I think bubbles are misnamed…err, misunderstood.
Maybe just all too often we focus on what goes up then down, rather than what just goes down.
That is, something that slowly “bursts” is just as much of a bubble as something that bubbles and bursts.
We only tend to notice those that bubble, first, though. Hindsight, or something…
On Commercial Real Estate
There’s a fascinating read from a recent board meeting involving Charlie Munger. You can read it here. He’s asked about what he thinks about retail, and it mirrors a lot of things I’ve always thought.
Something central to his thesis of a weakening environment for retailers comes from the following quote:
Then you add the fact that we have too damn many stores that are the natural over-optimism of both lenders and real estate developers and merchants and so forth. So, I would say retailing looks tough and dangerous to me. Now, that isn’t to say there aren’t some people in it that are so good they’re going to succeed in spite of everything, like Costco, but I think for ordinary people engaged in retailing, it’s a business that’s going to have a lot of head winds.
The primary difference between commercial and residential property has been, in my mind, longevity. That is, where an apartment can and probably will be rented for generations, a commercial property isn’t likely to be rented for that long. So many buildings are put up, exploited, then torn down to build another one.
Mathematically, a 10% cap rate on commercial real estate is the same as a 10% cap rate on residential. However, if a building or cash flows only last for 15 years for commercial and 60 years for residential, the IRR is vastly different.
Going for broke
I think longevity has to be central to any investment. I like investments that best mirror a perpetuity. I think residential real estate fits that mold, commercial real estate doesn’t. Of course, I have some pretty extreme views on commercial real estate, so I won’t pretend I’m in the majority.
But really, there’s one big commonality with all of the following retailers:
- Sears (Kmart, too?)
- Best Buy
- Barnes and Noble
- JC Penney (Maybe)
- Office Depot/Staples
They’re all anchor stores (B&N has a good pull for small centers) and all of them are likely to be dead in the next five to ten years. Then there’s the smaller corporate stores:
Those are toast, giants only in a bygone era when physical media mattered, cell phones were tried in store, and gaming content was only available via brick and mortar store.
It’ll be interesting to see what happens when Best Buy goes under – I think it’s the first to shutter. There’s one (two maybe, not sure – I hate that store) in my town located near other retail giants like TJ Maxx, Walmart, Target, and others. When Best Buy goes under, it’ll be interesting to see who fills the void – and at what price. You know, if it’s rented cheap enough, a smaller player could probably compete on price with Target or Walmart, despite smaller buying power.
With high fixed-costs and little to no variable costs, plus incentive to fill every vacancy (customer traffic is key!) the commercial real estate business is microeconomically similar to airlines.
It astonishes me how easy it is to get financing only because commercial real estate is considered a hard asset. Lend against it and if all else fails you can foreclose and resell to recoup your investment, except when you can’t. Lending $1 million against the equity of a commercial building doesn’t mean it’s worth $1 million, especially if 5 similar units are soon to be empty and priced at $500,000. Retail vacancies are in the double digits – and the list of companies above haven’t even really begun to slash store counts.
If I owned a retail center with any of the above anchor stores as a tenant, I think I’d be looking to get out right about now.
Commercial real estate never really bubbled. It’s just fizzling. It is a bubble, in part because we’re willing to lend against it recklessly knowing all too well that retail is dramatically changing. Amazon is changing the world – and making no one rich, if you’ve looked at the latest earnings reports. It will make a hell of a lot of people poorer, though.
That’s just my outlandish thought on a Wednesday.