Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
WeWonder About WeWork
Excessive monetary stimulus has created many kinds of economic disconnects, and I would encourage you to read Doug Noland’s Credit Bubble Bulletin for an in-depth look at credit bubble dynamics. One particular area we would like to explore at Hard Assets Insights that is relevant to our investment strategies is the notion of “disruption,” or, as defined by Wikipedia, “an innovation that creates a new market and value network and eventually disrupts an existing market….”
In the area of commercial real estate, there have been numerous secular trends that have implications for income growth for various sectors. For example, supply of affordable housing in key coastal markets generally remains quite tight. The movement of consumer shopping preferences from physical to virtual shops has shifted demand for space from brick and mortar to industrial properties, so warehouse vacancies are at historic lows.
The office market has also seen its share of paradigm shifts, and global negative real rates have encouraged significant malinvestment on the part of many office property landlords who now need to fill space. This brings us to the much-discussed and now much-maligned and failed IPO of WeWork, and the death of the “unicorn,” or tech startup. Let’s ignore for a moment the hubris and bizarre behavior of its founder, along with related corporate governance issues, and focus on the business itself.
First of all, WeWork is not a tech company (despite the absurd proposed initial public valuation of 26 times revenues) and is in fact not even a real estate company. To be clear, there are no hard assets. The business model is to lease office space and sublease this in a “co-working” environment. Although the company leases space, WeWork does not actually own anything except the lease liability, which is mismatched with the duration of the much shorter-term lease it provides for its lessors. Unlike a tech company, gross margins are quite thin for this business. In essence, the company is an intermediary. There are zero barriers to entry, and in fact there have been many competitors in this area. There is, in fact, nothing really new, proprietary, or disruptive about co-working; Regus is actually the largest co-working company and has 50 million square feet of office space in 2700 locations.
WeWork has a $50 billion-dollar lease liability and is the largest office tenant in many gateway markets, including New York, Chicago, London, and others. They were given heavy incentives in order to attract leases from the company. We have serious concerns as to what this will mean for office properties in gateway markets in the event that the WeWork financial situation deteriorates further. In fact, there are some buildings that count WeWork as over 50 percent of their total leased square footage. Most publicly traded REITs have very highly diversified tenant bases, and we believe that exposure in that area is limited for the most part. However, we understand that there is not-insignificant risk for some companies within our coverage, and despite valuations that are relatively attractive to the rest of the group, we believe there remains significant headline risk for companies with WeWork exposure.
Further, to the extent that WeWork has financial challenges, this will have an impact on lease rates in all markets where it is a significant lessor, and negatively affect net operating income across the office sector. In short, while not disastrous for the overall office market, it will have an impact in certain markets and is a dynamic we are following with great interest.
We thank you for your interest and are grateful for your continued support.
Chief Executive Officer