Hathway term loan. The most material update is Berkshire allowing Seritage to defer interest payments without triggering an EOD in scenarios where the company’s cash balance drops below $30mm. Any deferred interest will accrue penalty interest at a rate of 9.0% and be payable at maturity in July 2023.  

9.       June 2020: It’s announced that Sears will be exiting all of its Seritage locations by early 2021.

10.   Feb 2021: Andrea Olshan is appointed the new CEO of Seritage, replacing Benjamin Schall, who will become the new chairman of AvalonBay (NYSE: AVB). Since 2012 Olshan has been CEO of Olshan Properties, a family real estate firm that her father founded. Mary Rottler, who has been with Seritage since 2015, will be COO, and Amanda Lombard, who has been Seritage’s Chief Accounting Officer since joining the company in 2018, will be CFO.

11.   September 2021: Mary Rottler leaves after 7 months as COO to become the new COO of First Washington Realty.

12.   November 2021: The term loan is amended again, eliminating any prepayment penalties and giving Seritage a two-year extension option provided it is able to pay the term loan down to $800mm by the initial maturity. Seritage reports ~$5mm of “severance and restructuring costs” between 21Q2 and Q3, suggesting this wasn’t a totally friendly amendment.

13.   Jan 2022: Amanda Lombard resigns after 14 months as CFO to become CFO of Veris Residential. Lombard is replaced by John Garilli, who has previously helped lead REIT liquidations at Winthrop Realty Trust and New York REIT. 

 

 

 

Appendix 2: Management Incentives / Large Shareholders

 

          Olshan: I don’t have a strong opinion on Andrea Olshan as a CEO, and I don’t think one is required for this short thesis. Olshan certainly seems to have the right background for the job. Her family firm Olshan Properties (formerly known as Mall Properties, Inc.) has a decent reputation, but like most real estate developers they have walked away from projects before. In 2016 they offered up a deed-in-lieu of foreclosure when they stopped paying debt service on an ’05 vintage CMBS loan on Cortana Mall, eventually resulting in just $998k of net liquidation proceeds on a $40mm initial loan. They also stopped paying debt service in May 2020 on a mortgage on Hilton Orrington Evanston, and will give the property back to lenders if they aren’t able to sell it at auction.

 

Many people have quoted Buffett when talking about this stock and I think this Buffett adage describes Seritage’s current position well: “I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn’t been so energetic in creating examples.” I don’t know if Olshan is a brilliant manager, but I do know that any New York real estate developer worth her salt understands the attractiveness of stepping into a levered situation like Seritage. If things work out, you capture all the upside and look like a genius; if not, you give it back to your lenders and move on to the next one.

 

Lampert: Eddie Lampert remained chairman of Seritage from spinoff until last week, and as of 21Q3 he owns ~4mm common shares along with the 12.4mm remaining unconverted OP units. This represents 29% economic interest in the company, giving him by far the biggest single equity exposure. Lampert’s involvement with Sears has practically become mythology at this point, and I am not going to attempt to understand his motives on this one. Lampert making an uneconomic offer for all of Seritage is a real risk to this short thesis, although finding financing would be extremely difficult and I doubt he can take down a $2b EV company with all cash.

 

Buffett: As discussed in the timeline section, Buffett may or may not still own 2 million shares of SRG common stock in his personal account (today worth less than $25mm). He also faces exposure to the $1.44b term loan through Berkshire Hathaway, which would seem to present a conflict of interest in the case of a potential restructuring. Since Buffett’s total involvement in Seritage is such an immaterial percentage of his net worth, I would imagine the most important consideration for him will be reputational risk, although I’m not sure how that translates to the eventual outcome just yet. 

 

         Pabrai: On Seritage’s 2021 Proxy statement, Mohnish Pabrai is listed as the largest owner of common shares, with ~5 million shares or ~9% economic ownership. Pabrai has since sold most if not all of his position in late 2021, but I thought it was worthwhile to understand his rationale as he’s one of the most high profile investors to buy the stock post-COVID. Pabrai explains his rationale in the book “Richer, Wiser, Happier”:

 

                One company at the epicenter of [COVID-related] uncertainty was Seritage Growth Properties, whose tenants included many retailers that could no longer afford to pay their rent. “The market hates all of this near-term noise and pain,” says Pabrai. He exploited the panic to buy a 13 percent stake in Seritage at exceptional prices, figuring that he’ll ultimately make ten times his money as fears recede and others recognize the value of its prime assets. Pabrai also liked that Buffett, whose investment record in real estate is “almost perfect,” owned Seritage in his personal stock portfolio. “Not only are we cloning his approach,” Pabrai tells me, “we’re directly cloning his position at one-fifth or one-sixth of the price he paid.”  

 

If buying a stock that Warren Buffett put <0.2% of his net worth into and that subsequently traded down 80% makes you a value investor, I guess I need to start calling myself something else…

 

 

Appendix 3: Santa Monica Premier Property (Invesco JV)

 

                The freestanding Santa Monica asset, known as “Mark 302”, is owned in the Invesco JV, and was the first of Seritage’s Premier properties to open in December 2020. The property was given a $50mm makeover and redeveloped into 51k SF of shell “creative office” along with 56k SF of retail. During two years of construction and one year since construction was completed, not a single lease has been signed. 

 

                Directly adjacent to Mark 302 is Santa Monica Place, a 523k SF open-air shopping center owned by Macerich. Santa Monica Place is an excellent example of the challenges facing even the highest-quality malls. Green Street calls this mall A+ and it reports $820 PSF in sales, but excluding Apple and Tesla (standard convention in the mall industry) that number drops to solid b-mall territory of just $465 PSF. The mortgage on the property was securitized in the WFCM 2017-SMP transaction, so public financials are available. As of September 2021, the property is just 62% occupied. The second largest tenant Bloomingdales (102k SF) vacated at the end of its lease in Sept 2020, and the third largest tenant ArcLight Cinemas (48k SF) stopped paying rent in April 2020 and filed for Chapter 7 in April 2021. The loan is out of extension options, has a final maturity date of December 2022, and should struggle to refinance. What does one do with 150k SF of empty mall anchor space? Might as well try to lease it as office. Macerich listed the vacant space in December 2020 and has yet to sign a lease.

 

It’s worth noting that Macerich owns its vacant box space at a far lower basis than the Seritage JV’s. The SRG JV’s total cost basis is $145mm or $1,368 PSF. The full $300mm debt on Santa Monica Place is $573 PSF, and the 2017 appraisal value of $622mm is $1,189 PSF. It’s tough to back out a value for the anchor space specifically, but Bloomingdales was paying just $4.30 PSF in rent before vacating, vs. $34.90 PSF rent paid by ArcLight and $70+ PSF rents for the majority of the other tenants. This lower basis allows Macerich to be much more aggressive on price in what’s clearly an oversupplied market – it is still accretive for Macerich to sign office tenants at a low rent that would force Seritage to realize a huge loss. So far, however, this competitive advantage for Macerich has been a moot point as no office tenants are forthcoming.

 

                Given that Santa Monica Place is a superior property that is already experiencing distress, I feel very comfortable assuming what few office and retail tenants want to be in this micro-location will be lured away by Macerich. I think there is probably no bid for the Mark 302 property today, except perhaps at a deeply distressed price. The Sears box is considered a “Designated City Landmark” by the City of Santa Monica, which among other restrictions entails that, “Demolition is not permitted, except in very limited circumstances.” There is obviously no redevelopment value in the land if you can’t tear down the building on it to build something new. Santa Monica City Hall and Police Department are across the street – who knows, maybe SRG will get lucky and sell this white elephant to a local government agency. I (generously) value the project at cost of $145mm.

 

Further, I think $145mm is far above a potential distressed value. Assuming a 5.0% cap rate and 100% occupancy the property would need to lease at $68.40 NNN rent to support a $1,368 PSF valuation, not accounting for any tenant-specific buildout costs. In other words, there’s still significant downside to this appraisal valuation.

 

 

 

Appendix 4: Westfield UTC Premier Property (Invesco JV)

 

Seritage announced the grand opening of its first mall redevelopment project at Westfield UTC in October 2021. Before COVID, Seritage had pre-leased an impressive 150k SF of this project’s 226k SF of total space to experiential tenants including Equinox, Industrious, CB2, and Pinstripes. When COVID hit, all of these tenants except CB2 got out of their leases. As of 21Q3, Seritage reports 25.6k SF of in-place tenants and 19.2k SF of SNO leases, bringing the property to just under 20% leased. The grand opening announcement included the disclosure that, “The Collection at UTC is 88% leased or under active lease negotiations.” It would seem that most of that 88% falls into the latter bucket.

 

I found myself in San Diego over MLK weekend and decided to stop by Westfield UTC to see this property for myself. The mall itself was very lively on a Sunday evening. The nicest, newest part of the mall was built in a 2017 expansion and is located on the far west wide of the site, with frontage on both Genesee Avenue and the UTC trolley station that opened in late 2021. Walking through the mall had an intimate feel. All the shops are located on the ground level, and there’s plenty of art, landscaping, and sitting areas to spruce up the corridors.

 

Walking towards the Seritage site on the far Northeast corner of the mall, I realized there’s a large section of the mall that’s structurally vacant and looks primed for demolition. The majority of this space is an empty anchor box that Nordstrom left in 2017 to relocate to a brand new box on the far west wide of the mall. There are also about a dozen empty in-line spaces, split into an 80’s-style two story format that the rest of the mall must have already abandoned. As part of the Nordstrom relocation, Westfield bought this vacant section in July 2016 for $30mm, or $231 PSF. Nordstrom announced its intention to vacate the box in mid-2014, so Westfield has had over seven years to reimagine this part of the mall to no avail.

 

The Seritage space is centered around a large, mostly empty public plaza. Walking through the Seritage space, I counted just five tenants with built-out suites: Pacific Catch (restaurant), CB2 (furniture), Ideal Image (beauty salon), Blue Bottle Coffee (café), and Madison Reed (hair stylist). There were also two under-construction restaurant storefronts, with advertisements for Board & Brew (brewery) and Menya Ultra (ramen). This left about 2/3 of the ground floor spaces unaccounted for.

 

Facing inward towards the plaza I counted ~six empty storefronts on the ground floor. Even worse, there are ~six more ground-floor storefronts that face directly out onto the parking lot. The rest of the mall has no outward-facing storefronts like these, which I imagine is for a reason. The feeling of walking into a high-end clothing store from a wooded, art-filled walkway is completely different from walking through a parking lot to fairly standard strip retail. With the exception of Blue Bottle and Pacific Catch, which have prime frontage at the entryway to the plaza, the only outward facing retail tenant is Ideal Image. I don’t think that an apparel tenant would be interested in these outward-facing spaces, and there are only so many nail salons and bakeries. At best these spaces should fetch a fraction of the rents that the broader mall commands, and at worst this space will be structurally vacant.

 

The single set of escalators to the second and third floors was still fenced off, making those floors inaccessible. From what I could see, there appeared to be another ~half dozen retail storefronts on the second floor. Given the single set of escalators, there’s absolutely no natural foot traffic flow to the second floor retail. I would expect these second floor storefronts to be even less desirable to tenants than the outward-facing ones, and there appear to have been no second floor leases signed so far.

 

The remaining ~half of Seritage’s space appears to be office on the second and third floors, which was originally the Industrious and Equinox space. In the broader mall, CBRE has a 33k SF second floor office space in a great location overlooking the intersection of Genesee Ave and La Jolla Village Drive. Apart from that, there’s not much proof that real office tenants want to have space in UTC. Given no office leases signed so far I expect this space to struggle to lease also.

 

One of the few architectural features in the plaza is strips of astroturf connecting some of the landscaping. At least one demographic really appreciated this touch – there were several spots on the turf where visiting pets had seen fit to relieve themselves throughout the day, and apparently neither their owners nor any property staff had felt the need to clean up after.

 

This is all just my anecdotal take on the space, and admittedly the dog feces story is a bit of a low blow. Still, this site inspection helped me realize an important fact. Real estate is not rocket science, but creating a luxury retail center where tenants can generate $1000+ PSF in annual sales requires real expertise in things like placemaking, tenant curation, and attention to physical details. I don’t think Seritage has this expertise. Additionally, even if Seritage employed the absolute best luxury retail development professionals, they’d still face an uphill battle trying to create comprehensive programming for a 10-20% fraction of a center’s square footage when the rest is owned by a large, more experienced operator.

 

Finally, as with most of Seritage’s best-located properties, the UTC site will soon be facing competition from more experienced and better capitalized developers.  In Jan 2022, Alexandria Real Estate Equities (NYSE: ARE) purchased the 13.9 acre Costa Verde Center for $125mm. This property is adjacent to the west side of Westfield UTC, with excellent frontage on Genesee Avenue and the trolley station. Per The Real Deal, “Approved plans call for 178,000 square feet of shops and restaurants next to 400,000 square feet of bioscience labs and offices, plus a 200-room business hotel.” Pre-leasing should start soon for this better-located project, which will worsen Seritage’s leasing issues on its own site. Unless Seritage signs a flurry of new leases in the next few months, this end of the mall should develop a reputation for vacancy, further compounding the leasing problem.

 

Valuing these partly-leased fractional malls is exceptionally difficult. Westfield would be the most obvious buyer, but I doubt they’d be interested for a number of reasons. For one, in Feb 2021 Westfield announced its intention to completely exit the US mall business. “At the end of the day, exposure to the US will be minimal, if not zero,“ said URW CEO Jean-Marie Tritant, “There is no investment market in 2021 open today – that’s clear.” Further, whoever ends up owning Westfield UTC will have the opportunity to redevelop the empty Nordstrom box, so I doubt it would make much sense to buy Seritage’s site at anything above a distressed price.

 

Westfield UTC itself has no public financials, so I have little sense of what retail rents are at the mall. The JV’s reported cost basis for the property is $165mm, or $729 PSF. Assuming a 75% NOI margin, 90% stabilized occupancy, and a 6.5% stabilized cap rate (whether there’s a buyer at that cap rate is a huge question mark), the property would need to generate $70 PSF gross rents just to be worth what the JV paid to build it. Keep in mind ~half the Seritage space is office – the office buildings nearby rent in the $50 PSF context, which implies a ~$90 PSF rent on the retail space.

 

A good rule of thumb for a healthy occupancy cost (rent divided by sales) for an in-line mall tenant is 10%, which would mean the tenants at Seritage’s property need to do $900 in sales PSF to support the $90 rent. The rest of the mall does report $1,250 PSF in sales ex-Apple & Tesla, but I think it’s obvious that Seritage’s unusual mix of outward-facing and second floor spaces will not be generating anywhere close to that type of sales productivity.

 

For valuation purposes I mark the UTC property at cost of $165mm, implying $10.7 million of stabilized NOI at the 6.5% cap rate. In reality this property would probably only trade at a distressed level today.

 

 

 

Appendix 5: Aventura (Wholly Owned)

 

Aventura Mall is the largest mall in Florida and one of the top five highest-grossing malls in the country, doing well over $1b in annual sales productivity. The potential economics of owning space in this mall are tantalizing. A $1.75b 2018 CMBS refinance loan appraised Aventura Mall at $3.45b, or $2,833 PSF (well above Seritage’s entire enterprise value). This CMBS loan was backed by all of Aventura’s in-line space along with the JCP and AMC boxes – the other four boxes are ground leased to Macy’s, Bloomingdales, Nordstrom, and Macy’s Home. Average net rent for the loan collateral in 2018 was $125 PSF (~$150 PSF gross). 21Q3 revenue is flat from 2018, so I think it’s safe to assume $125 PSF net is a good proxy for today’s market rent. The Mall performed at 93% and 94% occupancy in 2018 and 2019, dropped to 89% occupancy at the height of COVID in 2020, and has rebounded to 94% occupancy as of 21Q3. Turnberry, family firm of original developers the Soffer family, owns 2/3 of the equity, and Simon owns a 1/3 non-controlling stake.

 

Seritage broke ground on its Aventura site, called Esplanade at Aventura, over four years ago in Nov 2017. The 2019 10k reported that the property was ~50% leased to tenants including Mercado del Rio (food hall), Pinstripes (bowling), and Industrious (coworking). Construction stalled at the onset of COVID, but subsequent disclosures in the 2020 10k and 21Q3 supplement report the same ~50% pre-leasing. SRG’s 21Q3 press release reads: “The Company continues to believe it is on track to open its project in Aventura, Fla., (Miami MSA), in the fourth quarter of 2022.”

 

Given the leasing struggles at the Westfield UTC and Santa Monica sites, I’m skeptical that the Aventura project will be a viable concept. It’s just such a difficult and unusual position to have to try to sign leases for ~10% of a mall when a far superior mall operator owns the other 90%. When asked about Esplanade at Aventura in Jan 2020, Turnberry CEO Jackie Soffer said, “I don’t know that we’re going after the same tenants.” This feeling appears to be a bit one-sided, as Seritage sued to stop a 300k SF open-air expansion of Aventura Mall in early 2016, eventually “settling” with Turnberry and Simon. What Seritage got from this settlement is unclear, but the expansion was completed by the end of 2017, less than two years after Seritage filed its lawsuit.

 

Digging into the actual leasing at Esplanade doesn’t quell my fears. Of the 111k SF of completed leasing, CoStar reports that Industrious comprises 61.8k SF on the 3^rd floor and Pinstripes is 30k SF on the 1^st and 2^nd floors. It’s great that Industrious didn’t terminate its lease at Aventura like at Westfield UTC, but I’m skeptical about the economics of that lease. Industrious is known for signing agreements that look more like hotel management contracts than leases. In many cases Industrious actually gets paid a recurring management fee for operating its spaces (instead of paying the landlord rent), and then Industrious and the landlord split the profits generated by the co-working space. This may or may not be the arrangement at Aventura, but either way I don’t find the Industrious lease to be much of a proof-of-concept for the rest of the space. Netting out the Industrious and Pinstripes space means Seritage has leased 19.3k SF of in-line space. News articles mention several different restaurants signing leases, but no traditional retail tenants. I suspect that, from the perspective of a national apparel-type tenant, signing a lease at Esplanade would be viewed as slapping your likely biggest landlord Simon in the face at one of their top properties. Still, given how strong the Aventura location is I think there’s a chance the Seritage space might lease successfully.

 

I assume Esplanade has to cut rents to $100 PSF net to draw tenants from the mall, and that it stabilizes at 90% occupancy (note this implicitly marks the Industrious space at $100 PSF of income). In this scenario Esplanade would generate $19.4mm of annual NOI. The hard part of valuing Esplanade is estimating the right cap rate, which ties back to the broader question of liquidity of Seritage’s boxes. Even if Esplanade gets leased, I don’t know who would stroke a nine figure check for the opportunity to compete with Turnberry and Simon at one of their best assets. As with most of Seritage’s mall boxes, the mall owner is probably the best buyer. For Aventura Mall, the $3.45b appraisal value implied a 4.5% cap rate on underwritten NOI at securitization. I value Esplanade at a 5.0% cap rate, giving just a 50 bp premium for being a fraction of the mall, implying a $388mm or $1,800 PSF value.

 

A final question on the Aventura project is how much additional capital will be needed to get it to the finish line. I’m no construction expert, but the photos of the stalled project in 2020 don’t show any walls or floors, so it looks like significant additional capital is needed. Additionally, retail tenants paying $100 PSF in rent are going to demand significant tenant improvement allowances, especially for first generation leases. I assume the project requires an incremental $50mm in base building work and $100 PSF in tenant buildouts, or $71.5mm total.

 

 

 

Appendix 6: Redeveloping Sites Sold Off by Seritage

 

     Though not core to the thesis I found it interesting to look at some of the sites Seritage has sold off. I found plenty of sites from Seritage’s original portfolio that will be repurposed in creative and profitable ways, but most of these have already been sold off to developers with access to cheaper capital and with more expertise in certain property types and locales. Here are three examples of developers who have planned what should be successful projects on former Seritage sites:

 

·         Infill Chicago Sites: Before COVID, Seritage had big redevelopment plans for two Chicago sites in the Irving Park and Austin neighborhoods. In Irving Park, it planned a $200mm mixed-use development with 434 apartment units and 100k SF of retail, and in Austin it planned to build 161 condos along with retail. The Austin location in particular seemed like a very speculative place to build luxury apartments. In Sept 2020, Seritage sold both sites to local developer Novak Construction, fetching $26.25mm ($74 PSF) for the Irving Park site and $12.3mm ($42 PSF) for the Austin site. Novak has since cut plans for apartments on the Austin site, with a company representative saying, “Plans [are] still being developed. We are talking to tenants, we haven’t signed any leases yet. And that will dictate more of what happens with those sites.” Seems like a not too subtle swipe at an out-of-town developer that didn’t understand the local market.

 

·         U-Haul Self Storage: A subsidiary of U-Haul (UHAL) called Amerco Real Estate has bought 20 different sites totaling 1.9mm SF from Seritage, for an aggregate purchase price of just $74.2mm, or $38 PSF (a few of the purchase prices are estimates and I may be missing some sales where the buyer wasn’t disclosed). These sites are all freestanding tertiary-market boxes that U-Haul plans to convert to self-storage properties. Self-storage is a great business with sticky tenants and very low CapEx needs in addition to COVID tailwinds, and I think these redevelopments will be successful ones for U-Haul.

 

·         San Bruno Life Sciences: Alexandria Real Estate (ARE) bought a vacant JC Penney at the Shops at Tanforan in San Bruno, CA for $105mm in Sept 2021, and the next month it bought Seritage’s empty box at the same mall for $128mm. Alexandria is a premier life sciences developer and will likely be building Lab/R&D space at the Tanforan site. The two biggest life science clusters in the U.S. – Boston/Cambridge and the San Francisco Bay Area – comprise well over half of the country’s Lab/R&D space. A lack of developable land in these two markets combined with increased post-COVID demand has led to explosive value increases for existing life science buildings and a mad dash to convert any underutilized real estate in those markets into Lab/R&D space. Per a 2021 CBRE report, the San Francisco Bay Area Lab/R&D market is currently just 2.6% vacant and has seen a YoY average rent increase of 17%. At $75 triple-net current market rent (per CBRE) and a conservative 5% cap rate, an average SF Peninsula life science building today would fetch ~$1500 PSF. Considering a brand new building should achieve an even higher rent PSF and tighter cap rate, Alexandria’s purchase price of $206 per buildable square foot for the Seritage box doesn’t seem very expensive. To be fair, selling the land parcel for $128mm is a good outcome for Seritage, as it was under contract to sell the same site to Shops at Tanforan owner QIC in 2018 for just $42mm. Of course, the downside to this transaction is giving up the most promising development site in Seritage’s portfolio.

 

 

 

Catalyst

• Failure to pay down the term loan to $800mm by July 2023
• Failure to sell, refinance, or de-leverage by fully extended debt maturity in July 2025
• Continued deterioration of fundamentals for US malls and physical retail space
• Any significant macro event that chills the market for development land