Consumers Have Disrupted This Extremely B2B Sector Twice in the Last Decade
And Both Times Wall Street Was in Denial
It’s been a minute since my last post that talked about investing at the intersection of consumer, culture, and commerce. Consumer cyclicals and consumer staples stocks only comprise about 17.5% of the market cap of the S&P 500, but as I wrote in my last entry “the reach of the consumer goes deeper into the economy than just those two sectors.”
A great example of this can be found in a corner of the financials sector: real estate. While residential real estate, self-storage, and hotel property owners are in the B2C business of collecting payments from consumers, large swaths of real estate – like office towers and retail real estate – are solely B2B.
Even in the subsectors of real estate that focus on serving consumer needs, like apartments and hotels, a lot of the long-term value is created in the financial machinations of the business. Acquiring and divesting property at the right time and price, in the right locations. Getting the best financing for the deal. In the case of REITs that own hotels, they outsource the actual day-to-day management of the properties, most often to unaffiliated third parties. Which makes these real estate companies – even the ones with real estate that consumers use - experts at financing and M&A, not necessarily expert operators of consumer businesses.
The reliance of REITs on financing cycles, valuation cycles, and M&A prowess is why they sit in the financials sector. But not once, but twice, in the last decade consumers prompted a sector upheaval for both public and privately held owners of real estate… and both times it was in traditionally B2B asset classes. These shifts caught many smart analysts who focus on financials off-guard, but they were easier to catch if you were closely watching consumer behavior.
Real Estate Disruption #1: Trouble in Aisle 3 – Distress at the Mall
In 2017, I was working in a job where I was primarily tasked with finding stocks to short, stocks that would go down. After having my face ripped off early in my career shorting stocks just because they were stupidly overpriced (valuation shorts - #donotrecommend), I had landed at a place where I looked to short stocks for one of three reasons:
1. Structurally challenged business model and/or business in secular decline
2. Risk of financial distress/bankruptcy is high
3. Extreme tail risk/catastrophic black swan risk (usually regulatory) not priced in at all + there is a catalyst
The third type of short - underpriced tail risk - is exceedingly rare. But it can be very lucrative when this kind of four-leaf clover of an opportunity presents itself (a story for another day would be European online gaming companies in 2006). The second type of short – financial distress – often requires a lot of patience or being in the right part of the business or interest rate cycle. By far, structural or secular decline short opportunities are usually the most abundant.
For the record, I should note a very solid fourth category of shorts – frauds – which can be very lucrative as well (100% downside potential!), but I have generally focused less on these in recent years solely because they tend to require a lot of time, a lot of resources (consultants, due diligence trips, etc.), and can often be very crowded.
Back to 2017…. We all knew that e-commerce was taking off and the movement of spending online was accelerating. While Amazon (AMZN) wasn’t the trillion dollar-plus market cap company it is today, it was hardly a shrinking violet at a $500 billion market cap around the time I was beginning this work. The growth of e-commerce was hitting traditional retailers hard, with department stores particularly hard it. It wasn’t a particularly novel observation that people love the convenience of shopping online and that the trend was accelerating.
While it was hard to get comprehensive data on traffic to traditional enclosed malls, there was enough anecdotal evidence to support a thesis that young consumers were not embracing the mall like people did when I was a teenager.
You could also see the impact of lower traffic manifest in occupancy rates that were plummeting in lower quality malls. Malls generally carry ratings from “C” to “A+++”, with the higher grades assigned to properties that have higher occupancy and rents, which are generally a derivative of being well-located in a populous and high-income metro area, being well-maintained and/or new, and having high sales per square foot. High sales per square foot comes from having lots of well-heeled visitors with money. It also helps to have stores that sell expensive stuff that moves… you are not going to find an Apple (AAPL), Tiffany, or Louis Vuitton (LVMUY) store in anything less than an A mall.
Back in 2017, department store chains Bon-Ton and Sears were both teetering on the brink of bankruptcy. They would both go on to file Chapter 11 in 2018. I thought the writing was on the wall as well, for JC Penney, although that one wouldn’t go under until 2020.
At the same time, retailers that had no immediate risk of bankruptcy – like Macy’s (M) and Children’s Place (PLCE) - were reducing their store footprints (closing stores) because even with the lower rents in B and C malls, they were no longer getting a good return on being there because so many of the customers were buying online.
As much as my 80s mall rat heart hated to believe it, a lot of malls were dead men walking.
It seemed obvious that a lot of malls were going to be toast – because consumers didn’t want or need them anymore. So equally obviously, any company that owned too many of the wrong kind of malls was going to be toast too. The exercise I went through at the time was to look at each public mall REIT’s anchor tenants by individual property. For each property at each company, I checked if one or more anchors were Bon-Ton, Sears, or JC Penney, since I was confident that those stores were going away. I also tracked if these malls had Macy’s as an anchor, since they were closing so many locations.
While anchors generally pay low rents so losing an anchor doesn’t mean losing a lot of direct revenue, they are important traffic drivers and big spaces that are hard to fill when they close. The meme is right – it’s depressing to go somewhere and see a big property boarded up and vacant. Also, many stores in the mall have leases with co-tenancy clauses that state if one or more anchor closes, rent drops or converts to a percentage of sales rent – which transfers some risk back to the landlord if traffic falls in the wake of the anchor closing.
Based on high exposure to the department stores listed above, I chose to short mall REITs CBL and Washington Prime. While it wouldn’t be until the pandemic lockdowns dealt them a death blow that both of these companies would file for bankruptcy, in 2020 and 2021, respectively, their stocks were on the decline for years heading into their ultimate demise. Both have since exited bankruptcy, and CBL is public again (but I haven’t looked at its current iteration – so no recommendation either way there).
Even though anyone who looked at consumers’ growing love for and embrace of e-commerce could have guessed malls were in trouble, most of the sellside REIT analysts were in deep denial about how bad things could get for the mall. While most conceded that C malls were in trouble, there was a Pollyanna attitude towards A and even B malls. As long as occupancy held steady and the average lease rate was more or less fine, the stocks were considered stable and even recommended. Secular decline was never uttered or considered.
But leases at the mall are long – usually five years, sometimes more – at least at the time (shorter is more common now – another bad sign). So there was a long lag before what was happening in terms of consumer preference would show up in actual financial results. But big changes in consumer preference and behavior are meaningful and will always manifest in financial results eventually.
Even though it is now fully understood that most of retail’s growth is in e-commerce and mall traffic is in secular decline, analysts are still in a bit of denial when it comes to letting these facts influence their stock recommendations. There are still 11 Wall Street buy recommendations on the largest mall REIT, Simon Property Group (SPG). Simon has a very high-quality portfolio, which has insulated its results from some of the decline that other mall owners have seen. Remember, those A and A+ properties are holding up the best – profiting off increasing income disparity, population shifts, and last man standing status. But even high-end malls can’t outrun the larger consumer preference for e-commerce, so it’s not surprising that FFO hasn’t grown at Simon since 2017.
If you look at the total return for SPG shares over the last six years, it’s basically flat – even counting in the REIT’s hefty dividends. If you bought SPG shares 6 years ago, you would be up 6% overall, versus 105% for the S&P 500.
The relative quality of its portfolio made SPG not a great short on an absolute basis over the last six years, but on a relative basis, this stock was a dog.
Mall REITs are totally B2B plays. They are big public companies renting space to other big, mostly public, companies. But following consumer trends would have kept you out of these dogs.
Real Estate Disruption #2: Office Real Estate and the Remote Work Revolution
You would have to be living under a rock to have missed the fact that a lot of people don’t want to go back to work in person, at least not five days per week, and that as a result, many offices are empty.
Vacancies are growing in office towers in downtown areas of big cities like New York and San Francisco, as companies find they just don’t need as much space anymore. As with the mall REITs, this is kind of a slow-motion car wreck in terms of how this is playing out in terms of financial results – leases tend to be even longer for offices than they are for retail, often 10 years. Given the long leases, the impact on occupancy, revenues, and property values is more like a trickle than a flood. But it is pretty clear that the direction is down, with many offices sitting half-empty.
This decline was already showing up in office property values in 2022…
Source: CNN.com
There is a lot of consternation right now about what this means for the banks. Because landlords are leveraged - and the combination of interest rates up and revenues down as space gets abandoned by companies that have too much of it is potentially deadly. A recent Goldman Sachs report estimated that 55% of U.S. office loans sit on the balance sheets of banks.
How this plays out for the banks is complicated. Commercial property prices had been on the rise for the last decade until very recently, so perhaps there will be enough cushion. Well-capitalized owners may have the cash to shore up their properties with increasing equity investments, and public office REITs can potentially tap the public markets for more capital to make equity infusions (of course at what price?).
How this could play out for the banks could be a whole other essay – or series of essays. But let’s look at how it has played out for one of the big office REITS – Boston Properties, an owner of premier office towers in major cities like New York, Boston, and Washington, D.C.
The catalyst for the remote work revolution that has been so painful for office property owners was the pandemic, so let’s look at BXP stock from right before the pandemic to where we are today.
Before the pandemic, BXP shares were sitting close to all-time highs, around $147, when concerns about COVID-19 traveling to America first started to boil up in mid-February 2020. The shares crashed along with everything else in March 2020 when the U.S. locked down. The shares gradually recovered over time as lockdown ended, the economy recovered, vaccines came out, and the world got basically back to normal. In March 2022, two years after the lockdowns began and a year after widespread vaccine deployment in the U.S., BXP shares were back up to 90% of their former valuation. Because everything had gone back to normal, right?
But no, that was wrong. The world had reopened, but for better or worse, lots of things haven’t gone back to exactly how they were before. Some industries – like travel – are doing much better. Carpe diem, everyone! Take that vacay – you deserve it. But other industries – office real estate among them – are doing worse.
The difficulty of getting remote workers back to the office is evident in the 50%+ drop in BXP shares since that early 2022 high. Reality has set in.
While some employers have been able to get workers back to their desks – big banks are probably doing the best here – others are having to offer a steady stream of incentives and prizes to get workers to come back, often unsuccessfully.
The return to the office has been more robust in some industries and some geographies than others. Companies are pulling in the reins on full remote, but very few are pushing five days in the office. Hybrid work seems to be the winning compromise… but hybrid schedules still mean a need for fewer square feet. If the labor market – which has been incredibly resilient overall despite layoff headlines – materially weakens, that could erode the demand for space even further.
It should have been obvious this was going to be the case to anyone with their eyes open. Lots of people like working at home. It means less time commuting, more time with kids or pets, more flexibility to get a workout in, spending less money on takeout lunches, or eating healthier. There is a long list of reasons to prefer working from home, and there are also some people who miss or prefer working in the office. But it is undeniable there has been a sea change in individual attitudes towards office work. And where the supply/demand pool of talent favors the worker (tech, at least until very recently), people are revolting against the end of remote work. Where the supply/demand favors employers (finance and big banks), there has been more success with forcing a return to the office.
Personal preference for working at home and employer accommodations have been unmissable and obvious trends for anyone who lives in the real world. If you talk to friends, watch viral videos, or read the newspaper – empty offices were an obvious conclusion to this story. Even the most basic observation of human behavior and conversation would have led you there. But somehow, many bank analysts missed this, and recommended office REITs right up to, during, and after their big fall. How did they miss it?
Financials sector analysts – the ones that cover REITs included, are rooted in interest rate cycles, property cycles, and M&A trends. They look at interest coverage ratios, how stocks performed the last three times that interest rates went up fast, and year over year changes in vacancies. But you had to look at what actual human beings were doing, thinking, and wanting to catch this shift that has caught the office REITs flat-footed. Reversion to the mean often works in financial sectors like real estate – but not this time.
Follow the consumer. Not just for B2C. But for B2B too.
Some Interesting Things I Read (or Watched!) the Last Few Weeks
Return to the Office Enters the Desperation Phase
New York Times, 6/20/2023
This was clearly the inspo for today’s entry.
Threads is All the Worst Parts of Twitter and Instagram in One Very Bad App
Vice, 7/7/2023
As an on-and-off heavy user of Twitter for 14+ years, I’ve been despondent about the deterioration of the service under its new corporate overlord, Elon Musk. Like many people, I am hoping a viable alternative for text-based information sharing and dialogue evolves. I’ve learned a lot on Twitter and connected with loads of interesting, smart people who have taught me things during my investing pursuits. I am hoping Threads can recreate that, but it’s going to be hard to recreate the magic, especially of early, pre-Crypto FinTwit, which was a fantastic place to do research and share ideas.
AI: Yes, Hollywood, You Should Be Afraid
Entertainment Strategy Guy for The Ankler, 7/6/2023
AI is a hot topic. Here’s how this evolving technology might change the entertainment industry.
Skandal! Bringing Down Wirecard
Netflix
OK, not reading. But after telling you I rarely look at fraud shorts anymore, this program pays great homage to how it’s done. It’s a surprisingly thrilling documentary given what you think might be a dry subject.
OK, also not reading. But I can’t wait to see this movie about the GameStop (GME) short squeeze scandal.
Tweet of the Week
Speaking of Threads…
Threads had a hell of a launch. The power of Instagram. This was an in-your-face reminder of what a gift META shares under $100 were last year for a shining instant. So much for efficient market theory.
As Threads enjoys the fastest launch ever, Elon Musk has accomplished the impossible yet again – this time he turned Mark Zuckerberg into someone people are rooting for. He did better than any PR agency could.
Prosperous Investing!
Disclaimer: This content is for informational and educational purposes only and does not constitute financial advice or a recommendation for a particular investment.
Disclosure: The author may have a personal financial interest in the securities mentioned. At the time of publication, personal investments included AAPL, SPG (short), BXP (short), and META.