Would A REIT Actually Help Sears?

Can a REIT strategy really rescue Sears Holdings Corp SHLD, or was this just another spike on real estate-related news destined to collapse under a pile of operating losses?

That is a multi-billion dollar question hotly contested between Sears real estate bulls and retail operations bears.

Friday's Spike

Sears CEO Eddie Lampert filed an 8-K containing the possibility of a REIT "Hail Mary" play on November 7.

Shares gapped up at the open $6.84 to $39.51, traded intra-day as high as $48.25, and closed at $42.81, up $10.14, or 31 percent for the day on huge volume.

A Big Day For Sears Bulls

The rise in Sears shares on Friday resulted in an increase in equity capitalization of about $1.08 billion. Since Lampert and ESL Investments are Sears' largest shareholders, it was a very good day for him, in particular.

Lampert has been at the helm of the K-Mart/Sears ship since taking control in 2005.

Red Ink

Analyst Brian Sozzi calculated that Sears lost close to another $500 million for the quarter. So, is the solution to have Sears' best store locations pay rent each month? Probably not.

But what that would do is this: Provide cash-strapped Sears with a significant cash injection in an attempt to buy more time to turn things around.

Related Link: Sears' REIT Announcement Only Delays The Inevitable: Brian Sozzi

Junk Bond Credit Rating

At Sears, it appears things are bad enough for Fitch to lower its debt rating from CCC to CC this past September.

Put simply, a CC rating indicates highly vulnerable, very speculative bonds. It is both difficult and expensive for Sears to continue to borrow money to pay its creditors and maintain inventory shipments from suppliers.

At This Point A REIT Is Pure Speculation

But what would a pro-rata distribution of shares in a new REIT actually accomplish?

Since there was no press release, clarification, or details given by Sears Holdings, it might be easy for investors to make some erroneous assumptions.

Reported Cupertino, CA Sale

A "one-off," sale of a prime full-line Sears store for $102.5 million was reported in the 8-K filing, two paragraphs prior to the company announcement that it "is actively exploring the monetization of its real estate portfolio…"

Investors would be unwise to use this transaction as a basis to value the vast majority of Sears' real estate assets.

Baker Street Real Estate Analysis

Back in September 2013, a hedge fund invested in Sears Holdings paid for an appraisal of the entire Sears real estate portfolio, and released a 139-page report. This report instigated a 27 percent spike in shares the week following its release.

Since the Baker Street analysis was published, Sears has sold some of its top locations and closed some of its poorest performing stores.

However, the big picture remains basically the same, as illustrated by Slide 6 of the presentation:

By spinning out the best real estate assets into a new REIT, Sears would be able to generate significant cash. Monetizing these assets, though, would be one of the last major sources of funds, assuming the REIT was comprised of the better locations.

Not An Attractive REIT

Even a REIT comprised entirely of the best remaining 200 to 300 retail locations (under master lease agreements with Sears) would likely not be popular on Wall Street. Who would want to own shares concentrated in property leased to a company with a junk credit rating, declining sales and consistently huge losses?

The lease payments from Sears Holdings to the REIT would most likely exacerbate the company's negative cash flow by the amount of contract rent on the master leases. The new REIT management and Sears Holdings would also likely have conflicting interests and vision for the real estate assets.

In the event of a Sears bankruptcy, all bets are off, as a messy situation rife with potential conflicts of interest could unfold over several years.

However, as unattractive as all this sounds, there could be some advantages for existing Sears shareholders:

1. Assuming the leases are structured so the REIT would have taxable income, at least 90 percent of it must be paid out in the form of dividends to shareholders -- not squandered on failing retail operations.

2. There is a chance that these real estate assets could be "walled off" from Sears's creditors, in a similar fashion to the U.S. rights to valuable brands: Kenmore, Diehard and Craftsman held in a separate entity.

3. The new REIT management may be more focused and have more success in maximizing the long-term property values than current stalled initiatives: Seritage and Ubiquity Critical Environments.

Bottom Line

The key to adding tangible value for Sears shareholders from a REIT strategy can only come from block and tackle effort and a vision to transform the bottom 1,500 locations, not from monetizing the top 300.