No country for old men

At the risk of sounding like Jimmy Carter, I felt a sense of malaise at this year’s commercial real estate summit. Last week, the Omaha conference reached its 35-year milestone under the guidance and creativity of the indefatigable attorney and developer, Jerry Slusky. Maybe it was the panel discussion that devolved into career counseling for young brokers by a grizzled veteran. Perhaps it was the lack of statistics on rental trends and square footage absorption, leading a developer to wanly muse about seeking out markets where “demand exceeds supply.” This revelation produced solemn nods and much chin-stroking from the pilgrims.

Lenders assured me that none of their loan books had the faintest whiff of distress, yet a panel on the subject implied otherwise. One general contractor told me that many of his clients in the southwestern portion of the US are going ahead with apartment projects “even though the numbers don’t work” because they know they are locking in today’s cost basis for the future. I had no response to this business plan. Using such logic, one could have made this justification to move forward on a real estate development at virtually any moment in the past 75 years.

It was the irascible Creighton economist Ernie Goss who brought out the wet blanket. I love an economist who is one-handed. There aren’t many. Dr. Goss gamely mixed John Maynard Keynes with Warren Zevon, befitting a professor who could pass for Bob Dylan’s cousin. Goss talked about the agricultural sector in gloomy tones. Corn at $4 a bushel is no bueno for Nebraska. His most sobering reminder was the chart showing that interest on the national debt now exceeds spending on national defense. No empires have survived this inflection point. All that Aztec bullion filled Spain’s coffers for two centuries before an overextended domain began to unravel in the late 1800’s. France sold its New World colonies to pay for Napoleon’s conquests. Lest one thinks such fate can’t befall the holder of the world’s reserve currency, it was Britain with her once-invincible pound sterling that was hobbled by two world wars and went cap-in-hand for an IMF bailout in 1976. George Soros heaped further ignominy on the beleaguered pound in 1992.

I can be prone to cynicism. It’s a blind spot, and an especially poor trait in a real estate developer where one’s raison d’etre is the rosy future. But I can’t help but feel there is a bit of the “end-of-the-Roman-Empire” feeling around. There’s bacchanalia galore with stock indexes hitting all time highs, private jets whisking families on vacation, the return of the Hummer, liquor lockers at private clubs, multiple country club memberships, CNBC masquerading as due diligence, billions of dollars in NIL money for college athletes, the de-facto legalization of THC and sports gambling, and Nebraska finally going all-in on it’s own casino gambling. Meanwhile, the low end of the income spectrum faces insurmountable home-ownership costs and pain in the grocery aisle. There are two wars being waged on the doorstep of NATO, a former president was nearly assassinated, and the current president all-but-admitted he was too senile to serve another term. And yet! And yet. What’s the VIX at? 100? Nope, try a benign 15.79. Credit continues to flow. Jerome Powell just declared victory. Game on.

You’re starting to ramble. Are you turning into an old man? Well, I don’t think of myself that way, but in actuarial terms the answer is unfortunately, “yes”. But there’s a place for old men. I’m not talking about ending up like Sheldon Levene in Glengarry Glen Ross. I’m envisioning Clint Eastwood here. Cigar and a Smith & Wesson. Let’s take another wise old Omaha guy I like – Warren Buffett. Berkshire Hathaway owns $235 billion of Treasury bills after significantly reducing holdings of Apple. Buffett may be old, but he’s not cynical. I can’t recall an annual meeting where the words “America’s best days lie ahead” weren’t uttered. However, in this instance, I prefer to watch what the man does, not what he says.

Dude, this is bumming me out, and your Hollywood references are beta. Let’s move along to that book you’re reading.

Ok. I’m about halfway through Nate Silver’s On the Edge: The Art of Risking Everything. It’s a fun read, but I think Silver could have used a better editor (pot, meet kettle). We follow his poker exploits, head down his sports betting rabbit-hole, take a tour of the venture capital industry, and then make an off-road excursion into the bizarre downfall of Sam Bankman-Fried. These are members of “The River,” Silver’s term for those who think in terms of probabilities and make wagers using their best estimates of positive expected value (EV). Yet, so much of what passes for rigorous evaluation of odds based on massive amounts of data often coalesces into little more than well-informed gut instincts. Silver seems to recognize this despite his continued attempts to explain most decisions in probabilistic terms. Take bluffing, for instance. Poker players smoke out a weak hand with a massive bet. Brute intimidation can often work better than the best statistical calculator. Venture capitalists are guilty of herd mentality and they have been conned by the likes of Adam Naumann and Elizabeth Holmes more often than they care to admit.

I am not a mathematician, and my knowledge of statistics is only good enough to read a Nassim Taleb book without a thesaurus. Nor am I a gambler. However, one character seems to be missing from Silver’s book – the 18th century Swiss mathematician Daniel Bernoulli. Silver relegates him to the footnotes. It was Bernoulli who first started to ask why people didn’t take certain bets, even though the probability might yield a positive expected value. Bernoulli figured out that the value of a bet was in direct proportion to the utility of the additional wealth to be gained. A rich man probably wouldn’t take long odds if it meant a major loss of capital, but a poor man has little to lose on a longshot. If you want a great discussion of Bernoulli and his role in finance, pick up The Missing Billionaires by Victor Haghani and James White.

Silver brushes right past Bernoulli’s revolutionary discovery. In a parenthetical aside, he writes “If you had a net worth of $1 million, would you gamble it all on a one-in-50 chance of winning $200 million and a 98 percent chance of having to start over from scratch? The EV of the bet is $3 million, but I probably wouldn’t.” Probably wouldn’t?!?! How about “no way”! Unless you are very young and have immense confidence that you can re-earn your million-dollar nest-egg, you’re not going to take that bet.

The marginal utility of wealth is critical to understanding the business wagers called “investments.” A venture capitalist on Sand Hill Road with $200 billion of assets under management will not agonize over staking $20 million on an AI-powered start-up that automates logistics in warehouses if it has a chance for asymmetrical upside returns. A solo investor with a net worth of $20 million would never take on such a venture alone, despite his or her immense personal wealth. Kahnemann and Tversky famously uncovered the psychology behind such thinking. Humans are risk averse. Most of the time expected pain of loss is greater than the appeal of a gain.

All of this talk of Bernoulli and wagering based on one’s wealth rather than simply the expected value of a bet reminds me of another Warren Buffett gem: When discussing the failure of Long-Term Capital Management which was headed by Nobel laureates and nearly brought markets to a standstill in 1998, Buffett remarked:

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.

I think we’ll leave it here for now. Coming soon… I have crunched some more numbers on Peakstone Realty Trust (PKST), and I think it trades at a 30% discount to it’s net asset value. You also get a 6% dividend while you wait. Elsewhere, Iron Mountain (IRM) seems to be infected with the same kind of data center hype that is artificially buoying the legacy data center stocks Digital Realty Trust (DLR) and Equinix (EQX) – companies that inflate their earnings by minimizing their depreciation and distorting operating cash flow by attributing far too much weight of capital expenditures to “growth” vs “maintenance”. Finally, I ran some numbers on Carnival Cruises (CCL) with the thesis that it would make a good short. It’s leveraged to the hilt. There were no COVID bailouts for cruise operators who are domiciled in tax-havens. Sorry, you can’t have it both ways. It seems I am wrong about CCL. Barring a major consumer slowdown (not entirely out of the question), the stock seems fairly valued. Until next time.

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The secret life of the gas station

I’ve read a lot of business books and I have to say that The Secret Life of Groceries now ranks in my top four. It’s right up there with Power Failure: The Rise and Fall of General Electric, Shoe Dog, and the Enron book by Bethany McLean, Smartest Guys in the Room. Benjamin Lorr spent over four years working alongside the army of the invisible who feed us every day. Lorr introduces readers to the groundbreaking approach of Trader Joe, but quickly descends into the harrowing world of industrial fishing where human slavery still exists. The indentured servitude faced by many long-haul truck drivers is only slightly more uplifting. You can learn about the battle for shelf space by following the journey of the unheralded condiment known as “Slawsa”, but your stomach will get queasy reading about everything from industrial chicken plants to the seafood counter at Whole Foods. The writing is masterful.

It’s probably time for a similar book on the convenience store industry. The growth of commercial roadside stores seems to encapsulate all that is right and wrong in our post-industrial society. The bright lights, shiny logos, ice-cold refrigerators, and elaborate coffee kiosks say much about our need for instant gratification, instant calories, and lack of time. Gleaming canopies with antiseptic white LEDs beckon drivers in need of gas for the automobile, but hydrocarbons are merely an appetizer. Fat margins are earned from products that mostly make you fat. What’s your addiction? The gas station can give you a quick fix. Candy, soft-drinks, alcohol, cigarettes, lottery tickets, caffeine and even pizza and brisket can be found in the widening world of convenience. Low-wage employees are surprisingly friendly. Or are those nervous smiles? Anyone heading through the door could turn out to be packing heat and looking for cash, or a strung out junkie searching for a place to sleep.

There’s a reason why Buffett fought hard for the Pilot truck stop empire with the Haslam family. The profits are staggering. (Note: a recent article in the Knoxville, Tennessee paper has a wonderful story on the Omaha son who reached the highest levels of business and now runs Pilot.) Have you seen the returns on capital for Casey’s? My, oh, my they are something to behold. When Casey’s bought Buchanan Energy and the associated Bucky’s chain for $580 million in 2020, I thought they were crazy. That’s an amazing amount of coin for 94 retail stores and 79 dealer locations. Guess what? Casey’s barely broke a sweat. Adding pizza to the stores was sheer genius. More margins. Pile ‘em on. My favorite convenience store owner? Alimentation Couche-Tard, the Quebec giant owner of Circle K and Couche-Tard. I just like saying the name. Buying your Zyns from a French depanneur seems tres exotique.

The chart on Casey’s looks like they sell graphics chips. Au contraire. Just potato chips.   

Casey’s is a $13 billion market cap company trading at nearly 28 times earnings. The stock is not cheap. CASY is the third biggest chain now with over 2,500 stores in 16 states. Adding $5 billion of market cap to a convenience store business in eight months seems a little excessive to me, but hey, when the stock market trades on vibes… you get Fireballs. Casey’s is based in the Des Moines suburb of Ankeny. Iowa is also home to the headquarters of Kum & Go (another store name that people love to say for some reason).

Not all parts of the automobile service world are going up and to the right like French pole-vaulter Anthony Ammirati. Take car washes. Somehow Omaha managed to go for thirty years with a bunch of sad little spinning brush machines at the back of gas stations. These soapy muppet tunnels were augmented by about three full-service “touchless” emporiums that faced varying degrees of near-insolvency. The VIP at 90th and Center wasn’t just a lounge back then, kids.

Now in 2024, there are car washes everywhere! Apparently, we’ve had it wrong for 30 years. Our cars have been in desperate need of more washing! Or at least that’s what the guys in private equity thought. Sign people up for a subscription model to get a car wash whenever they want in a gleaming new facility and your total addressable market is every car owner in existence. If I see one dirty car in Omaha from now on, well that’s just a damn shame. There’s no excuse. You want a car wash? The choices are endless.

I’m going to go out on a limb here with this prediction. There will be a lot of car washes for sale in about three years. Oh sure, some will be fabulous businesses. Dropping by Menards? Get a car wash. Stuck on Dodge St? Get a car wash. Huge amounts of fixed capital investments, low labor costs, a subscription model. Ka-ching. In fairness, the average age of a car is 12.6 years, so there is something to be said for people wishing to preserve their principal mode of transportation.

Well, if there’s one thing private equity is good at it’s finding a business model and beating the absolute sh*t out of it. Yes, there’s that competition problem: a lot of people with infinite amounts of cheap capital had the same idea. At the same time. Plus, did I mention huge fixed capital costs? That operating leverage cuts both ways. When volumes aren’t there, the losses pile up quickly – especially when there’s a lot of debt (and debt masquerading as leases). Oh, and the nice equipment requires expensive chemicals, expensive water, and breaks down eventually. So, you can see the risks. The only publicly traded car wash company, courtesy of an escape act from Leonard Green & Partners, is Mister Car Wash.

Despite the stock collapsing from an IPO debut of $20 per share in 2021, MCW still trades at a market capitalization of $2.43 billion. The company has $1.8 billion of debt and operating leases. Sales grew at a lackluster 5.77% in 2023 at the Tucson-based company, and operating income for the first six months of 2024 is basically flat compared with 2023, at $97.5 million.

The problem with Mister Car Wash is very apparent: It simply is not improving returns on capital and economies of scale. More locations in a saturated market are not a recipe for shareholder value creation. Should a car wash chain be selling at more than fifteen times EBITDA? Probably not.

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Old dollars

Rocco Schiavone is a chain-smoking police investigator who has been banished to the Valle D’aosta in the Italian Alps in the humorous and dark cop drama that bears his name. Early in the series, Rocco introduces us to his version of Dante’s hell. Murder is a “level 10 pain-in-the-ass”. Dealing with magistrates is at level 8. A closed tobacco shop is level 9. If Rocco owned apartment buildings, he’d probably list capital improvements on old buildings as a level 7.

We own and operate a collection of older buildings that were constructed in the late 1960’s and early 1970’s. Let me tell you something. They eat money. Sh*t breaks all the time. Literally. Air conditioners, pavement, carpets, decks, windows, appliances. Depreciation is real, my friends. Yes, it’s a lovely tax-deductible non-cash expense in the early days when a property is new. But as the depreciation wanes, you find yourself replacing capital items at a cost well in excess of the tax benefits.

This is the problem of old dollars. It’s even worse in an inflationary environment. If you have a parking lot that was built in 1990 for $20,000, you’ve got zero depreciation benefits today. It’s over. Now you need to replace the pavement. Guess what? It costs $35,000. The greatest inflation in 40 years in the pandemic boom made this problem so much worse. About $10,000 of that parking lot cost increase occurred in the span of four years. Four years! Maybe Rocco would elevate this to a 9.

Buffett lamented the pain of inflation when discussing Berkshire Hathaway’s BNSF railroad. He figured it would cost $500 billion to replicate the railroad today. Depreciation and amortization amounted to $2.5 billion in 2023. In 2024, the railroad announced a $3.9 billion improvement plan. Old dollars vs new dollars. Inflation destroys old dollars. Level 9 agony.

Therefore, a capital-intensive business that is not expending asset replacement dollars at levels significantly ABOVE current depreciation is probably under-investing in the year of our Lord, twenty twenty-four. Take Verizon (VZ). There are only three major wireless carriers in the US. The word “oligopoly” comes to mind. The dividend yield is so tempting at 6.6%. You might think that it’s the sort of holding widows and orphans should cling to for the quarterly stipend. Yet, you would be sorely mistaken.

Verizon doesn’t earn enough to cover it’s dividend when you take into account the immense investment needed to maintain a robust wireless network. Verizon is making capital expenditures that are roughly equivalent to depreciation charges. Four years ago, you might think this was a satisfactory situation. Today? They are behind the curve.

Verizon revenues have been flat for three years at $133 billion. Depreciation on a $307 billion asset base runs to roughly $17 billion per year. The market capitalization for VZ is $168.8 billion and the company has net debt of $148 billion. I think debt-holders will do just fine, but the equity holders will continue a slow grind into obscurity. The company can’t afford it’s hefty dividend of $11 billion per year, and if you account for investments in wireless licenses, the business is cashflow negative.

Defenders may argue that Verizon has been on a costly multi-year 5G network investment path that is about to wind down. I suspect not. If there’s one thing we know about bigger, stronger, faster technology demands, there will be a 6th, 7th and 8th generation waiting in the wings. I’m not even considering the ball-and-chains legacy land line business, pension fund requirements, and the whiff of litigation from aging lead-encased wires from the NYNEX days.

Capital expenditures amounted to $18.8 billion in 2023, so they are running about 7% higher than depreciation. What about inflation? If construction costs are 40% higher in four years and BNSF is spending 40% more, shouldn’t Verizon? The stock’s 30% decline since 2021 reflects a dwindling return on capital. Returns have declined from a healthy 12% in 2021 to just about 7.8% today. Let’s file Verizon in the value trap category. Avoid the siren song of that big dividend.

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Too Hard

I’m getting a little weary of Charlie Munger quotes, to be honest. Don’t get me wrong, there’s no question that we recently lost an intellectual giant and a man of high moral character. His investment acumen and the genius ability to cut straight to the heart of a matter was legendary. But I think the elevation of his aphorisms to a form of business gospel reduces our own capacity to think for ourselves. He was just a man. Mortal. It’s ok to have heroes, but it’s not safe to put them on pedestals.

I imagine Munger could be insufferable at times. A real crusty bastard. Did you ever see his dorm design for USC? He must have been a dynamo when he was earning his capital as a lawyer and real estate developer. You probably regretted getting in his way. He was unapologetic about his desire to be rich and I’m sure he never suffered fools gladly. Ah, but yes, at his core he was among the wisest of the wise. So, after a long-winded preface, here is my Charles Munger quote: “If something is too hard to do, we look for something that isn’t too hard to do.”

I’m filing Welltower in the “too hard” category. Welltower (WELL) is a $62 billion market cap REIT that owns senior living facilities and medical office buildings. WELL is also a bank of sorts. It lends money to developers of properties. It has JVs with a bunch of developers. Some of the assets are leased triple-net to operators, many are operated directly by Welltower. The company is also a prolific issuer of new stock and an expert at churning real estate. It’s head-spinning and hard to completely grasp. This is a company whose CEO, Shankh Mitra, quoted Jensen Huang in the annual report. I’m not saying that running real estate for old people doesn’t have much in common with NVDIA. Ah hell, who am I kidding? This is the vibes economy. Everything runs on NVDIA.

In fairness to Mr. Mitra, he also candidly told a 2023 audience, speaking of the industry, “On average, in the last 10 years we haven’t made any money for capital [providers].” The oversupply conditions of the middle part of the last decade were just beginning to recede when COVID hit. Now, prospects for better economics seem to finally be destined for senior housing operators due to the unfeasibility of new supply and the rapid aging of the boomer generation. The stock market seems to agree. The stock has run up 24% since the start of the year as occupancy and margins vaulted upwards.

Despite Mr. Mitra’s humility, there’s not much for me to like about the company as an investment. A REIT with a mixed collection of properties doesn’t deserve to trade at a higher multiple than apartment buildings, and certainly not better than medical office buildings. The demographic story has legs, I’ll grant you that. But you can say that about Skechers slip-ons or Hey Dudes.

I was first intrigued by Welltower late in 2022, when Hindenburg published a report questioning the absorption of some troubled JV assets. The short-seller specifically cast doubt upon the relationship with Integra Healthcare Properties. There was a lot of mystery about Integra. Hindenburg called it a phony transaction. Integra’s website is still just a collection of canned photos of smiling elderly folks with zero substance (at least they updated the copyright date to 2024!). Crickets from the market.

In my view, the only thing Welltower is guilty of is being exceptionally underwhelming. Welltower generated $6.4 billion in revenues during 2023. Property operating expenses absorbed 59% of revenues vs 52% of revenues in 2018. The industry sees itself getting back to pre-pandemic margins as staffing issues abate. I’m not so sure. States have ramped up calls for minimum staffing levels. The industry is also facing a lot of scrutiny about Medicare reimbursements. I don’t know enough about these challenges, so I can’t opine about the true risks to the company. I just know they exist.

What I can tell you is that I don’t think Welltower has much room to expand its distributions to shareholders above it’s current paltry yield of 2.35%. Once you deduct maintenance capital items from operating income and interest on over $15 billion of debt, there’s not much left.

No matter how many assets the company churns, the return on capital seems mired in the mid-single digits. The company has issued over $14.4 billion of stock since 2018, acquired $18 billion of assets during the period, while selling $9.9 billion. All this huffing and puffing hasn’t produced a formula that shows it can distribute increasing levels of cash to shareholders in a sustainable way. It is not unfair to say that some of the distributions are being funded with new equity. That’s not a great recipe. And for a CEO that says there aren’t many opportunities for new construction, the deal guys didn’t get the memo because Welltower had about $1 billion of construction in progress at the end of 2023.

Apparently, the market completely disagrees with me about the Welltower story. A 25% stock increase for a senior housing play is impressive. I am equally impressed that Welltower just raised over $1 billion of new debt at 3.25%. Is it pure debt? No, not for Welltower. It’s another dilutive offering. A convertible note due in 2029 that vests once the stock price rises 22.5%. I’m not sure who buys such debt when the five-year Treasury yield can be had for 4%, but it was probably a couple of fund managers who were feeling as frisky as Wilfred Brimley and Don Ameche in swim shorts.

So, I bid you adieu, Welltower. Low returns on capital, poor coverage on a low dividend yield, a churn of assets, acting like a loan shark, pumping new stock and forming a lot of unconsolidated JV’s… sounds like this one’s just too hard.

The easy column. I missed a fat pitch. I looked at it and didn’t have time to get my bat off my shoulder. It may not be too late, but I still need to dig deeper. Hat tip to Adam Block on social media who noticed Peakstone Realty Trust (PKST) was trading around $11 per share on July 10, giving the REIT a market cap of about $382 million. It sported a dividend yield north of 8%. Alas, it ran up 20% in two days. It still trades well below the $39 per share of last summer, so there may be juice left in the squeeze.

Peakstone had $436 million in cash at the end of March with a book value of real estate (excluding depreciation) in the neighborhood of $3.3 billion. Yes, there is debt of $1.4 billion. It costs Peakstone about 6.75% to finance the loans which roll over during the 2025-26 period. So, there’s loan renewal risk as well. But this is a pretty good portfolio of assets. The buildings consist of office and industrial space, but they’re mostly leased to single users with high credit such as Pepsi Bottling, Amazon and Maxar. Total square footage of the assets is 16.6 million. Net operating income for the quarter was $47.6 million. As far as I can tell, the market was essentially ascribing zero value to the assets at the beginning of last week. Even if you figure a monstrous 12% capitalization rate on an annualized run of quarterly NOI, there is adequate cushion above the debt. Seems like one to dig into. Easy? No. Simple to comprehend? Yes.

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Postive leverage

The Code of Hammurabi dates back to 1750 BC. These ancient laws contained the essence of the first banking contracts for managing loans. The farmer would borrow a bushel of seeds, reap the harvest, give the king about seven bushels of rye and keep three bushels for the family. In the modern parlance of Hammurabi’s descendant Jamiz ur-Dimon, a sound business endeavor earns positive leverage: the return on one’s capital investment should exceed the cost of borrowed money – the rate of interest. What happened if the loan required the farmer to pay back eleven bushels? It would probably end with the removal of a finger or three.  

Business in the front, party in the back

As crazy as things got during the pandemic boom, the basic premise of positive leverage remained intact. Purchases of apartment complexes yielding 4.5% bordered on insanity, but at least lending rates could be found in the 3% range. Now, we have entered a strange, new post-pandemic era. Buyers of apartments have reduced their purchase prices in order to earn a higher rate of return on their capital. Low 5% levels are the reported “capitalization rates” that many buyers are willing to pay. This sounds logical until one realizes that the cost of fixed rate debt today is about 6%. Watch your fingers.

Why would a buyer accept such a meager deal? Three reasons. One, they are willing to earn a return on their own equity that is below the cost of debt. This seems nonsensical. Very liquid low-risk alternatives abound in the form of humble T-bills or, say, Chevron stock with a 4.2% dividend yield. Two, some believe interest rates will decline in the future. There are signs that such joy awaits: The Fed seems poised to reduce rates as inflation slowly approaches the target 2% level.

The third reason takes the opposite tack. There is a belief that inflation will lift rents faster than expenses in future years, and negative leverage will pleasantly reverse itself. This theory has merit. The greatest supply of apartments since the 1970’s is about to come to an end. Construction costs and interest rates have risen so high, that most new developments are unfeasible. Home purchases are out of reach for most Americans. The incumbents have a long runway to raise rents once the period of apartment oversupply abates. This is the theory behind KKR’s purchase of Lennar’s multifamily portfolio.

Flared trousers are back in style.

Publicly traded apartment real estate investment trusts (REITs) benefit from a low cost of debt and continue to earn positive leverage. Unlike their private competitors who must grovel for 6% permanent loan rates and 7% construction loan costs, the REITs have healthy balance sheets and can borrow at 5%. Mid-American Apartment Communities (MAA) and AvalonBay (AVB) are two of the largest landlords, and they are projecting returns of 6.5% on their (much reduced) development pipeline.

Both firms locked in low-rate long-term financing during the pandemic. Even as notes mature, healthy balance sheets at MAA and AVB provide pricing power in the bond market. In early January, MAA raised $350 million of debt at 5.1% for ten years – just slightly above a 100 basis point spread to the Treasury note. Assuming their development yields hold to projections and leverage is in the 30% range, they should be able to drive returns on equity to low 7% levels. Not fantastic, but sufficient to sustain dividend yields in the 3%-4% range and grow values in line with the broader economy. Both companies reported record low levels of resident turnover as home purchases have become less affordable.

Not everything is rosy for the REITs. The apartment supply hangover has arrived to pandemic boomtowns like Dallas, Atlanta, Houston and Nashville. Indeed, both MAA and AVB offered some sobering news: rents on newly vacant units were trending negatively in the first quarter. MAA, focused primarily on sunbelt markets, posted a negative 6.5% new lease rate. AVB was closer to negative 0.5%. Fortunately, high resident retention and rent increases of 5% on renewal leases kept the top line growing at both companies. Neither of these stocks is cheap. Taking projected 2024 funds from operations (FFO) – the preferred measure of operating earnings for a publicly-traded REIT – AVB trades at an FFO yield of 5.35% and MAA trades at a 6.43% forward FFO yield.

Meanwhile Farmland Partners (FPI) presents the perils of negative leverage. FPI owns and manages farms (177,000 acres) and has a market capitalization of $553 million. FPI shares peaked at $15 in 2022 and sit at $11.50 today. The dividend yield is a paltry 2.09%. Corn prices have round-tripped during the past five years from $4 per bushel in 2019 to $8 per bushel in 2021, and back to around $4.25 today. Not even Russia’s invasion of one of the world’s top grain-producing nations was enough to sustain wheat prices much higher than $6 per bushel.

You and Whose Army? Corn prices since 2019, Source: Macrotrends

Given these daunting agricultural prices, FPI doesn’t offer shareholders much value. The company generated $57.5 million in revenues in 2023 and had $31.3 million of EBITDA. The company spent about $25.6 million on interest and divdends to preferred shareholders, leaving just $5.7 million for common shareholders. This diminutive profit is not sufficient to cover the common shareholder dividends of $12.2 million.

FPI has been selling land to cover its dividend, and really, this is probably the best path forward – sell assets, reduce debt and retrench for the future. The floor on the stock is probably the market value of the land. A swag number of $6,000 per acre means there may be well over $1 billion of land vs $480 million of debt and preferred stock.

Positive leverage feeds your family. Negative leverage only feeds the king.

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Totti, Totti, Totti

I remember watching the World Cup back in 2006. Italy won the tournament after Zinedine Zidane of France was sent off for headbutting Marco Materazzi in one of the most infamous moments modern football, er, soccer. The network must have thought Americans would get bored watching guys kick a ball around for 90 minutes, so they decided to scroll instant messages from worldwide fans across the bottom of the screen during several games.

Everyone remembers the headbutt and red card, but I remember a message on the screen. It was a Roma fan’s tribute to Italy’s beloved midfielder Francesco Totti that is forever etched in my memory. “Totti, Totti, Totti…We love him so much we name our dog Totti”. I don’t know what it was about this message of devotion to a piccolo cane italiano, but the little pooch earned a place in my heart. In my imagination, Totti is a gray Italian dachshund who loves to mangia soppressata. Oh Totti, ti amo.

I’m a day late. Already, my goal of therapy writing investment insights on a bi-weekly basis has gone the way of Monsieur Zidane – straight down the tunnel and into the locker room. But hey, rain or shine, we’re gonna walk Totti. Scrivi bene!

Who needs a meme when you can have a statue?

Before we get to the Totti of the matter, here’s a musical diversion that blew my mind. Seven Nation Army’s signature bass line is not from a bass guitar. It was actually played by Jack White on a Kay hollow-body guitar. According to Rick Beato, he used a DigiTech digital whammy pedal with the octave-down setting. Maybe I shouldn’t have been surprised. After all, Jack White is a masterful musician and the White Stripes were pretty much a drum/guitar duo. I never saw White Stripes live, so I had no reference point. Totti for you, my friend.

You like some Totti, you say? I think I have a couple of dividend ideas. Equity Commonwealth has a preferred yielding just below 6.5% and trades slightly less than the call price of $25. Equity Commonwealth was founded by the legendary Sam Zell to take advantage of commercial real estate bargains. Sadly, Zell passed away last year. Distress that he predicted in the industry was postponed due to all that pandemic juice. Present management sits on a cash pile of $2 billion and a handful of assets. They have said that if they can’t come up with a strategy to deploy the funds, they will wind down the business. The common is appealing, but the preferred is a fairly low risk way to park some cash.

A more adventurous dividend can be found in BCE, Inc. This is the old Canadian Bell. Like the AT&T of yore, it contains a lot of good (fiber optic and cellular networks, some tv networks), a lot of bad (legacy landlines, pension funds, debt), and some intangibles (37% of the Maple Leafs & Raptors, 20% of the Canadiens). The business is basically sound ($30 billion USD market cap) and the dividend is well-covered with a yield above 8.5%. The stock is down 50% since 2022 as government funds to boost the expansion of fiber optics networks were dialed back (pun for the boomers). They have curtailed capital expenditures and are laying off 9% of the workforce. I intend to do a deep dive on BCE because there may be some hidden value in a break-up and I like the positive Canadian demographic trend. I think you are adequately compensated for what is probably, at worst, a stagnant business. In a world of NVDA go up, 8.5% dividend checks sound like a snoozer but that’s where we be at. Vibes. 🔥

I took the Myers-Briggs test for the third time in my life yesterday. Wait for it. The first letter is an “I”. Shocking, I know. The rest of it actually was a surprise. I came in with an INTJ. Now, this made me well pleased. Uncle Warren is an INTJ. Zuckerberg, Musk? INTJ. F#%*ing Schwarzenegger is an INTJ! This is a small segment of the population. Rare air. Yes *silently pumps fist*.

I don’t recall exactly where I scored back when I took the M-B in my 20’s. I think it was INTP. Can’t remember. My Mom, a world-famous and passive-aggressive “I”, didn’t scrapbook those results. But this score contrasts sharply with my result from two years ago: INFP. I didn’t like that one. Too much feeling. Too many emotions. Now, it is true that some cool people are INFP’s. Creators. Bob Marley, John Lennon, Kurt Cobain, William Shakespeare, Johnny Depp. But not a lot of 4-star generals, Navy Seals, or NBA legends on that list. That’s probably not accurate. Dennis Rodman has got to be an INFP. You catch my drift here. Doris Kearns Goodwin isn’t pitching any biographies of INFPs to Penguin Classics. These are Oprah’s guests.

Questions naturally arise when you read the cast of characters. Did Arnold Schwarzenegger really sit for a Myers-Briggs exam? Did William Shakespeare truly prefer a quiet pub lunch with his mates to the crowded midsummer fayre? I am now on a search for the deeper meaning behind these two personality test results. INFP? INTJ? Who am I? Can I be both? Can I have Bob Marley’s soul and Zuckerberg’s bank account? It doesn’t work that way. Sorry. Or maybe it does? Maybe we are all coins with two sides? Janus with two faces. Jesters with two masks. Totti the man…Totti the dog.

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Preaching to the converted

Florida panhandle beaches are some of the finest in the world. Pristine white powder. Pensacola is not the kind of place I wanted to visit for lessons about the fleeting nature of human existence, yet there I was. Life is full of cruel twists and turns. Throw the genetic dice often enough and someone you love (maybe even you) will roll snake eyes. It’s not fair.

Philistines are met by the Holy upon arrival in Pensacola. Bible-clasping gentlemen stand on four corners proferring salvation to drivers. Can a young man in a white shirt and black tie with perspiration rings forming under the sleeves reach a sinner with averted eyes at a red light? Does it ever work? Does anyone ever turn into the Dollar General parking lot to ask for directions to the on-ramp of righteous eternal existence? One is all it takes. One driver. One soul.

If you’ve read this far, you may be thinking, “Death and salvation? Is this guy always so serious?” The answer is “hell, no”. I just sat down to ponder the weighted average cost of capital and this is the weighty path I took. I offer no salvation, no divine guidance. I’m not even very good with Google maps. But I decided to stand on a corner for the first time in a long time. Pen in hand. It’s good for my soul.

Mortality can be a pretty good business if you’re a skilled actuary. Promise to hand someone a large pile of dollars in the distant future in exchange for small cash payments over many years. Find enough healthy mortals to make lots of small payments, and immense wealth can be generated by investing these premiums before you have to return the piles of cash. The life insurance industry is really just about winning at the game of death. Outlast your policy holders and beat the clock. There are no Luka Doncic three-pointers at the buzzer on the court of life insurance. That’s because there’s no buzzer. The best life insurance companies tick along perpetually with Swiss precision.

Mutual of Omaha has been very good at the business of reinvesting insurance policy premiums. I decided to take a look at their most recent public financial reports. The venerable institution had over $9.6 billion in cash and invested assets at year-end 2023, and nearly $4 billion of policy holder surplus. I wanted to look at their financials to see how they are paying for the largest development in Omaha: the $650 million skyscraper that will soon become the tallest building on the horizon. I learned a few things reading their report:

  1. Similar to most real estate developers, a big slug of leverage is invloved: At March 17, 2023, “the Company entered into a $550,000,000 senior unsecured credit agreement that is available for purposes of funding the new home office building.” In real estate terms, Mutual of Omaha is just like Bruce Dickinson – they put their pants on one leg at a time.
  2. The bond bear market has not been kind to the fixed income portfolio. The worst sell-off of bonds in a generation left Mutual of Omaha with over $526 million of gross unrealized capital losses.
  3. Mutual of Omaha has $214 million of short-term outstanding borrowings from the Federal Home Loan Bank. This represents a significant increase from the $40 million borrowed at the end of 2022.

I don’t know that many conclusions can be drawn from these observations. Personally, I would not have sunk 7% of my investable assets in a building that will likely be worth 20% less the day it opens. But Mutual of Omaha is a perpetual financial insitution, not a cyncial and balding middle-aged guy with a computer and a finite time horizon. They will hold the asset for longer than its depreciation schedule and it is an emphatic statement of corporate strength. In other words, $650 million is a fair price to pay for permantently establishing your image as a solid financial giant when such an image is essential to your brand. There’s a reason why Louis Vuitton sells bags in a palace on the Champs-Elysees instead of a Carrefour in Nanterre.

Second, the losses on the bond portfolio present no threat. Unrealized losses are actually much improved from 2022 when they amounted to over $690 million. Mutual of Omaha matches its investments to its policy obligations and they epitomize the definitition of “held-to-maturity”. There is no risk of an imminent loss of capital. There is a downside, however, in the form of opportunity cost. $500 milion could be earning 2-3% more per year. Instead, Mutual of Omaha has to let those underwater bonds mature. Because the only thing worse than unrealized losses are…realized losses. It’s just the sort of income you might wish you had available if you were to, say, pay for a new office building.

Finally, the Federal Home Loan Bank borrowing raises some concerns. The FHLB window was opened wide last spring when some banks ran into liquidity issues. Are there liquidity issues in the Mutual of Omaha portfolio? It seems unlikely, yet the $175 million increase didn’t suddenly materialize out of nowhere. Calls were made. Flesh was pressed. Deals were done. Frankly, I did not even know that insurance companies could borrow from the FHLB. This was news to me. Apparently $134 billion has been loaned to insurers, and the low cost of funds present a wonderful arbitrage opportunity. Imagine that. A taxpayer-backed hedge fund mechanism. I’m not sure how I feel about being the backstop for more leverage in the housing system. But as the saying goes, “Teach a man to arbitrage…”

So, there you have it. Dante might be proud. We started our little story with damnation and ended with a cursory look at the financial results of an insurance company specializing in death benefits. As a wise man once sang, “Don’t fear the reaper.”

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Yield curve inversion.

For a moment today, the three-month United States Treasury Bill offered a yield higher than what could be earned by loaning the government money for ten years. Prepare accordingly.

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Best wishes to Barb Terry

Congratualtions to Barb! She is leaving Alchemy Development and joining a leading engineering firm in Omaha. Barb joined Robert Hancock & Co. in 2004 and went on to manage construction projects including Pinhook Flats, Cue and Shadow Lake Square. She has been an outstanding partner and her experience and wisdom will surely be missed. We wish her all the best on her new journey.

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Data Center REITs Look Like A “Big Short” To Jim Chanos, But What Do The Numbers Say?

Jim Chanos, the famous Wall Street cynic, has cast a wary gaze upon real estate investment trusts that own large data centers. “This is our big short right now,” Chanos told the Financial Times. He has no doubts that cloud computing will continue to grow, but he believes that companies like Digital Realty Trust (DLR), Equinix (EQIX), and CyrusOne (CONE), are destined for trouble. His thesis: Amazon Web Services, Microsoft Azure, and Google Cloud will increasingly bypass the REITs to scale their operations by building data centers of their own. “The real problem for data center REITs is technical obsolescence,” said Chanos. “Their three biggest customers are becoming their biggest competitors. And when your biggest competitors are three of the most vicious competitors in the world then you have a problem.”

Chanos has a long record of success betting against overvalued businesses, but his assessment of the industry contrasts with Blackstone which recently purchased QTS Realty Trust for $10 billion. Meanwhile, Bill Stein, the CEO of Digital Realty Trust, quickly countered Chanos’ comments by pointing out his firm’s record bookings for the first two quarters of 2022. Yet the changing dynamics of the industry were on display Tuesday when FedEx announced that it will save $400 million annually by closing all of its data centers to move completely to the public cloud.

My rudimentary analysis of Data Realty Trust (DLR) indicates that the stock is overvalued by 10-15% relative to its underlying real estate. This kind of premium is uncomfortably high, but I’m not exactly grabbing my drumsticks for a round of Pantera. After all, the company has grown net operating income (or funds from operations, in REIT parlance) by 15% annually.

Despite the growth, there isn’t much appealing about a stock with a 3.8% dividend yield when you can earn 3% from 2-Year and 5-Year Treasury Notes. A business staring at such formidable competition should require a spread better than 80 basis points. A 25% drop in the price of the stock would be needed to produce a 5% yield.

Statistics for Digital Realty Trust are presented below. The table demonstrates a valuation of its real estate assets by capitalizing 2021 funds from operations (FFO). I add development in progress at cost and subtract debt to arrive at a net asset value of $111.89 per share, which is about 13% below the price on July 7, 2022. One could argue that I should employ forward estimates of FFO for my computation, and this would be fair. However, I am using a very low capitalization rate of 4.31%. This reflects the company’s low borrowing costs (2.22%). The FFO yield was used as a proxy for the cost of equity.

The second table shows results for the past 12 years. It indicates the rapid growth in net income for DLR, but it also shows that returns on total invested assets have been declining for years to levels below 7%. The low interest rate environment of the recent past juiced returns on equity, but even these results have become less impressive in recent periods. DLR has debt of about $13 billion on roughly $30-32 billion of assets, so the business is not exactly shy about using leverage. However, cheap debt acquired during the pandemic provided ample FFO debt coverage at 6.25x interest during 2021.

I don’t see a compelling reason to invest in DLR with the stock price trading above net asset values. And even though Jim Chanos may be hyperbolically talking his book, the threat posed by Amazon, Microsoft and Google is very real. Meanwhile, the dividends aren’t sufficient when the comparable safety of 3% Treasury yields beckons.

Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content presented.

Bert Hancock, Author. July 7, 2022.

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