“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”
– Warren Buffett
It’s fitting that we’re using a quote from the Oracle of Omaha today, as Berkshire Hathaway’s annual meeting was recently held on May 6th. Some pertinent pieces of wisdom from the dynamic duo that is Mr. Buffett and Charlie Munger stood out to me while breezing through the linked article:
- “It’s never good when a company cuts dividends dramatically” (regarding Paramount). We agree as we utilize a foundation of Dividend Growth as a core portfolio component.
- “Commercial real estate is starting to see the consequences of high borrowing rates…We are starting to see the consequences of people who could borrow at 2.5% and find out it doesn’t work at current rates, and they hand it back to somebody that gave them all the money they needed to build it.”
The Berkshire sentiment corroborates the notion we’ve discussed in this series, which is that we expect some softness in parts of commercial real estate – notably where demand is the weakest – and the related losses will impact either equity holders or debt holders (or both), for example:
- Equity owners with significant “skin in the game” (e.g., from a down payment made to purchase a property); in this case, the equity value may be wiped out entirely, and lenders can then assume ownership of the property via foreclosure or other agreements to mitigate losses.
- Even if “scenario a” plays out, lenders who were too aggressive in their underwriting and failed to create adequate loan-to-value (LTV) cushion to withstand declines in property value can lose money if the loan becomes worth less than the property value (aka it is “underwater”)
Where were we?
Now we’ll continue through the list of property types, subtypes, and notable attributes we began to cover in Part 7. As a reminder, we so far touched on Multifamily and Office, leaving us six other property types to consider. Here we go!
Industrial:
- Distribution Centers: Also known as fulfillment centers, these have been a recent/current favorite of real estate managers we’re in touch with. Technological evolution has allowed us to change many habits, but its impact on our shopping behavior has been incredible. We love having packages magically arrive at our door (sometimes the same day!) with only a few clicks of a mouse. And I’m sure companies love selling us all that stuff, whether we need it or not. But, there are MAJOR logistical developments that have had to accompany the desire to move goods from point A to point B so quickly. Key components of that home-delivery chain are distribution centers strategically located near highly populated areas.
Using residential real estate as an example, imagine a person finding their dream home within walking distance of their workplace. Suppose hundreds or thousands of dollars of monthly savings (fuel, parking, tolls, perhaps elimination of the need for a car) stem from such an ideal location. In that case, that buyer may logically be willing to “overpay” for the property. Applying that same thinking to logistics, a distribution center closer to final delivery destinations can save time, fuel, and labor, adding to real savings. Thus, it makes sense that those savings could a) increase demand for such a property and b) translate to a willingness to pay a premium over similar properties with a less attractive location.
However, distribution centers are NOT just storage facilities, so get that outdated image of your grandfather’s warehouse out of your head (I know “grandfather’s warehouse” isn’t a thing, but you hopefully get what I’m saying). These dynamic facilities and the companies that operate them (sometimes third parties) add value via inventory control and order management that are invaluable for keeping customers happy. I’ll stay out of the weeds today, but very cool things are happening under the roof of your local fulfillment center; feel free to check out this ShipBob article to learn more, and maybe it’s something for us to cover in-depth in the future. Stay tuned.
As with the distribution center example, my guess is that other types of Industrial properties – heavy manufacturing, light assembly, bulk warehouses, and mixed-use – are also finding ways to increase value via more integration and flexibility for their customers and supply chains.
Retail:
- When I go to the mall, which is rare nowadays, I feel nostalgic for my early teen years. I spent a ton of time at our local mall (shoutout to Ross Park Mall in the North Hills of Pittsburgh) when I was about 13 years old; in fact, my best friend and I were at the mall every single day between Thanksgiving and Christmas in either 1992 or ’93 – and we didn’t work there or ever buy anything other than the occasional CD. It was just the place to be! Who would have liked to own a mall in the early ‘90s? Everyone! [This is unprovable, so let’s just pretend it’s true] But who wants to own a mall in 2023? It’s certainly far less than “everyone.”
- Anecdotally speaking, people love talking about multifamily and distribution centers, but few are excited about retail. We previously discussed medical offices and why the tenant rosters are “sticky.” Now juxtapose that with owning a strip mall, where simple changes, like road construction projects, can quickly divert customer bases and bankrupt retail tenants. As with the topic of commercial office space we’ve covered extensively, the best retail properties in the best locations can be solid investments and offer a degree of resilience; however, the success of many retail properties can be challenging to predict, as tenants and customer basis may be far more fickle.
- Here are a couple of caveats worth mentioning before we move on from retail:
- The concept of a “mall” is changing as we speak. Owners of the massive properties I loved during my youth aren’t resting on their laurels and allowing online shopping culture to destroy their investments. Could people live at the mall? Is a giant parking lot still needed if no one is going there? Could part of the space be repurposed as a distribution center? I think we’ll see some very interesting reconfigurations in the coming years.
- Restaurant chains tend to have some resilience to them, and – based on investments held for clients in the past – a lease can be tied to the corporation behind a given restaurant across many locations. So, even if one store goes out of business, the corporate entity may still be on the hook for rent, mitigating risk for the landlord.
In the next edition, we should be able to wrap up the remaining four property types – Hotels & Hospitality, Mixed Use, Land, and Special Purpose.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
