Follow Up on CBRE
On this blog, I try to be as transparent as possible. That is why I publicly track the stock performance of all of the companies I write about. I do not try to play up my wins and bury my mistakes. In this way, I hope to learn from my mistakes. I also hope that the openness builds credibility rather than making me look like an idiot.
I also like to engage with my readers who point out holes in my thinking. In this vein, a friend of Punch Card, Cliff Sosin of CAS Investment Partners, helpfully commented on my recent post on CBRE. He generally agreed with my qualitative view. That is, he agreed that changes in the CRE industry structure will generate more benefits for scale players. However, he argues that I have dramatically underestimated the extent to which CBRE is over-earning as a result of the current boom cycle in CRE.
As Cliff suggests, there is persuasive evidence that we are in a CRE bubble. Real estate values, like all asset classes, are affected by long interest rates. But, unlike other asset classes, real estate is particularly attractive to those seeking bond-like safe, long-duration assets. As a result, investors regularly compare what can be earned on real estate versus what can be earned on a long bond. As can be seen here, capitalization rates on real estate correlate with the 10-year treasury rate – that is, real estate prices go up as bond prices go up and the cap rate drops as the bond yield drops.
But, even though CRE prices have gone up, real estate is still generating large spreads over treasuries. The monetary policies of the central banks of the US, Japan, Europe and the UK have caused yield curves to flatten. Therefore, even though cap rates are very low, capital continues to put into the real estate sector. To state the obvious, prices of assets are dependent on the supply and demand of capital. As capital pours into CRE, prices go up.
But, how long can this continue? A bursting of the real estate bubble seems inevitable. We are now 8 years into a bull market in real estate and getting close to a point in the cycle when “financial accidents happen” as Brookfield Asset Management CEO Bruce Flatt put it. (Flatt is putting his money where his mouth is. He is monetizing assets and hoarding cash to prepare for the eventual downturn.)
What does this have to do with CBRE? Even though transactional revenue is now just 30% of revenues, it makes up a much larger percentage of CBRE’s profits. Brokerage activities and investment management earn much higher margins than outsourcing. Thus, a turn in the cycle will have a disproportionate impact on CBRE’s profits and drive a much greater decline than I used in my post.
Thus, in a scenario where CRE prices drop 30%, CBRE’s results look like this:
These numbers are based on the following assumptions:
- CRE prices are probably 30% over normal
- CRE transaction volume is probably 15% too high.
- These factors combine to cause a 40% decline in revenue (0.7×0.85 = 0.595).
- Incremental EBIT margins on this revenue are ~30%.
Further, when taking into account interest expense and tax, the normalized P/E for CBRE is 25 not the 12 I cited in my post. Of course, even at a P/E of 25, a stock can be a home run but the odds of success decline at that level.
Also, there are a number of offsetting factors that might mitigate the drop in transactional business. First, if the CRE market declines, CBRE should be well positioned to pick up smaller rivals on the cheap. Second, a high percentage of broker compensation is variable. Thus, a key expense item should drop along with revenue. Third, the model does not take into account any continued growth in the outsourcing business. Fourth, the model does not take into account margin expansion as a result of increasing economies of scale in the outsourcing business. But all of these factors would have to have a pretty dramatic impact to make up for a ~50% drop in profits.
Fortunately, I am not alone in trusting temporarily inflated profits.
In early 2000, Wesco Financial purchased Cort Furniture, furniture rental business. Over the previous ten years, Cort’s business and profits had climbed impressively. Charlie Munger was CEO and Chairman of Wesco at the time of the purchase. Munger’s rationale for the acquisition, as describe in Atul Gawande’s The Checklist Manifest, was straightforward. “(Munger) believed Cort was riding a fundamental shift in the American economy. The business environment had become more and more volatile and companies therefore needed to grow and shrink more rapidly than ever before. As a result, they were increasingly apt to lease office space rather than buy it—and, Munger noticed, to lease the furniture, too. Cort was in a perfect position to benefit.”
But the purchase was a mistake. Munger’s valuation of the company rested on the premise that its late 1990s earnings were sustainable. But, they were not. Cort’s earnings had been temporarily inflated by the dot-com boom. Venture capital was funding start-ups all over the country who saw the benefit in renting furniture. When the do-com bubble burst, it took a big chunk of Cort’s business with it. Munger described this cyclical boom and bust in the 2008 Wesco shareholder letter: “CORT’s operating results are subject to economic cycles. When we purchased CORT, its furniture rental business was rapidly growing, reflecting the strong U.S. economy, phenomenal business expansion and explosive growth of IPOs and the high-tech sector. Shortly thereafter, with the burst of the dot-com bubble, followed by the events of September 11 and a protracted slowdown in new business formation, CORT’s operations were hammered, reflecting generally bad results in the “rent-to-rent” segment of the furniture rental business.”
Like Munger, I assumed CBRE’s current earnings were sustainable without fully taking into account a turn of the cycle. That is, I did not take into account that customer demand for CBRE’s services are exposed to cyclical changes. But, it is easy enough to run the numbers to model the impact of normalized earnings on CBRE’s valuation. This will be a checklist item from this point forward.
 A capitalization rate (“cap rate”) is the ratio of Net Operating Income to the property’s asset value. It is synonymous with yield.