The Flip: When Assets Become Liabilities
The Flip is the moment where a company's assets become profit-leeching liabilities.
Investors looooove assets. Real estate, aircraft, mineral rights, intangibles like trademarks and process technology...Hard and soft assets are the foundation for the most basic forms of credit - mortgages, asset-based revolving lines of credit, reserve-based lines of credit, equipment leases and sale-lease-backs....
In more recent times, asset-rich companies have been the target of activist investors. It’s hard to argue against higher ROAs, but I would in turn argue that building this outcome by stripping out the A and not increasing the R is simply a form of financial engineering. For example, it will, of course, look better for returns to do a sale lease-back of a building, all else being equal, in a yield-starved environment where interest rates are near historic lows and cap-rates are in the same ballpark. Trading-oriented activists will push for the move, trade the event and move on. The companies are then left to navigate their new business model and perhaps have different decision dynamics as leases come due and their long-term plans do not match those of their new landlords. But I digress...
Hard assets have also been taken as a form of downside protection or security. This is typically the case, typically. I cannot think of the number of times I have heard someone discuss a retailer and remark that even if the business isn’t doing well, at least the company owns it’s real estate and then can look to monetize assets (and often the conversation point is directed towards underperforming assets) to generate needed capital to support the rest of the business. I have heard the same conversations regarding real estate investment trusts. As they say, REITs can always churn assets in order to generate capital to support growth in more attractive markets or support other areas of the business. Suburban office isn’t that great right now versus core urban, then sell the suburban to another party and reinvest in core. Population growth in Jacksonville, FL isn’t as compelling as Austin, TX, then sell the JAX assets to someone else and reinvest in Austin. Assets, assets, assets; there is always value in assets.
Riddle me this dear reader...can an asset become a liability? If so, when does an asset become a liability? I assert that assets can become liabilities and that certain assets have been transforming into liabilities over the past ~10 years. Furthermore, this metamorphosis has accelerated in the past few years and more-so in the wake of the Coronavirus (d/b/a/ “COVID-19”). In that regard, let’s turn our attention to retail real estate.
It’s not news to anyone that big box / department store retail has been suffering for over a decade. The damage has been inflicted by a number of things: too many undifferentiated stores, online shopping, changes in generational shopping habits and desires, reurbanization, increased focus on reuse and shopping vintage / second hand.
What strangely seems to remain news, or at least did up until the last few years, is that as more and more of these companies downsize or outright close and liquidate, the value of the real estate assets decreases and might even turn negative. You may ask what is a negatively valued asset...well that is a liability.
Follow me on this logic train. If one retailer faces issues for company-specific reasons, whatever those may be, and the rest of the industry remains unaffected, I can see where the real estate assets could have value to a competitor / another operator. This pattern probably holds true if instead of just one, maybe a handful of companies face issues. But what happens when more companies are having issues than not and, moreover, what happens when most or even ALL companies in said industry are having issues? This is akin to having no-bid in a market for a stock or bond. But it’s more than that for real estate assets. Not only can the holder take losses on valuation, but these assets have real carrying costs attributed to them...think taxes, utilities,maintenance expenses. In a situation where there are literally no bidders and all sellers, the seller is then made to pay these costs until…? This reality has hit people in a number of recent department store/big box specialty situations where carrying costs remain high and realizations from sales remain lower and slower. The asset has become a liability.
Let’s add a mortgage or loan against the real estate to the dynamic. A bank may have underwritten a mortgage or loan at a conservative loan-to-value...but did that process take into account the situation and dynamics above (namely those we are seeing today)...no bidders? I suspect not...I know not. I doubt any lender underwrites a property with any expectation of it becoming literally dead space. Granted there are alternative uses, but there is also a limit to the number of new fitness facilities, self-storage facilities, movie theaters, etc that the market needs...and today even those are flipping into the liability side in some cases. In this case these assets are then liabilities to the lender who forecloses and then steps into the shoes of the prior owner with respect to these ongoing cash flows. Perversely, this asset to liability flip may be THE thing that prevents foreclosures in many cases...potentially nobody wants to own these “assets,” even the lenders.
The same view of a flip can apply to other assets. A few additional examples (especially during COVID-19 times):
1. Are movie theaters going to follow the trend of department store real estate?
2. What is the value of mining equipment (assets) specific to industries that are in secular decline, such as thermal coal?
3. What is the value of a thermal coal power plant that is coming to the end of its power purchase agreements, especially one in an area of the country where natural gas or renewables are growing rapidly?
4. Which commercial aircraft are now liabilities as travel has fallen off dramatically?
5. Which supply chain / logistics assets are now liabilities - tractor/trailers, ships, rail cars with specific uses (eg. coal)?
6. Are cruise ships going to be assets again anytime soon?
7. Are mineral rights in some cases liabilities, specifically those that are unlikely to become economical to produce in near-to-medium-term liabilities?
8. Are hotels destined to become liabilities if travel remains subdued and more meetings are taken virtually?
9. Are theme parks and other large gathering-oriented venues morphing into liabilities in some cases, especially those that may have already been experiencing declines due to changes in consumer tastes and behaviors?
10. Is new-build multi-family an instant liability today?
The list above is not intended to suggest that any of these things are liabilities. Instead, it is intended to change your potential perspective on assets and to get you thinking about how assets can become liabilities for companies you invest in or trade. In today’s market and economic environment, this flip appears more possible than ever, and in unexpected places.
I leave you with this dear reader: as businesses and industries collectively struggle, the potential grows for certain assets to flip to the liabilities. As those collective struggles grow and increase, more assets flip to liabilities. If nothing else, think about the potential for this flip, what would it take to cause the flip, and what would the impact of this flip be for the company in question?
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