News

Landmark Links April 27th – Junk Sale

 

Lead Story… During the Great Recession, banks nearly failed because they had a massive mismatch in assets and liabilities.  Lenders were highly leveraged and borrowed short term capital to fund long-term assets.  This ended in tears when short term rates shot up and the markets eventually froze, requiring a massive federal bailout to avoid the entire financial system going up in flames.  Hindsight is always 20/20 but financing long-term assets with a fixed return profile by using short term floating-rate debt is one of those business plans which works really well until it doesn’t.  While the above still holds true, having fixed, long term liabilities offset by variable short term revenue streams isn’t any better, which brings us to co-working unicorn startup WeWork.

WeWork has occupied a rather unique corner of the stodgy and often slow-to-evolve real estate world since it’s inception back in 2011.  Depending on one’s outlook, it is either poised to become the Amazonian disruptor of the office market by leveraging it’s immense data reservoir and ability to bring multiple functions under one roof or it is little more than old-school executive suite operator Regus with a better pain job (and free beer).  WeWork has benefited massively from it’s perception as a tech company, raising more than $6 billion in equity, implying a valuation of a whopping $20 billion dollars, substantially more than office REIT behemoths such as Boston Properties, Inc. and Vornado Realty Trust, despite the fact that WeWork owns very little actual property – or anything else, for that matter.

As a real estate operator, WeWork’s business plan is actually quite straight forward.  Esther Fung of the Wall Street Journal recently explained it perfectly:

WeWork takes on long-term leases for office space, renovates the space using flexible and modern designs, and then subleases it to others for shorter durations.

In addition, WeWork throws in free beer, ping pong tables, common rooms, etc that tend to attract a Millennial crowd.  While WeWork is a relative newcomer, the model itself has actually been around for quite a while, just never at valuations anywhere close to $20 billion.  In order to keep up their growth trajectory, WeWork has to spend a whole lot of money on office space build-out and take on significant long-term leases, all-the-while never really owning much of anything tangible.  WeWork sold bonds this week to help raise cash for their money-losing operation and had to disclose their finances publicly for the first time.  Via Sam Goldfarb at the WSJ (emphasis mine):

WeWork Cos. sold $702 million in bonds Wednesday, becoming the latest startup to win over debt investors despite a cash-burning history that is atypical for a bond issuer.

WeWork, a New York-based office-space provider with a hip reputation and $20 billion valuation, was able to sell its seven-year bonds at par with a 7.875% interest rate, people familiar with the matter said. That rate was in line with the guidance set by a JPMorgan -led group of underwriters on Tuesday, although the size of the deal was increased from $500 million.

Investors looking at the deal cited concerns about WeWork’s minimal assets, sizable lease obligations, negative cash flow and strategic challenges as the company expands beyond high-rent cities like New York and San Francisco.

When VC and equity investors look at a company like WeWork, they take the risk of investing knowing that they will make a fortune if the company succeeds and potentially lose everything if the company fails.  This is why it’s puzzling to me why fixed income investors would invest money into a company with little in the way of assets that is bleeding cash.  Via Elliot Brown at the WSJ (emphasis mine):

Last year, WeWork’s revenue doubled to $866 million, according to the offering documents. The revenue comes mostly from monthly rental payments it calls memberships, as well as sales of some services such as business software.

But losses also more than doubled to $933 million as the company incurs hefty construction costs for most of the new offices it opens. WeWork spends millions of dollars renovating new offices with glass walls, modern lighting and furniture, investments the company says will pay off in the future. Discounts are often used to fill new offices.

Does that sound like the sort of venture that you’d want to invest in if the upside was getting re-paid with a 7.875% return?  Me neither.  The ratings agencies were not impressed either which is why they rated the offering as below investment grade aka junk.  This is the epitome of the yield chase that has been a defining characteristic of this market for several years.  WeWork attempted to justify their ability to repay the bond debt by playing all sorts of bizarre games with the English language. Via Eliot Brown at the WSJ (emphasis mine):

In the offering documents, WeWork went to unusual lengths to show ways in which the company would be profitable. While many companies typically offer “adjusted” earnings, WeWork offered three different layers of adjustments.

It called the fully adjusted number “community adjusted Ebitda,” by which it subtracted not only interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs. Those earnings were $233 million, WeWork said.

Don’t understand what “community adjusted Ebitda” is?  I’ll translate for you: it’s a way of saying “we’re only profitable if you ignore any and all costs and expenses.”

All of the above notwithstanding, WeWork is faced with a fundamental problem – it has only operated in a market where office rents have gone up.  It’s easy to look good when you fix your main liability (rent) for long periods of time and the market moves in your favor.  It’s a lot harder when the market moves against you and the rent that you charge tenants – nearly all of whom are on short term leases – falls while the long term liability does not.  To give this some context, WeWork is on the hook for at least $5 billion in rent obligations by 2022 and they owe an additional $13.2 billion beyond that point.  Sure, this does not all roll up to the parent company and corporate guarantees vary in scope but these are still some massive liabilities.  WeWork bulls have always pointed out that the company is not leveraged and would thus have more flexibility to ride out a recession.  However, that has never been completely true as they do have to deal with long term lease obligations.  Now the company is further layering debt on top of those obligations by tapping the bond market for financing, potentially putting themselves in an even more perilous spot when the next recession hits.

As stated above, nothing that WeWork is currently doing is unprecedented – it’s only the scale that is.  During the late 1990s tech bubble, a company called HQ Global Workplaces, LLC leased up office space in tech hubs and took out debt to grow.  It then leased that space to startups and made a lot of money until the bubble burst, eventually leading to bankruptcy.  The phrase “history does not repeat itself, but it rhymes” is probably the most famous thing attributed to Mark Twain that he didn’t actually say.  IMO, it’s very applicable here.

Economy 

Perceived Shortfall: Rising medical and long-term care costs as well as uncertainty surrounding Social Security and Medicare benefits have retirees losing confidence about having enough to live on.

Between a Rock and a Hard Place: Asset prices are booming yet economic growth remains relatively tepid, leaving the Federal Reserve in the position of trying to thread the needle between managing inflation risk and pushing the economy into another asset price driven recession.

Windfall: A booming economy and soaring tech sector have California’s income tax revenues poised to far exceed both projections and last years totals.

Commercial

Upended: The delivery boom is changing everything about the restaurant business.

Game Changer?  Property giant Brookfield Holdings has set up a venture capital fund to invest in startups that focus on potentially disruptive technologies in the real estate business.

Residential 

Help Wanted: A severe lack of construction workers means builders can’t keep up with new home demandSee Also:Home builders are increasingly able to pass on soaring construction costs to consumers, meaning that already high-flying home prices driven by supply shortages could be poised to spiral even higher.

Rising Share: New homes are hot because buyers don’t have many other choices as the supply of existing homes continues to dwindle.  See Also: Challenges are mounting for first time home buyers as costs continue to increase much faster than incomes.

Profiles

What A Mess: Federal banking regulations dealing with the legalized marijuana space are the epitome of bureaucratic stupidity:

Banks are required to file reports for anyone depositing funds “derived from illegal activity.” According to that logic, banks must also file a report when a state government deposits tax revenue paid by marijuana firms into the state’s bank account. The result is banks telling Uncle Sam that Oregon is a possible money launderer. Not only does it not make sense to consider a state government a money launderer, there is no reason for banks to be the ones reporting to the U.S. Treasury that Colorado, Washington, Oregon, Alaska, California, Massachusetts, Maine and Nevada are profiting from the sale of marijuana. Voters and state legislators did not exactly make it a secret this was their plan.

Gutted: Eddie Lampert’s hedge fund is trying to buy Sears business units that have not attracted offers despite being on the market for two years in an effort to keep the sinking ship afloat.

Fake News: Amazon has a fake ratings as merchants use Facebook to flood the site with fake reviews.

Chart of the Day

Luxury homes in LA are selling faster than they are elsewhere.

https://asset.wsj.net/dynamic-insets/charts/cdc_aa992e49e1d31a2b0b978550_embed.html

Source: Mansion Global

WTF

Grand Theft: A Texas man has been sentenced to 50 years in prison for stealing $1.2 million worth of fajitas over nine years.

No Poo Left Behind: Kim Jong Un is bringing his own toilet to the historic summit taking place in South Korea because…..this is a direct quote from a North Korean official:

“The leader’s excretions contain information about his health status so they can’t be left behind.”

Seems Reasonable: A man was arrested for stabbing his wife after alleging that she put a voodoo curse on him because Florida.

Not From the Onion: Some British schools are removing analogue clocks from exam halls since teenagers don’t know how to read them.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com