To be clear from the outset, I’m not now, and have never been, a professional real estate investor. I spent 28 years as a professional equity investor, much of that time heavily involved in Asian stock markets, where commercial real estate companies were a key–sometimes dominant–sector. So I know a little bit. Anyway…

the academic finance take

In business school and for many years later, I read academic articles extolling the semi-magical properties of real estate as an investment. According to “research” analyzing records of transactions, real estate had both the highest return of any asset class and the lowest volatility of return (the preferred academic measure of risk)–meaning that, when compared with either stocks or bonds, real estate had the highest return and the lowest risk. The theoretical iron law that higher return must entail higher risk simply didn’t hold.

What the scholarly works ignored, however, is what every homeowner knows–real estate is very hard to sell in times of high interest rates or in economic downturns. So no one does it. If, for example, my wife and I had been forced to sell in 1982 the house we bought in 1981, we would have been lucky to get 2/3 of what we paid a year before–not enough to pay off the mortgage, either. It wasn’t until 1984 that For Sale signs began to pop up again in our neighborhood.

Academics working with publicly recorded transactions as their source for pricing happily (although very incorrectly) concluded not only that my house was worth the same in 1982 as in 1981 but that real estate of all types was as well. And that compared favorably with stocks and bonds, both of which decline in periods of higher rates (because transactions continue to happen).

All this would have been simply laughable had large US investment companies not taken this academic nonsense to heart and bought tons of real estate, whose illiquidity they only began to work out when they tried to sell in the late 1990s.

boom and bust

Commercial real estate projects, especially urban ones, tend to be large and to take years between initial planning/permitting and the end of construction. That’s even if a project is executed in phases. Also, the same economic signals that lead real estate company A to greenlight a major expansion also send their message to B and C …and maybe D. Also, office space, which has been regarded as the most dependable investment, tends to come in large chunks. Take Hudson Yards just west of Penn Station in Manhattan as an example. So there has tended to be at least a mild shortage/excess capacity character to office, hotel and retailing real estate expansion.

where we are now

Starting with what we know:

–if we count worker days as one worker being in the office for one weekday, total worker days in urban office complexes are running at around 47% of the level just before the pandemic

–if all workers are in the office only Tuesday – Thursday, then office occupancy is 78% of the pre-pandemic level during those three days

–if so, companies have 20% more office capacity than they need. If workers could be spread evenly over Mon-Fri, the overcapacity is 50%.

–the amount of office space on offer by current tenants for sublease is double the amount just before the pandemic

–office space is typically rented on multi-year leases. So tenants are on the hook for a while for space they probably will never need. During the 2008-09 financial crisis, the bottom for commercial real estate came around 2011. That would suggest 2023-24 for a new bottoming–the first time we’ll know which landlords will be able to make their mortgage payments

–experience suggests that tenants will gravitate away from the oldest buildings toward the newest and most technologically up-to-date, and may well end up with lower rents, to boot

externalities

–for landlords, since they’re renting space, there’s probably a big difference between having tenants who need a smaller amount of space that’s used five days a week and ones needing more space that’s going to be used only three

–for supporting services–restaurants, hotels, retail–the more critical variable is likely that worker-days may only be half the prior norm

–for municipalities, I’d imagine the big issue is the falloff in taxes–income, sales, property (?), even though the demand for public services may not be that much lower.

The financial press has been reporting recently that large institutional real estate funds have been experiencing enough redemption requests that they’re invoking clauses in their contracts that allow them to limit redemptions. I have no idea why, but the possibilities that occur to me are: sophisticated clients are trying to lessen their exposure to a potential crunch a couple of years down the road; clients are rebalancing into areas (IT?) that have been crushed in the downturn; clients need cash and are selling in areas that have held up relatively well.

are the stay-at-home stocks bottoming?

I don’t know. But I’ve noticed that names like Zoom or Roku, which have fallen by 80%+ since their highs, appear to me to be having a relatively good–at least to the previous year or more–stock market performance. Have they bottomed? I don’t know. But if they have, that would be good for overall market sentiment, I think. I’m not rushing out to buy either one, or even to take a look at their financials, but their stabilization would suggest sunnier weather is in prospect, not only for them but for the market as a whole.

dollar stores

There’s an intricate market-share dance among: department stores, Target, Walmart and the dollar stores. Generally speaking, in good times, consumer tend to shift their spending from right to left; in bad times, they reverse course and go from left to right. So bad news for the dollar stores–who appear to be reporting disappointing earnings for the most recent quarter–may be good news for the economy as a whole. Again, I haven’t investigated. I did listen, though, to a Yahoo Finance explanation of results for Dollar general and Odd Lots.

The “analysis” was all about margin contraction, and was jaw-droppingly bad. The assumption was that higher margins are, in themselves, a good thing–which I what I want to comment about. This completely ignores the fact that high margins are kind of like blood in shark-infested waters–they draw competition. Another, typically less noticed thing is that margins have to be taken in tandem with inventory turnover. Take two businesses, each with $1 million in inventory:

–business A marks up by 100% and turns its inventory once a year–think, furniture store. It makes $1 million in gross profit a year

–business B marks up by 20% and turns its inventory 20x a year–think, pharmaceutical distributor. It makes $4 million in gross profit a year

All other things being equal, which would you rather be?

ebitda

Yesterday, I read a curious commentary by Cathie Wood about her investment strategy.

It starts with a critique of ebitda as a measure of a company’s value. Ebitda is after-tax earnings to which you add back interest expense, taxes and depreciation/amortization, and use as a measure of a company’s value, sort of like PE or price/cash flow.

I’m not a fan of ebitda. Neither is Ms. Wood, but for different reasons.

I’m old-fashioned. My objection is that companies are shaped by their managers in ways that are designed to maximize their profit potential. They do borrow money, they do pay taxes and they do own plant and equipment (so there should be a charge for wear-and-tear). Yes, these choices may end up subtracting value rather than adding. And in an M&A situation, a cash-rich rival with extra plant and equipment may acquire a company, repay its debt, sell its plants, do better tax planning and end up capturing the entire ebitda and then some. But change of control is not always possible. Anti-monopoly laws are the traditional barrier. Much more important in today’s world is the dual share structure of many companies (think: META) that allow founders to stay long beyond their best by dates and prevent hostile takeover approaches. I think it’s better to look at companies as they are, warts and all.

Just as important, probably considerably more so, I think, is the market structure in which a company operates. How big is the addressable market? how fast is it growing? are there substitutes? is our company gaining or losing market share? is this a market with three main companies, each with a third of the market (implying bruising competition), or does ours have half the market, with mom-and-pops making up the rest (implying much less competition).

Ms. Wood’s approach is the opposite. Her idea is that one gets true earnings by taking ebitda and adding back research and development spending, some (?) sales and marketing expense, stock-based compensation and deferred revenue (advance payments by customers).

I understand that doing so makes cash flow look better. Still, companies do dilute eps to some degree with stock-based compensation, and I’m not sure that capitalizing sales expense and R&D is the right way to look at things. In fact, the latter practice was disallowed a generation ago after a history of substantial abuse by tech companies (meaning considerably overstated earnings) came to light. There’s also the question whether a high level of R&D and S&M are luxuries or the bare minimum that one has to do to stay in the game and keep from falling behind rivals.