Carl Icahn (Trades, Portfolio)’s largest position is a short bet on the U.S. commercial real estate market. In an GuruFoucs article published on March 15, I discussed the possible reasons behind the Guru's decision to bet against an industry that was seemingly poised to benefit in the long run.
Since then, the U.S. economy has entered a recession, and Jonathan Litt, who runs the hedge fund Land & Buildings Investment Management, has decided to short companies that are depending on rental income from New York office properties. This was revealed in a statement released by the fund on its website.
Litt is widely known for being an activist investor in the real estate space, and this short position has baffled many investors who pay close attention to this sector of the market. A closer look at the industry dynamics reveals a few possible reasons that might have led the Guru to make this bold decision.
The lockdown is a headwind for the industry
Business activities came to a standstill in late-March when a nation-wide lockdown was imposed to control the Covid-19 pandemic. Many businesses that have high debt and depend on foot traffic to their stores have been pushed to the brink of bankruptcy as a result, and cash flows have dried up across all business sectors, save for the e-commerce industry.
The Wall Street Journal reported that office leasing volume in Manhattan fell 47% in the first quarter, and the numbers can only be expected to worsen in the second quarter. The New York Times reported last week that many retail tenants in the city have failed to make rental payments for the last two months. Even when business activities return to normal, many tenants might want to cancel their lease agreements because of difficult operating conditions.
Empirical evidence suggests that Manhattan office vacancy rates tend to spike during recessions. The worrying sign is that vacancy rates were already increasing even before the current downturn.
Source: Cushman & Wakefield
The economic downturn will likely worsen the numbers in the coming quarters, and this will become a challenge for real estate companies with a focus on the New York commercial property market.
The stay-at-home economy and its impact on office properties
Both Twitter Inc. (TWTR, Financial) and Square, Inc. (SQ, Financial) have rolled out plans to shift to a permanent work-from-home culture, and a few other tech companies, including Facebook Inc. (FB, Financial) and Alphabet Inc. (GOOG, Financial), have requested employees to work remotely through the end of this year. These companies are setting the tone for other businesses to be part of this stay-at-home economy as well. This is not welcome news for the commercial property market in New York, which is the busiest business hub in the world.
New York is home to some of the largest financial giants in the world, and the likes of Barclays PLC (BCS), JPMorgan Chase (JPM, Financial) and Morgan Stanley (MS) are few of the largest tenants in the city. All these companies have realized that their workforces might never need to utilize the office spaces in New York, as many of their employees are happy to work remotely. Research firm Nielson, a company that employs more than 3,000 people according to The New York Times, has also arrived at a similar conclusion as work-from-home is proving to be effective.
Halstead CEO Diane. M. Ramirez is considering a similar move as well. When The New York Times asked him about his thought process in requesting employees to report back to work, he said, “Is it really necessary? I’m thinking long and hard about it. Looking forward, are people going to want to crowd into offices?” The company has 32 offices in New York, and a decision in favor of working remotely will be a blow to the local commercial real estate market.
Even before the current recession, the job market in New York was expected to slow down in the coming years. The economic downturn will only accelerate this decline. Lower-than-expected job growth is bad news for office properties, which is another threat looming on the horizon.
Source: NAI Queens
The supply-side situation further dampens the outlook
All things considered, the demand for commercial properties in New York is likely to decline sharply in the coming years. To make things worse, millions of square feet of new office spaces are expected to hit the market in the next few years. As highlighted by Jonathan Litt in the statement released on May 22, these expected deliveries paint a pessimistic outlook for the industry, as there would not be sufficient demand to absorb this supply. This will eventually lead to a decline in the value of properties.
Source: NAI Queens
The megadevelopment of Hudson Yards accounts for nearly half of the square feet under construction in Manhattan. This property is being developed as a modern office space to attract billion-dollar companies. According to data from The News Funnel, leading financial institutions such as BlackRock Inc. (BLK), Ernst & Young and KKR & Co Inc. (KKR, Financial) are some of the tenants that are expected to occupy this property.
However, many of these companies are already drawing plans to implement remote working policies permanently, which might lead to a significant drop in the demand for the property once the project is complete. These are signs of troubles ahead for the commercial property market in New York.
WeWork, the infamous failed unicorn IPO and the largest office tenant in New York City with over 8.9 million square feet of office space, is facing even more dire financial circumstances as a result of the current economic downturn.
Source: Citylab
The company was planning to list its equity securities on U.S. stock exchanges last year, which had to be canceled primarily due to the lackluster financial performance of the company. Since then, WeWork owners including Softbank have been on a mission to reduce its operating costs to improve profitability. One of such measures is to reduce the number of properties it leases in New York. The company is expected to experience more financial pain in the coming years, which is bad news for the real estate industry as WeWork would be forced to let go of even more properties.
The supply-side outlook is grim, which is one of the reasons Jonathan Litt would want to bet against the New York commercial real estate market.
Takeaway
Jonathan Litt has joined Carl Icahn (Trades, Portfolio) in predicting doomsday for the U.S. commercial real estate industry. Warren Buffett (Trades, Portfolio) seems to agree with these two gurus as well. In the virtual 2020 annual shareholder meeting of Berkshire Hathaway Inc. (BRK.A)(BRK.B) in early May, Buffett said, “A lot of people have learned that they can work at home.”
The unfavorable macro-economic outlook will weigh on the share prices of companies that generate the bulk of their rental income from New York properties and REITs that have a high concentration on this market. Below are some of the players that are likely to see a significant impairment in profitability this year:
- Empire State Realty Trust, Inc. (ESRT, Financial)
- Vornado Realty Trust (VNO, Financial)
- SL Green Realty Corp. (SLG, Financial)
Considering the industry-wide challenges, I also think it would be a prudent decision to avoid these real estate companies, despite the enticing dividend yields.
Disclosure: I own shares of Facebook.
Read more here:
- Ray Dalio Says China's Economy Will Soon Surpass the US
- Why Facebook Shares Could Have More Upside
- Buffett's Sale of Goldman Sachs Is Not Bad News for Bank Stocks
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