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As a rule of thumb, when EVERYONE's talking about something, it's usually not a good trade. Yet on the back of the banking crisis everyone's talking about commercial real estate.
So is it overblown? Or is the coverage too generalised?
Over the past couple of weeks you may have seen charts like this 👇
Or this one...
It's been a theme ever since the pandemic. We've even written about it a couple of times... 👇
Recent banking turmoil brought the issue sharply into focus. As the economy slows and lending availability dries up, commercial real estate is likely to feel the pain...
Wells Fargo Summary 👇
Tighter credit conditions are likely to weigh heavily on CRE. Banks play a key role in the CRE financing system, and increased scrutiny on lending practices means tighter credit for CRE borrowers could be in the offing.
Commercial property valuations have already started to downshift and are set to fall further. In addition to limiting new CRE funding sources and investment, tightening credit conditions increase the likelihood the U.S. economy experiences a recession later this year.
An economic downturn is likely to weigh on demand for space and new development, which will impact rent growth and valuations. If history is any guide, property prices are likely to fall further if interest rates remain elevated and a recession occurs, as we currently anticipate.
Declines in office property values could be more acute, especially for outdated supply which makes up the vast majority of the office market. Of course, there is likely to be a great deal of variability by geography as well.
Nothing controversial in there.
However, it's hard to find a trade. Many of the real estate options available to retail investors are REIT ETF's. As with any index, strength and weakness tend to balance things out, negating the asymmetry of potential returns.
We need to dig deeper...
Our detective is Jim Chanos. The famous short-seller has lost some battles but usually wins the wars...
And he's set his sights on some very specific targets lately. Data Centres. The thesis is laid out in detail on this superb podcast 👇
First up, the different types of data centres, and which ones Chanos is focused on...
There's really three ways for an enterprise to maintain its data. One, you do it yourself on-site and you have your own IT department. They keep the servers running, maintain the software and the cybersecurity. Second, and that which the legacy data centers that we short epitomizes, the colocation data centers, whereby you keep your server at a third-party location. The third-party maintains the servers, keeps the air conditioning on, does whatever routine maintenance is needed to do, and provides the network connections.
And those are the so-called legacy data centers. That is the focus of our big short. And then the third way, which is the way that is garnering the most market share now is the so-called cloud providers. These would be what we call and others call the hyperscalers. Amazon AWS, Microsoft Azure, Google Cloud, et cetera. Oracle has one. And this is just simply you keeping your data on their servers and they maintain them, try to sell you add-on services on top of just a hosting fee. So that's the three ways in which data is kept for enterprises.
The crux of his reasoning isn't really to do with interest rates. It's more about the narrative and the business model (emphasis added) 👇
If you go back and look at the returns on this business and returns on incremental capital, the business peaked pretty much around 2016. Ever since then, incremental returns have been terrible and in some cases, negative on capital. And so although the stocks continued to perform for a few years after that, really was on the back of a narrative than it was analysis in our view. And we love those kinds of shorts where the business is quite a bit different than the narrative.
And the narrative was these are the beneficiaries of growth in data. And therefore, you should -- if you're a real estate investor, the one way to play growth in tech and growth in data is to buy the data center REITs. And the problem with that, of course, is that on a same-store basis, the returns are, in many cases, flat or in the case of Digital Realty, DLR, negative on a same-store basis for the last handful of years.
So really, the unit economics have just gotten worse and worse and worse as the hyperscalers have taken more and more share. And that's the real problem here is that at the end of the day if your incremental return on invested capital is negative then it doesn't matter how fast you grow. In fact, if you grow, you're liquidating faster.
Yes, you're liquidating. And so just to give you an idea, we did some numbers last year, they're still pretty valid. Since 2016, we calculated that Digital Realty, the largest of these players, Digital Realty required $11 in new capital since 2016 to generate $1 in new revenues at a 50% EBITDA margin. And we'll get to that why EBITDA is not the right metric for these companies in a little bit. But given that, so it costs them incrementally $11 of new capital to generate $0.50 of gross cash flow.
As with so many businesses, low interest rates were an enabler of poor capital use, a zombie life support system.
Digital Realty (DLR) is mentioned as the weakest link throughout the 43 minute podcast and it's already trading well down from the highs...
This being the modern world, Chanos is tracking all of this publicly on Twitter and thinks there's still plenty of room for valuations to fall further...
Maybe there's still some juice in the trade, but it's not one for tourists in my humble opinion. However, the detail and information density in the podcast is supreme.
It's also great example of why appreciating the idiosyncracies is a solid approach to constructing a trade idea. Way better than shorting a random REIT because "the property market's in trouble bro"...
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