From a small northwestern observatory…

Finance and economics generally focused on real estate

Sears on life support

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I write mainly about real estate, and while the glass has been more than half full these past few years, the recent announcements from Sears are troubling, to say the least.   For those not keeping up with such things,  In their most recent annual report, Sears made a “going concern” announcement, which essentially said that there is a reasonable chance they will not survive as a going concern for another year.

This is a massive problem, and the real estate issued will take years to sort out.  Sears has announced some steps to try to address this, including selling off real estate, selling key brands (Kenmore, Craftsman) and shutting badly performing stores.  However, they’ve already been doing this for years.  Craftsman is now owned by Black and Decker, they’ve been shutting stores for over a decade, and they formed Seritage REIT several years ago (in no small part owned by Warren Buffett) to monetize their real estate holdings.

As of the most recent reports, Sears runs about 1500 stores in the U.S., mostly under the mastheads “Sears” and “K-Mart”.  They employ 178,000 people, and had revenue of $22 Billion in 2016.  They’re bleeding cash, losing about $1.2 Billion in cash in the past 2 years.  Their net equity now stands at negative $3.8 Billion, according to recent reports.  At an average store size of about 100,000 square feet, they operate about 150 million square feet of retail space, which will be a real problem to deal with.  (I’m writing this while sitting in my office in Key West.  There are 5 big “anchor tenants” of shopping centers in Key West.  Three are groceries, and the other two are owned by Sears.)

Dumping 150 million feet of retail floor space into the market is a pain any way you look at it.  Currently, new retail construction in America is about half that.  However, this “new retail construction” includes a lot of stuff that doesn’t look like an old Sears or K-Mart store.  Indeed, repositioning big-box and anchor tenants can be a daunting challenge, and often the best use is demolition of the structure and repurposing of the vacant site.  Losing a big anchor retailer can blight an entire shopping center and need an entire large neighborhood.

One might suggest that a leaner, meaner Sears could be in the offing.  In someone’s dream world, Sears and K-Mart might retrench to half their current size — say 700 or 800 stores.  This is still a big problem, but at least kicks some of the cans down the road.  I’m a real estate guy, not a retail guy, but I think the problems of running a small chain of big, diversified retailers is pretty obvious.  Distribution, financing, and brand management will all die on the vine.  No, Sears and K-mart have bigger problems.  Sears tries to sell to a slice of the market that doesn’t shop much anymore (your grandmother) and K-Mart tried to be Wal-Marts scruffy little brother.  Neither of these retail strategies work very well.

We’ll see how this turns out, but the complexity of a Sears bankruptcy will keep real estate consultants busy for years to come.

Written by johnkilpatrick

March 24, 2017 at 8:20 am

Thus Spoke Janet

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Yeah, who else tried to slug their way thru Thus Spoke Zarathustra back in their halcyon days?  Now that the storms of autumn breath over my career, I find the pronouncements of Janet Yellen every bit as obtuse as Nietzsche.

I’ll try to make it simple. CNBC had an excellent piece this afternoon.  If you borrow money, you’re going to pay more.  If you invest in debt instruments, you’re not going to get paid more.  Simple?

So what does this mean for real estate?  I’ll posit a few axioms.

  1.  If you have a home equity loan and a first mortgage, and you have positive equity, you need to rush to your friendly banker and refinance all that into a fixed rate loan before happy hour this evening.
  2. If you’ve been planning to buy a house with a loan (as most people do) then yesterday was the day.  Today maybe.  Tomorrow… eh…..
  3. If you can invest in rental property, look for “equity positive” locations.  These are cities with solid economics, but the cost of construction is disconnected to the local rental rates.  Existing rental houses sell for a discount to new construction.  Buy all you can grab.
  4. There are three different explanations for the shape of the yield curve — rational expectations, debt stratification, and liquidity preference.  Today, liquidity preference trumps the other three.

Written by johnkilpatrick

March 15, 2017 at 1:08 pm

Economics of Climate Change

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To give credit right up front where credit is due, today’s post was stimulated in no small part by an excellent piece written for NPR last month by Angus Chen titled 1,000 Years Ago, Corn Made This Society Big.  Then, A Changing Climate Destroyed It.

In “all my spare time”, I’ve wondered a bit about the dichotomy of North American natives versus Europeans.  The latter developed a relatively advanced society by the time of Columbus, while the former seemed to be living in the bronze age.  I’ve really not had the time, effort, or inclination to study it much, and the few pieces I’ve read didn’t seem to be very robust, from a scholarship perspective.  One stream of research notes that pre-Columbian Europe, in the crossroads of trade among three continents, had more complex influences.  However, North American tribes traded among themselves, and before the Europeans brought gifts of small pox and syphilis, the population of this continent was certainly at a critical mass.

One of the less convincing arguments stemmed from lack of wheat.  In short, a population needs a robust agriculture in order to sustain modern civilization.  One farmer needs to be able to feed more than him or herself.  To me, this was also suspect — I’d been taught as a grade schooler that east coast natives actually demonstrated advanced cultivation techniques to European immigrants.  Chen’s article turns all this on its head by noting the Mississippian American Indian culture, a group of farming societies ranging from north of St. Louis down to present day Louisiana and Georgia.  The most prominent of these was the city of Cahokia, about 15 miles east of present-day St. Louis.  Around the 9th and 10th centuries AD, this society was fairly robust and successful, with large cities, complex agriculture, and trade.  In the absence of wheat, their principle row crop was corn, and apparently this contributed their diets in the same way wheat contributed to Europeans.

However, by the time Europeans came in the 15th century, these cities had already been abandoned.  Modern research now pins the failure of this civilized society on climate change.  The rains which sustained the corn crops for hundreds of years dried up, and by 1350 AD the region faced profound drought that lasted up to 500 years.

Climate change and crop failures led to destabilization of society and government.  Current archeology points to construction of palisades, burned villages, and skeletal injuries consistent with warfare beginning around 1250 AD.  Scientists are reluctant to blame the  entire collapse on climate change, but rather that climate change was probably one of a series of problems that brought down this remarkable American civilization.

The vast majority of scientists today concur that climate change is real.  Something on the order of 97% of recently published peer-reviewed empirical studies support this.  Admittedly, there is less concurrence regarding the impact of human factors, such as CO2 emissions, but the majority of scientists still seem to agree that at the very least, human intervention has probably accelerated existing trends.  That said, speaking as an economist, this all has implications for societal change which must be addressed in an organized, cogent manner.

Written by johnkilpatrick

March 9, 2017 at 1:37 pm

So, how’s Real Estate?

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OK, OK, OK — we get it.  The stock market has been the “place to be” the past few months.  Actually, it’s been a great place the past few years.  You may not realize it, but 2016 was the first year in the past 6 that the S&P 500 did NOT turn in a double-digit return.  That said, the S&P came in at 9.4% for the year, and that’s nothing to sneeze at.  The Nasdaq turned in 7.5%, also a decent number.

So, comparatively speaking, how were the returns in Real Estate?  Two of the best markers for that are indices produced by the National Association of Real Estate Investment Trusts (NAREIT) and the National Council of Real Estate Investment Fiduciaries (NCREIF).  NAREIT is made up of 167 publicly traded equity REITs and 34 mortgage REITs (for our purposes, we’re only interested in the equity side).  These have a total market capitalization of slightly over $1 Trillion.  NCREIF is an index of non-securitized commercial properties, generally owned by tax-exempt institutions, and totals slightly over $500 Billion in value.  Both indices do a pretty good job of benchmarking commercial real estate returns.

For 2016, the NAREIT index came in at 8.63%, or slightly above the NASDAQ and slightly below the S&P.  The NCREIF index came in at 7.97%, also not a shabby number.  Because of the nature of the NCREIF index, it’s not quite as granular as the NAREIT index, and only reports quarterly.

However, NAREIT reports monthly, and also gives us some return numbers on a sector basis.  This can be very telling, because it reminds that an equally weighted REIT portfolio may be inferior to one more carefully chosen.  Year to date, the NAREIT index has come in at 4.19%, which is somewhat below the S&P’s 6.68%.  However, some sectors such as timber, specialty, and single family homes have turned in double-digit returns already this year, and data centers, infrastructure, and manufactured homes have also bested the S&P.  On the other hand, shopping are actually turning in negative returns thus-far this year (notably, regional malls came in negative for 2016).  The industrial sector has turned negative in 2017, but enjoyed the top returns of all sectors in 2016, at 30.72% for the year.  Lodging/resorts is also negative thus-far in 2017, and also turned in significant positive returns in 2016 at 24.34%.

As always, this is not a recommendation or solicitation to purchase any particular investment, and prior returns are not indicative of what may happen tomorrow.  This is just a blog — nothing more than that.

Written by johnkilpatrick

March 2, 2017 at 8:32 am

Dreams of GDP growth

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Paul Krugman and I don’t necessarily agree on everything, either in politics or economics, but I respect his research (and yes, envy his Nobel Prize).  That said, he has an insightful piece on his blog about The Donald’s economic projections, which both Paul and I find probably untenable.  I encourage you to read it here.

In short, The Donald projects 3% to 3.5% GDP growth throughout his tenure in the White House.  Under Reagan, it was at the lower end of this scale, and under Clinton it hit 3.7%.  Remember that both of those presidents inherited crappy economies, and so  a pendulum bounce in GDP would have been expected.  The Donald is inheriting a healthy overall economy (admittedly, with pockets of problems).  As such, growth in the 2+% range is more likely. So why are they projecting such glossy numbers?  In short, they back into what they need to say in order to fit their rosy projections.

I would note that the Chair of the Council of Economic Advisors sits vacant as of this writing, with no nominee in the offing.  This Council serves the president, among other ways, by putting a reasonableness test on just such projections.  Truly excellent economists have served on this Council thru the years, from all sides of the economic spectrum (and yes, there are more than two).  In the absence of trained, academic economists in this role, these projections are left up to whim.

Unlike Paul K, I have some hope that Paul Ryan may be a voice of sanity here.  He seems to understand that balance sheets need to balance.  Let’s see how that works out.

Written by johnkilpatrick

February 21, 2017 at 12:00 pm

The long lost shopping mall?

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Common wisdom holds that the shopping mall is on life support.  I venture into maybe one or two a year, and my most recent ventures weren’t very encouraging.  Two recent Wall Street Journal articles illustrate the complexity of repurposing.

First, in a January 24th article by Ester Fung, “Mall Owners Rush to Get Out of the Mall Business”, the Journal notes that even the big-names in the biz are making use of strategic default to get rid of underwater properties.  Citing data from Morningstar, the story detailed that from January to November 314 loans secured by retail property were liquidated, totaling about $3.5 billion.  According to the story, these liquidations resulted in losses of $1.68 billion. Washington Prime, CBL and Simon have all sent properties back to lenders in recent months.  Ironically, these big players have seen no dings to their credit ratings, and the equity market in fact views these put-backs as evidence of financial discipline.  On the downside, surrounding properties, such as out-parcels and other nearby retailers, such as restaurants, that depend on spillover from the mall, are suffering from the loss of shopper attraction.

One alternative to strategic default is a revamping of the real estate itself.  This often includes attracting a new or new type of anchor tenant or demolishing the mall entirely to make way for offices or apartments.  Unfortunately, as detailed in a February 14 WSJ piece by Suzanne Kapner, existing tenants often have covenants or restrictions standing in the way of such revamping.  In “Race to Revamp Shopping Malls Takes a Nasty Turn”, Ms. Kapner outlines how many department stores want to protect existing parking or existing exclusivity through “reciprocal easement agreements”.  For example, large swaths of unused parking space have value for repositioning.  However, as Gar Herring, chief executive of the MGHerring Group, a regional mall developer, put it, “But if you want to put a snow cone shack in a parking space furthest from the mall, you need the agreement of every department-store anchor.”  Currently, for example, Sears is suing a mall developer in Florida to prevent it from adding a Dicks Sporting Goods as an anchor. Lord & Taylor filed suite in 2013 to stop a Maryland mall’s demolition to make way for offices, residential properties and a hotel.  The retailer claimed violated an agreement signed in 1975 that prevents the landlord from making changes to the property without its consent.

The shopping mall is three different things.  From a consumer perspective, it’s a place of gathering and  consumption.  Indeed, the loss of the shopping mall, which replaced Main Street, has sociological implications as well.  Does Amazon.com now become a place of gathering as well as consumption?  That’s an interesting subject for another day.  Second, from a business perspective, the mall is a bundle of contracts, and sorting through those contracts will keep lawyers and real estate experts busy for some years to come.  Finally, a shopping mall may be, in some circumstances, a valuable piece of real estate.  Repositioning that real estate, either as retail with different tenants and focus, or as something other than retail, will be an interesting story in the coming years.

Well THAT’S interesting…

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Most of the conversations I’ve had about real estate and The Donald focus on housing, and particularly the storm clouds forming over low-income housing.  However, while The Donald is one of the luckiest income presidents in history in terms of inheriting a great economy, his Achilles heel may be the commercial real estate sector.

cbre-graphic

CBRE was kind enough to tweet the accompanying chart this morning, which is pretty self explanatory.  (Of course, I’ll go ahead and explain it anyway.)  After the real estate storm that Obama inherited, commercial transactions have regained lost ground in the past several years.  Note that we peaked in 2015 with total commercial transactions of nearly $1 Trillion for the year.  However, the market backed-off considerably, with the first three quarters of 2016 coming in a bit lower than the previous year, and then the 4th quarter coming in nearly $50 billion lower than the same period in 2015.

Did we just see a trend line break?  One wonders.  Commercial real estate feeds a lot of other sectors of the economy.  For example, new construction employs lots of the sorts of jobs The Donald is promising.  We need to keep our finger on this particular pulse.

 

Written by johnkilpatrick

February 14, 2017 at 9:41 am