Commercial Real Estate: The King Kong Of Category Killers by Danielle DiMartino Booth, Fed Up: An Insider’s Take on the Willful Ignorance and Elitism At the Federal Reserve
Kings are threaded through time, from all incarnations, realms, and mediums. Some are real, others imagined. There are great ones from literature, such as the tragic Lear and the legendary Arthur, to name but two of a multitude. The great, or not so great, of recorded history may inspire or fascinate as does King Henry VIII with his notoriously insatiable appetites. In Egypt the king was pharaoh with the most famous of these, Tutankhamun, discovered in 1922, and very unroyally immortalized in pop culture by one of comedy’s most irreverent kings, Steve Martin.
The silver screen too has its kings, and one of those is surely that enormous silver back, regally sporting a remake crown on his massive head. Debuting in 1933, King Kong featured primitive animation and an ape doomed to never get the girl. The public was hooked, and with ever more sophisticated technology, Hollywood would remake this winner six more times. Borrowing from modern vernacular, you might call Kong what he is, a colossal cinematographic category killer.
In his 2021 year-end letter, Baupost's Seth Klarman looked at the year in review and how COVID-19 swept through every part of our lives. He blamed much of the ills of the pandemic on those who choose not to get vaccinated while also expressing a dislike for the social division COVID-19 has caused. Q4 2021 Read More
Commercial Real Estate
Sadly, Kong couldn’t win, but he did make scaling the Empire State Building look like child’s play, as he battled annoying aircraft and tenaciously guarded his shrieking starlet prize. Some might even say the ill-fated ape was Amazonian in his feats.
Few would dare dispute that a different kind of Amazon reigns supreme, lording over the retail realm, growing its kingdom by killing one category after another. In the event you are unfamiliar with the term, ‘category killer,’ it refers to a company, service or brand that has such a unique advantage that it makes it nearly impossible for competitors to operate profitably.
Amazon long ago killed off legions of book vendors and electronics retailers. Most recently, though, it’s left the entire commercial real estate (CRE) sector feeling as if it too is under siege. Such is the depth of the carnage in retail and its potential to spread to other areas of the commercial landscape.
Think of the burgeoning situation of the sum of the parts overwhelming the system. For a time, the notion of malls crushing the CRE space was unfathomable. The initial debate centered around which malls would emerge as ‘winners,’ and which would be retrofitted, and into what would they be reincarnated.
Followers of CRE quickly learned to distinguish between the top ‘A’, middle ‘B’ and bottom tier ‘C’ malls. There was also a ‘D’ category, which gallows humor quickly branded ‘death malls.’ The Reader’s Digest version of what was to come consisted of predictions that a choice few of the swankiest outfits surviving while the rest were left to rot and eventually die off, or as mentioned, come back in another form.
Innovative incarnation ideas include indoor sports venues, charter schools, residential communities, movie production studios, and the king of irony, fulfillment centers for online vendors. (What better way to be closer to city centers at deeply discounted rates after you’ve killed off the occupants?)
In mid-May, Morgan Stanley’s Richard Hill initiated coverage of the retail REIT sector, as in real estate investment trusts, companies that own and operate income producing commercial properties. He titled the piece, ‘Malls Aren’t Dying (Just Some of Them).’ Devising the dividing line involved simple and elegant analysis – if a property generated north of $400 per square foot in sales and was located in a major market, it was apt to survive. The ‘major’ aspect assured sufficient population density and a high enough median income to support minimum sales thresholds.
To take the sales argument to the extreme, Apple stores generate $5,000 per square foot. Throw in a few luxury anchors and a Microsoft store to keep things honest and you’ve got the mall of the future.
To place the ultra-high end into context, the average mall in America last year generated $165 per square foot, a 24 percent decline over the past decade. According to the latest data available from Cushman and Wakefield, this dramatic sales decline stems from a cratering of mall traffic: In 2010, there were 35 million visits to malls; by 2013, that number had halved to 17 million.
A landmark study by Green Street Advisors released earlier this year estimated that one-in-five anchor department stores would have to be shuttered to return many struggling chains to the same levels of productivity they enjoyed 10 years ago. Big department stores, such as J.C. Penney, Sears and Macy’s, occupy some two-thirds of anchor space.
Without a doubt, the hatchets are in full swing. In April, Sears announced it was closing 78 stores, including 68 Kmart stores. You might be saying, ‘No surprise on that one,’ — few of us even claim to know someone who has frequented these stores of late.
But the Macy’s announcement from a few weeks back, that was anything but fully priced into market expectations. In January 2014, the retailer said it would shutter 14 stores followed this January with the news another 15 were on the chopping block. Hence investors’ surprise when the company revealed it would close 100 more stores by early next year.
Anchor closings have a contagion effect; they weigh heavily on the smaller retailers that depend on the draw of the big boys.
“Retail bankruptcies and store closures have thus far represented the greatest risk for mall operators, but also a potential opportunity if they can be replaced by higher-quality tenants” wrote Hill in the wake of Macy’s news. “Further store closure announcements by department stores would be an incremental headwind for Mall REITS.”
If only it was as simple as a pure mall story. Retailers from the mammoth Walmart to the luxurious Ralph Lauren have also announced they will close stores this year to the tune of 154 and 50 locations, respectively. They too will be laying off thousands of employees nationwide.
Moreover, there’s no magical macroeconomic expectation of a dollar-for-dollar shift from bricks-and-mortar to eCommerce sales. Recall what set the train in motion in the first place — finding the cheapest price online with the added convenience of shopping basically anywhere, an increasingly important driver of shopper behavior.
As for households’ continued laser focus on prices, stretching your paycheck is pretty important when it refuses to keep up with the growth in the cost of living. Wage inflation has picked up a bit, to an annual 2.4-percent rate in August from the 2-percent pace that characterized much of the ‘recovery’ years. And while food inflation has cooled to a flat reading over last year, an immense relief for families coast to coast, wage growth is still running far behind that for rents, at 3.8 percent, and that of healthcare, at 4.0 percent.
That gets us back to commercial real estate and the odd prospect that retail stresses could eventually spill over into other sectors of a market that is, by any measure, riding a runaway train of heated valuations. It will not surprise you that for years now the engine driving that loco locomotive has been luxury apartments.
While it had looked as if CRE was off to a rocky start to the year, according to the latest data, price growth has perked back up. The Moody’s/Real Capital Analytics composite index rose at an annual pace of 8.4 percent in June, up from 4.9 percent in April. Granted, this is off the blistering 17.1-percent pace clocked in February of last year, but it is still plenty respectable.
New Albion Partners’ Brian Reynolds reckons there’s a good reason to expect prices to continue to gallop ahead in the coming years. It comes down to two words that send shivers up regulators’ spines: regulatory arbitrage.
“We believe that all of the new regulations of this cycle are critically flawed. Whether its Dodd-Frank, Basel III, or the SEC’s insane money market rule change, they all attempt to limit certain products and services,” laments Reynolds. “We have described these flawed measures as, ‘treating the symptoms, not the problem.’ When only the symptom is treated, the problem actually grows in size.”
The underlying problem will be familiar to loyal readers: the requirement for pensions, insurers and other large investors to hit certain return bogeys that have little to nothing to with life on Planet Earth. We’re talking 7.5 percent in the case of pensions and 6 percent for insurers.
This fundamental challenge is nothing new, but how those holding the liability bag approach the issue has, shall we say, evolved. Derivatives in some form are typically deployed to produce outsized returns; structuring an investment vehicle around an income producing asset by adding leverage produces instantaneous outsized returns….until they blow up, that is. Think of the lovelies churned out by WorldCom and Enron, followed by souped-up subprime-mortgage-backed assets and finally the mammoth structured trade that inflated the commodities bubble, the bursting of which we’re still living down.
In the event you thought the prolific profiteers went gently back into the night, consider today’s Exhibits A & B. The size of private equity real estate funds raised continues to set records. Starwood’s promise of 14-16 percent net annual returns helped the $51 billion fund firm set a record target size for its current fund of $6 billion. According to Bloomberg, ‘opportunistic’ real estate strategies led the way in the second quarter, raking in $16.8 billion across nine funds compared to a scant $2.2 billion in lower-risk funds. Why go home when you can go big?
As for Exhibit B, REITs have swiped the baton from Commercial Mortgage Backed Securities (CMBS) – see unwise regulation reference above. REITs have been conspicuous in the presence in the debt markets of late – why not pile debt onto a lightly regulated platform?
In early August, Boston Properties, Hilton Escrow, Builders FirstSource, Kennedy-Wilson, MGM Growth Partners and Rexford Industrial Partners all tapped the debt markets. To not be outdone, private equity giant Blackstone filed to launch a $5 billion nontraded REIT.
“Not only have REITs begun to pick up the slack of the CMBS regulatory-induced slowdown,” noted Reynolds, “they are now beginning to do so in a leveraged fashion.” As public pensions desperately pour more and more money at these go-go vehicles, Reynolds predicts REITs will propel CRE lending to fresh heights in 2017 and for years to come. His conclusion; “That should make the CRE bubble, and the eventual bust, more intense.”
Well, at least that gives us something to look forward to. Throwing good money after bad always ends well, especially against a backdrop of the immense oversupply of retail space hitting the market in the coming years. Your gut would tell you that there’s no way many of the weakest properties manage to secure the refinancing required to keep the lights on. The billions upon billions of dollars being thrown at CRE, however, would seem to suggest otherwise. The question is, how many former movie theaters can be transformed to movie studios before the credits roll? Are there as many remakes in the cards for America’s malls as there were for the likes of Kong? If not Jeff Bezos, perhaps Chuck Prince could help out in answering that question.
FED Up is Danielle’s clarion call for a change in the way America’s most powerful financial institution is run—before it’s too late. See more on Amazon.com