“Future profitability of the industry will be determined by current competitive characteristics, not past ones. Many managers have been slow to recognize this. It’s not only generals that prefer to fight the last war. Most business and investment analysis also comes from the rearview mirror.”
- Warren Buffett (Trades, Portfolio), 1982 Letter to Shareholders
Buffett’s comment above was made with regard to the insurance industry but is no less applicable to numerous other industries. Investors have a strong tendency to extrapolate from their most recent experience. Rearview mirror investing obscures the ability to recognize evolutionary changes in an industry, changes that can yield strong and enduring moats, until it is clear to everyone and shares are priced accordingly.
One such industry that has been beaten up recently by Mr. Market is the corporate real estate (CRE) industry.
The industry is exposed to dramatic variations in transaction volume (primarily leasing and investment sales activity and real estate values). After the bursting of the credit bubble in late 2008, commercial real estate transaction volume plummeted by more than 70%. This caused havoc amongst less diversified regional brokerages and even caused formerly prominent firms like Grubb & Ellis to declare bankruptcy.
Though the CRE market has recovered from its 2009 trough, transaction volume remains well below its pre-recession level. Europe, in particular, has been slowest to recover.
Investors now anticipate another downturn. There are concerns that business prospects for commercial real estate had peaked and will deteriorate meaningfully in the months ahead. From the November 16, 2016 Wall Street Journal under the headline “Trouble Brewing in Commercial Real Estate”:
Defaults are rising in a key corner of the commercial real-estate debt market just as borrowing costs are set to jump, raising the likelihood of a slowdown of the $11 trillion U.S. commercial property sector in 2017. A financial crisis-era regulation is about to take effect that is expected to make some commercial real-estate borrowing more expensive and complicated, analysts said.
At the same time, interest rates have increased since the election of Donald Trump as the nation’s 45th president last week and seem poised for a sustained rise from recent historic lows, which would further squeeze an industry built on borrowed money. “I can paint a picture that it could be disastrous, with runaway inflation and high interest rates,” said Charlie Bendit, co-chief executive of Taconic Investment Partners LLC, at a New York industry luncheon last week.
The worries raise fresh concerns for the commercial property market as it enters its eighth year of expansion.
The stocks of the two largest public entities have all suffered this year and the valuations are rather reasonable as a result.
In other words, the market is drawing on its recent bad experience with this industry in guiding its view of the future. We call this thought process “rearview mirror investing.” It is also known as “recency bias.”
The market’s focus on the past is causing it to miss long-term competitive shifts in the CRE industry – shifts that deepened in the wake of the financial crisis. These shifts are likely to continue, as customer demands evolve. These trends, along with the increasing importance of scale and scope in certain customer segments, will shape competition in the CRE industry.
Here, we take a look at where the industry is headed and how firms are responding to changes in the competitive landscape with a focus on CBRE Group (CBRE, Financial).
CBRE – Highly Regarded International Brand, Global Capabilities and Broad Array of Services
Alongside Jones Lang Lasalle, CBRE one of only two or three CRE companies with global scale and a fully-integrated product suite. By positioning itself as a one-stop, full-service shop with broad coverage, these companies focuses on primarily on the large-client segment of the market where clients often need help with complex transactions and related facilities management.
How Does CBRE Make Money?
Large CRE companies like CBRE serve two sets of clients, investors and occupiers – that is, owners and users of real estate. The companies strive to provide one-stop shopping for all the services around CRE for each type of client. Services for investors include: strategies to rasise capital, to source deals, to value real estate, acquire real estate, finance it and refurbish it, manage, lease and sell a property. Occupiers turn to CRE companies to develop a real estate strategy that best fits their strategic objectives. “It may be that you’re trying to use your real estate as a way to attract millennials and digitize your workforce and you want to occupy real estate in an entire different way. It may be that you’re a logistics company and you’re all about cost efficiency and how much product you can get in buildings. Whatever your particular business is, our objective is to understand your strategies and how real estate can play and how we can help our client get a competitive advantage in the industry that they’re in and how we can apply our scale and our data and our knowledge towards that end.
CBRE engages in six primary activities:
Outsourcing Services, 25% of 2015 Net Fee Revenue
CBRE generates fees by providing facilities management services for occupiers and owners of property. This business is focused on taking on activities outside of the client’s circle of competence with the goal of reducing the client’s total cost of ownership. Facilities management refers to property management, property maintenance activities (including janitorial services, Heating, Ventilating, and Air Conditioning [HVAC]), office design (ergonomics, materials, spaces), and office outfitting (walls, partitioning, hardware, painting), security services, catering, water management, waste collection, and laundry.
Outsourcing is the fastest growing businessline at CBRE.
Note: 2015 revenue includes four months of contribution from the Global Workplace Solutions business acquired on September 1, 2015.
Source: Data per company filings via Sentieo.
Leasing Services , 33% of 2015 Net Fee Revenue
CBRE earns money by acting as a broker for investors, owners and occupiers of real estate.
Capital Markets, 28% of 2015 Net Fee Revenue
CBRE earns money by both brokering the sale of property and providing debt and structured financing to effectuate these sales.
Valuation services, 7% of 2015 Net Fee Revenue
CBRE generates fees by valuing real estate for its clients.
Investment Management, 6% of 2015 Net Fee Revenue
CBRE provides investment management services to pension funds, insurance companies, sovereign wealth funds, foundations, endowments and other institutional investors seeking to invest in real estate.
Development Services, 1% of 2015 Net Fee Revenue
CBRE develops properties for clients as well as its own account.
Industry Overview
CBRE is the largest CRE company. Others include Colliers (CIGI, Financial), Jones Lang LaSalle (JLL, Financial), and DTZ/Cushman & Wakefield (private; merged in September 2015). CBRE’s scale advantages can be seen here:
Source: Data per company filings via Sentieo.
The CRE industry is highly fragmented. The market for commercial real estate services is greater than $148 billion annually, and the top five players have less than a 18% market share.
The CRE services industry has evolved a great deal over the past 30 years. It began as a fragmented collection of individual brokerages helping to match sellers and lessors of real estate with buyers and lessees. The business was typically highly localized and built around star brokers. Further, they offered little in the way of collateral services.
Ten years ago the CEO of CBRE could say the following: “We operate in one of the most fragmented and competitive landscapes of any industry, anywhere. Barriers to entry to many of our business lines are virtually non-existent, with literally thousands of competitors here in the States, in Europe, Asia and throughout the Pacific.”
Along the way, though, a number of trends on the demand side appeared which fundamentally altered the competitive landscape.
Globalization
The first such trend is globalization. As multinational corporations enter new markets across the globe, they are required to purchase or develop new office space, factories, and distribution centers. International markets present a challenge because of the uncertainty of foreign real estate laws and protocol. Instead of trying to solve these problems internally, multinational companies rely on the experience of the real estate service providers.
Outsourcing
As we saw above, CBRE’s outsourcing business is growing quickly. What are the industry growth drivers?
- Surprisingly Large Expense. Real estate-related expense typically represents 4% to 5% of a corporation’s revenue.[1]So a $10 billion corporation will spend $400 million to $500 million on real estate.
- Strong Value Proposition. CBRE says that for each dollar a customer pays to CBRE, it saves $5.03 in expense.[2]
- Increased Focus on Expense. In sync with the prevailing weak macroeconomic conditions, all companies have started to focus more on core processes, thus facilities management outsourcing has become much more prevalent. They are naturally attracted to this large opex item.
- Outside the Circle of Competence. Real estate is not a core competency of most companies. CBRE’s clients include IBM and large healthcare providers. They have no desire to focus on managing real estate.
- Expanded Range of Services. Outsourcing companies are also driving growth by expanding into non-traditional areas such as energy management.
Centralization of Services
Globalization and outsourcing left customers with a dilemma. They could either hire multiple small scope providers around the world or try to consolidate services with a single provider with a global presence. To resolve these issues, comprehensive facilities management agreements with a single provider have become commonplace.
The Rich Get Richer – Bifurcation of the CRE Industry
The trends described above have caused the market to bifurcate. That is, a new customer segment has emerged: large multinational corporations which rely on fewer but more qualified suppliers and broad service breadth. In particular, the trend toward outsourcing created a demand for more sophisticated global solutions from a single provider. Large, well-capitalized multinational companies are better able to satisfy these customer demands than are smaller competitors. Only the largest players have the scale and deep pockets to meet these demands.
Consequently, the market has bifurcated between global, broad reach suppliers who can capitalize on this opportunity and highly specialized smaller suppliers. On one end sit huge global service providers such as JLL and CBRE, which can fill virtually every real estate need for conglomerates worldwide, from transaction services to property management. At the other end are narrow-focus firms, such as HFF and Marcus & Millichap, which generally offer property brokerage and financing services. Competition is very limited at the JLL/CBRE end of the market. Why? High barriers to entry shield incumbents from new competition and more of the benefits of consolidation accrue to the largest players. These barriers to entry can be seen in five areas:
Hard to Replicate Global Infrastructure
The table stakes for entering this market niche is a global infrastructure. As discussed above, outsourcing, globalization and the need for a single provider requires the CRE companies have a global infrastructure in place to serve the needs of their customers. For example, when a Fortune 500 company shrinks its real estate function from 500 people spread across the world with local independent broker relationships to having five sophisticated executives sitting in corporate headquarters, they look for brokerage partners with the broadest and deepest global platforms. This company can sell a building in New York, acquire office space in India, and receive development consulting on a project in Germany using solely CBRE or JLL.
As DTZ CEO Tod Lickerman said, “The biggest corporate occupiers and investors work all over the world so they expect their advisers to do the same. Only CBRE and JLL have the global infrastructures in place that can truly meet the outsourcing needs of a multinational company. The costs of replicating this global infrastructure are enormous. “
The CEO of Jones Lang LaSalle described the barriers to entry as follows:
Brad Burke, Goldman Sachs – Analyst [45]
Okay. So as you’re looking forward over the next two to three years, we shouldn’t think about the number of competitors that can offer large global outsource contracts being significantly larger than it is right now?
Colin Dyer, Jones Lang LaSalle – President, CEO [46]
No, I don’t think so. It takes a lot of work to build a platform to be able to perform for the large corporations. I mean, they’re by definition demanding clients. They expect top quality service. And certainly when they’re looking across regions, they’re looking for a uniformity of performance from their providers. So putting together a platform that can provide multiple services to demanding clients across geographies is not done in a day. And it took us and a few competitors we have in that sector of the market a decade or two to put these capabilities together. So it’s pretty tough to replicate. And it’s tough to replicate organically. It’s tough to replicate by assembling bits of business. Because again you don’t get the uniformity of performance by just assembling individual separate geographical entities.[3]
Established Brand Names
Only the largest players have the well-established brands and the deep-pockets to meet the customers’ need for reliability. Clients are generally risk-averse and prefer to rely on top-notch service providers. Just like a Board can’t get fired for hiring Goldman Sachs or Morgan Stanley as their investment bankers or one of the top four auditors to complete financial audits, clients often lean on the brand names of Jones Lang LaSalle and CBRE to handle important commercial real estate transactions. CBRE, through its many years in the industry, its marketing and advertising budget, and its sterling reputation, has developed a strong brand name.
Network Effects
The provision of property management services creates a network effect that accrues in favor of the largest providers of commercial real estate services. While the growth has been impressive for the past several years, the trend is self-re-enforcing. That is, the bigger the firm gets, the more it has to offer its customers. As the firm expands, the breadth and depth of services offered increases to the benefit of its customers.
Economies of Scale
Outsourcing services are a high fixed cost/low variable cost business. Each incremental square foot under management costs less than its predecessor. As a result, the largest players enjoy economies of scale and can undercut smaller competitors on price.
Enhanced Talent Retention
High-performing brokers currently not with the company are following their clients to the platform. This business has also been growing at double-digit rates and we think can continue to outgrow the market for the foreseeable future. Similar to a law firm or medical practice, the value of the firm is in its employees. As a result, the competition to hire the best professionals between rival service providers and even other vertically integrated clients is often quite fierce.
Impact on Competition
Looked at as a whole, competition in the CRE industry remains as fierce as ever. The industry is still highly fragmented and barriers to entry are low. If you’re a tenant rep with a few good accounts or a landlord rep with a few good listings, it doesn’t require a big capital investment to hang out your own shingle. The outsourcing sector is similarly competitive. Competition is primarily based on price and the quality of service. Firms face competition from a large number of regional and local owner-operated companies, located mostly in key cities.
However, a closer look at the marketplace shows that competition is not evenly spread across all customer segments. For the reasons listed above, competition in the large customer segment of the market is highly reduced. Demand for global services is increasing while at the same time supply is tightening because only 2-3 companies are able to serve large customer segment of the market. Thus, CRE is undergoing a pronounced change in the competitive environment, hard to see for many years but now quite visible. A traditionally fragmented industry of localized brokerages subject to the ups and downs of the real estate market has been pushed towards consolidation. JLL and CBG, being the only two providers of outsourcing with international scope and full breadth of service, have been the beneficiaries of this trend.
CBRE described the changing competitive dynamics as follows: “So, we sit in a very unique space in the industry. There is really at this point a true bifurcation in the industry. And what you have now are really two big global diversified services firms, us and our good competitor, Jones Lang. And you have a whole number of boutique firms that do something really well. They might do retail in midtown Manhattan; they might do property management only in Cleveland, Ohio. But they do those things exceptionally well. The firms in the middle, they are all going away. They are all going away and we have been talking about this for 15 years. And every year I get up here and tell you this, the next year three more are gone. You are going to end up in this industry with only two groups of firms, and all of those folks in the middle are going to disappear whether they get acquired, or they go bankrupt, they will be gone.”[4]
In industries with competitive dynamics like this, small companies will disappear, often by selling out to the company or companies that are actively consolidating the industry. These acquisitions lower the exit barriers to unviable competitors and facilitate the growth of those that are viable. If the prices paid are reasonable, the strategy makes much sense, as it achieves several objectives at the same time: increasing the size of the leading companies, decreasing the number of competitors, reducing the exit barriers and facilitating geographic expansion, which is usually necessary as part of the strategy of the leading companies.
In this way, concentration in the CRE industry mirrors what took place in the accounting industry over many years. The number of accounting firms that have the global network to service large multinationals has been reduced to just 4.
Source: Colliers September 2016 Investor Presentation via Sentieo.
Impact on CBRE
The story of evolution and new competitive advantages told above is reflected in CBRE’s results.
Increased Recurring Revenue
There is no doubt that CRE brokerage continues to be a highly cyclical business. What has changed, however, is CBRE’s exposure to it. However, CBRE’s revenue mix has changed dramatically since 2008. The company is much better prepared to withstand cycles in its end market.
CBRE’s EBIT peaked in 2007 at $698 million. In 2008, CBRE’s EBIT was -$788 million. It would take until 2014 for CBRE to surpass its 2007 EBIT. The primary drivers of this sharp decline were revenue from the transactional businesses: real estate sales services (-48%), mortgage origination (-44%) and investment management (-53%). The company did not have the balance sheet to withstand this downturn. It had to issue equity three times at the bottom. The stock went from $21 at the end of 2007 to as low as $3 in 2008, and then bounced back to around $25 as the crisis passed.
Now, transactional revenue represents just 30% of revenue.[5] The remainder is recurring (fees from property management, advisory valuation and consulting, and investment management services) and provides significant predictability
Source: CBRE August 2016 Investor Presentation via Sentieo.
Consider some mathematics: CBRE currently earns well over $800 million pre-tax annually. If the transactional business dropped by 50% as it did in 2008, the company will still turn a profit. This result contrasts with a pre-tax loss of $788 million in 2008. A year like that – which we consider only a low-level possibility, not a likelihood – would not distress us. (Indeed, a cool down in the CRE market would allow CBRE to pick up companies on the cheap.)
Sticky Customer Relationships / High % of Sales To Existing Customers
Closely related to the concept of increased recurring revenue are sticky customer relationships. Unlike a brokerage relationship, outsourcing agreements average 3-5 years in duration. Further, the company has increased its ability to cross-sell. As we all know, it is easier to sell to an existing customer rather than win over a new one. In Q3 2016, the company had 52 expansions of existing client relationships, a new record.
Strong Growth Track Record
JLL has a long history of profitable growth. Since emerging from the financial crisis in 2009, CBRE has compounded EBIT at 23% CAGR.
Source: Data per company filings via Sentieo.
Abundant Acquisition Opportunities
As discussed above, the cyclical nature of CRE allows CBRE to consolidate weaker, regional brokerages. As the CEO stated, “Being one of the top-tier players in a rapidly growing industry provides us with countless consolidation opportunities on a global basis and for many years to come. “
CBRE’s tuck-in acquisitions are in the 5 to 6 times EBITDA range.[6] This allows CBRE to earn double-digit returns on M&A. The ability to continually reinvest cash flows into a steady stream of bolt-on deals and international expansion allows CBRE to compound value much more effectively than a business focused on deploying capital through share buybacks or dividends.
Further, and perhaps most importantly, CBRE is not using debt or equity to make these acquisitions.
Other Attractive Features of the CBRE Business Model
Modest Capex Requirements
CBRE’s service-based business model requires modest operating capital expenditures. The lack of capital intensity results in low debt requirements and produces attractive financials characterized by strong margins and healthy free cash flows. Capex has averaged just 1.6% of sales over the past 10 years.
Growth
CBRE has enjoyed high growth over the last 10 years and it has accelerated since the financial crisis for the reasons enumerated above. This can be seen in this comparison between CBRE and JLL:
Source: Data per company filings via Sentieo.
High ROIC and FCF Generation
As one would expect from a service business, these businesses have very high ROIC and little need for capital. The companies also convert accounting earnings to cash at a high rate.
Is This Just Another Platform Story? Will Consolidation Increase Cooperation?
In recent years, a number of investment theses have been based on (1) acquisition fueled growth and its cousin (2) consolidation fueled growth.
Acquisition fueled growth comes in a number of different flavors. Some see the corporation as a mere platform upon which an acquisitive “outsider” CEO will construct his masterpiece. Examples of this include the aptly named Platform Specialty Products, Valeant and Kraft Heinz.[7] Others point to the corporation as the base for “rolling up” an industry and enjoying the fruits of all the synergies that are created.
The consolidation story is based on the idea that an industry with a reputation for cutthroat competition will consolidate and cooperation will improve. All things being equal, it is better to have fewer competitors than more competitors. This is self-evident. Accordingly, investors frequently cite industry consolidation as a compelling catalyst to realize value enhancement. In the excellent book Capital Ideas, this dynamic was described as follows: “The ideal capital cycle opportunity for us has often been one in which a small number of large players evolve from a situation of excess competition and exert what is euphemistically called ‘pricing discipline.’ Having a small number of players is important, since retaliation (say a price cut) is likely to be a more powerful weapon in the hands of a dominant price setter, although barriers to entry are also required to deter opportunistic entrants from taking advantage of any price umbrella.”
In the past I have been critical of investing theses based on (1) acquisition fueled growth and (2) consolidation fueled growth. Yet, my thesis on CBRE is based largely on these factors. CBRE has made over 100 acquisitions since 2005. How does CBRE’s strategy differ from the others? How do they avoid the pitfalls that have brought down others?
First and most importantly, they have not issued debt to fund acquisitions. The killer for most of these roll-up stories is the debt burden. Here, CBRE’s debt has actually gone down.
Source: Data per company filings via Sentieo.
Second, given the malleability of US GAAP, acquisitions provide an opportunity to artificially boost accounting earnings. These games eventually catch up with companies. To date, I have not seen any red flags in CBRE’s accounting.
Third, there are enormous execution risks in trying to integrate 100 companies in 11 years. CBRE seems to have a good process in place for avoiding any problems.
Fourth, acquisitions on this scale require strict discipline to avoid overpaying. Thus far, CBRE seems to have been very disciplined.
What about consolidation? Do I think an era of good feelings will suddenly arise in the CRE industry? After all, some industries have oligopolistic industry structures, and yet persist in generating poor returns. It is very difficult to handicap the odds of rational pricing discipline taking hold. As Charlie Munger (Trades, Portfolio) put it: “Here’s a model that we’ve had trouble with. Maybe you’ll be able to figure it out better. Many markets get down to two or three big competitors—or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well. Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets, there’s destructive competition that destroys shareholder wealth. “[8]
In the CRE industry, a lack of cooperation could take the form of over paying for top talent, over paying for acquisitions or cutting prices in a misguided attempt to seize market share.
However, CBRE has such a large lead in scale that, while they are certainly not impervious to competition, they are certainly insulated from it. Further, the company has demonstrated good discipline in sitting out bidding wars for talent and acquisitions to-date. So, these factors combine to ameliorate the downside risk if competition does not abate as the number of competitors declines.
Is the Security Mispriced?
As discussed here, a bet on CBRE is founded on the belief of a rising corporate/ institutional outsourcing market and those corporations and institutions will increasingly rely on fewer, but more qualified suppliers that bring unprecedented geographic reach and service breadth for corporate real estate and facilities services. CBRE now enjoys a leading competitive position in an oligopoly industry. It is one of only two or three CRE service firms with global scale and a comprehensive product suite, and deep expertise in all aspects of commercial real estate services. This leadership gives it important advantages in a market niche were scale is increasingly important.
At the November 16, 2016 close, CBRE’s price per share was $27.82. The mid-point of the company’s 2016 earnings forecast is $2.22. Therefore, CBRE sells for a P/E of just 12.53, well below the S&P 500 average of 18. It is hard to understand why an industry leading company with a moat is selling for a price below the market. We believe it is because rearview mirror investing is causing the market to miss the evolution of the CRE industry and CBRE’s widening moat.
[1] CBRE Business Review Day, November 17, 2010.
[2] Ibid.
[3] Q4 2014 Jones Lang LaSalle Inc Earnings Call
[4] CBRE Group, Inc. at Barclays Capital Global Financial Services Conference, Mon 09.10.12
[5] CBRE treats leasing revenue as recurring rather than transaction. At first I thought this was misleading but I found this explanation reasonable: “We regard leasing revenue as largely recurring because unlike most other transaction businesses, leasing activity normally takes place when leases expire. The average lease expires in five to six years. This means that, on average, in a typical year approximately 17% to 20% of leases roll over and a new leasing decision must be made. When a lease expires in the ordinary course, we expect it to be renewed, extended or the tenant to vacate the space to lease another space in the market. In each instance, a transaction is completed. If there is a downturn in economic activity, some tenants may seek a short term lease extension, often a year, before making a longer term commitment. In this scenario, that delayed leasing activity tends to be stacked on top of the normal activity in the following year. Thus, we characterize leasing as largely recurring because we expect an expiration of a lease, in the ordinary course, to lead to an opportunity for a leasing commission from such completed transaction.”
[6] Bob Sulentic, CBRE Group, Inc. – President and CEO, Q3 2016 earnings call
[7] See here for an excellent overview of the platform company boom.
[8] Charles T. Munger, Vice Chairman of the Board of Directors of Berkshire Hathaway, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”
