From a small northwestern observatory…

As the madness of this Federal shutdown continues, the lead news story every day features obvious pain and suffering faced by hundreds of thousands of government employees, an unknown (but probably much larger) group of federal contract workers, and the general citizenry who depend on those government workers.  Compared to the very real problems this is causing so many hard-working Americans, whining about the real estate industry, and business in general, may seem to be superfluous.  That said, the economy as a whole — and by that I mean working people, their jobs, their savings, and their lives, will be impacted for quite some time by this stupidity at the highest levels of our government.

A few random points, just to illustrate:

1.  Local schools depend heavily on Federal support for school lunches.  Even schools with few students receiving free lunches will receive significant dollars each month to subsidize the school lunch program.  This money immediately trickles into the local economy to pay for food and cafeteria salaries.  Interrupting this for even a short period of time can really impact school districts that already have problems paying teachers and providing school supplies.
2. Many Federally-produced business reports, which are necessary for business intelligence and decision making, have been delayed.  For example, the international trade report was not released last week, as was the January 11 agricultural supply/demand report.
3. JP Morgan lowered its GDP growth estimate by a quarter of a percentage point.  That may not sound like much, but it represents a materially large impact on our economy and its ability to provide private-sector employment.
4. Mass transit systems throughout the US — on which many workers depend for their daily commute — have temporarily lost financial aid that supports maintenance and repair costs.
5. Federal courts are increasingly having to delay or defer litigation, including almost all civil cases.
6. Cyber security at many Federal agencies is handled by outside contractors, who are not being paid and thus legally cannot provide those services.
7. College students applying for student loans cannot verify parent income through Federal sources.
8. Department of Agriculture loans to farmers and rural dwellers are on hold.
9. Wildfire prep work and firefighter training, a needed preparation for the 2019 fire season, are on hold.
10. The FCC, which licenses and regulates TV and radio, plus private radio licenses (such as the radio in an airplane or a boat) has shut down.
11. The Federal government missed paying its $5 million monthly water bill to the District of Columbia.
12. IRS staffers cannot answer consumer questions about the new tax law.
13. Employers cannot use the Federal E-Verify system to check if workers are in the US legally.
14. The National Hurricane Center is now off schedule for badly needed upgrades to the main American weather model.
15. Some states are delaying contracts for road and bridge maintenance.
16. Mergers and IPOs are being delayed because the SEC cannot issue approvals.
17. The FDA has stopped many food inspections.

Sigh….

Yeah, I grew up in one of those households.  Mom would pack me in the car and drive 40 miles to the nearest Sears to be at the door when they opened at 9am.  Christmas shopping always involved The Catalog (THE Catalog).  Except for a car, a house, and a dog, if Sears didn’t sell it, we probably didn’t own it.

As of this writing, it appears that they may — or may not — emerge as a shell of their former self.  Many (most?  all?) of the stores will close.  Every retail pundit in the universe is trying to explain why the business went into bankruptcy.  I have my own ideas, but that’s not the issue here.

One of the more interesting stories, though, is how badly Sears has apparently managed its real estate holdings in the last few years of its life.  There are a lot of claims on the assets out there (one argument is that Sears’ expensive defined benefit retirement program is taking it under).  Intriguingly, however, Sears owns a very valuable asset which, in bankruptcy, it will simply throw away.  That asset is a nationwide network of below-market leases on very valuable real estate.  The current Board Chair, Eddie Lampert, is making a $1.8 Billion bid for this real estate, although there is some question as to whether the court will accept his bid.  In fact, many of the landlords are clamoring to evict Sears and turn the assets over to more profitable tenants.

Imagine you own a shopping mall, and you can rent 140,000 square feet of Sears space (the average size of a Sears store) for $15 per square foot.  Instead, however, Sears currently rents that space for $5 per foot, due to a favorable lease they negotiated when the mall was first built.  Imagine that Sears still has 20 years remaining on said lease.  At a 7% rate of return, the difference is almost $15 million in present value.  In real estate terms, that’s called a Leasehold Estate.  Multiply that by hundreds of stores, and… well… you get the picture.

Leasehold Estates may or may not be transferrable, but often can be subleased.  Indeed, Sears in its hey-day made quite a bit of money sub-leasing portions of the store to third-party merchants (many big retailers still operate this way).  When Woolworth’s realized that they were not long for this world, rather than head down the bankruptcy path, they carefully managed their long-term leasehold assets.  Indeed, some analysts argued that Woolworths was worth more as a real estate holding company than as a retailer.  In Sears case, that may have been a possibility at one time, but sadly that ship has sailed.

I’m currently writing a book chapter on the importance of differentiating between the business value and the real estate value in the analysis of a closely held enterprise.  The melt-down of Sears is a shining example of the failure to do just that.

Home ownership rates have plummeted from pre-recession “bubble” peaks, and have recently begun stabilizing around the pre-bubble levels.  Before, during, and particularly after the recession, apartment construction and absorption soared.  Many (most?) analysts feared an overbuilding in apartments, necessitating a retraction in construction until excess units could be absorbed.

The one very small black swan we all missed in that prediction was the shortage of homebuyer credit and the difficulty for buyers — particularly first-time homeowners — to accumulated down payments.  Admittedly, the zero-down world of the housing bubble was unhealthy for the stability of the market, but the job-market of the past few years has made it difficult for younger buyers to enter the homeownership market.

Diana Olick Olick wrote a great piece for CNBC over the holidays about the unexpected strength of the apartment market.  She details both the current state of the apartment market as well as the causes and trends in that arena.  You can view the original article here.