Summary
Sears is closing 17 Kmart stores within Seritage's portfolio and paying a termination fee.
The base rent on these properties averages approximately $3.40 per square foot, allowing for significant improvement with new tenants.
However, these 17 stores are likely lower-tier properties and this will be a test of Seritage's ability to improve the value and revenues from its lower-tier properties after Sears leaves.
Sears is likely to terminate the leases of many more Kmart and Sears stores in the future as its per store sales have been crumbling for years.
There was recently news that Sears Holdings (NASDAQ:SHLD) was closing 64 Kmart stores. As well, Seritage Growth Properties (NYSE:SRG) mentioned in an 8-K filing that Sears was terminating leases on 17 unprofitable stores and paying Seritage a termination fee as a result. Although the list of Seritage portfolio stores affected was not announced, the stores can be determined by cross-referencing the Kmart closure list with Seritage's property list.
List Of Lease Terminations
The 17 Kmart stores that are scheduled to be closed and are part of Seritage's portfolio are listed below. The Sears Holdings leases of those stores add up to 1.73 million square feet of space as per Seritage's S-11 filing. This square footage number does not include the portion that was already leased to third parties at the time. It appears that there has been no change in the footage leased by third parties at these 17 stores between the S-11 filing and the year-end 10-K report.
There are a couple stores located in cities where Seritage owns more than one properties, so I've noted the address beside it.
Cullman
AL
98,522
Sierra Vista
AZ
86,079
East Fry Blvd
Thornton
CO
190,174
Chicago
IL
118,816
Kedzie Square
Springfield
IL
84,180
Elkhart
IN
86,479
Merrillville
IN
108,339
Houma
LA
96,710
New Iberia
LA
91,653
Alpena
MI
118,200
Manistee
MI
87,848
Sault Ste. Marie
MI
92,650
Kearney
NE
86,479
Deming
NM
96,571
Harlingen
TX
91,653
Yakima
WA
97,251
Riverton
WY
94,840
Lease Termination Effect
Each year Sears Holdings is allowed to terminate the master lease for properties with annual rent payments that add up to close to $30 million per year if the EBITDAR for those properties over the past four fiscal quarters is less than its rent expense. Sears will pay a termination fee of $5.8 million (aggregate annual base rent) plus estimated operating expenses to Seritage as well as continuing to pay normal rent until January 2017 for the 17 Kmart stores affected.
Fitch previously estimated that there were 35 properties in Seritage's portfolio where the Sears Holdings' store had EBITDAR that was less than rent. However, Sears's sales (and consequently its gross margin dollars) have been falling faster than Sears can cut costs, so there are likely more properties with EBITDAR less than rent expense now. Thus I would not be surprised to see Sears exercising the termination clause for more and more properties as its per store sales continue to dwindle.
Seritage's Challenges
One of the items that has attracted investors to Seritage is the potential for Seritage to achieve significantly higher rental rates for its properties once Sears leaves. The base rent for the 17 Kmart stores appears to be around only $3.40 per square foot, so any new tenants would be paying significantly more. However, Seritage does still need to actually find tenants for any empty properties.
These 17 properties should serve as a good indication of whether Seritage is actually able to fill its recaptured space. Given the poor profitability of these stores (not just absolute profitability which can be attributed to Kmart's struggles, but also relative profitability to other Kmarts), many are likely in less desirable locations. Any new tenant can probably achieve higher sales levels than Kmart, but may have challenges getting these new stores to above average levels of profitability for their chain.
Thus, if Seritage is able to find tenants for these 17 properties at a reasonable rate and within a reasonable timeframe, it bodes well for the transition of the rest of the properties, some of which would be more desirable. If Seritage struggles to fill the space, then Seritage could be stuck with a lot of lower-tier inventory if Sears continues terminating its leases.
I've also found brochures for some of these locations indicating that Seritage may have been attempting to gauge interest from new tenants wanting part of the Kmart space prior to the termination notice. Seritage has the ability to recapture 50% of the space for most of its properties, apparently without needing to pay a fee. One brochure indicates rent of $7.50 per square foot for the 50% space.
Conclusion
With Sears Holdings unable to turnaround its business for many years it is now in the position where it has a number of stores where EBITDAR is less than rent. Thus, Sears has started to terminate the leases on some of its stores in Seritage's portfolio, starting with the 17 Kmarts mentioned above.