Wall Street and Main Street have had different philosophies for a long time when it comes to investing. Wall Street’s focus is securitizing the underlying businesses. They’ve created so many derivative products that create financial leverage. This is a packaging and re-packaging of investment vehicles into increasingly large opaque homogenized pools of assets.
What’s insane to me are the valuations being attached to these companies. I’ve long held that wall street valuations are far too high for the underlying assets. If a property is trading at, say, a 6% cap rate. If all the properties being held by that company are trading at a 6% cap rate, and the company is only in the business of holding assets like this, then how could the company be trading at 50x earnings, or the equivalent of a 2% cap rate? Yes, I understand that leverage can increase the yield. But leverage also increases the risk. That risk is already built into the cap rate for the property. How can a company be worth more than its underlying assets?
We saw crazy valuations in the early 2000’s with the collateralized debt obligations. These were nothing more than packaging of pools of mortgage loans into a new financial instrument that could be sold. It had the effect of moving the debt off the bank’s balance sheet and allowing banks to loan even more money. The opaque nature of those debt obligations nearly collapsed the global financial system. It all worked fine as long as the default rate on those debt obligations remained low. When things blew up in 2008, the fragile nature of these paper assets became apparent.
Wall Street seems to be at it again. The latest is a major push by Goldman Sachs to get into real estate, and the commercial sale leaseback game in particular. A unit of Goldman Sachs just purchased Oak Street Real Estate Capital for an estimated $2B.
Sale leasebacks are a way for some companies to strengthen their balance sheets. The buyer purchases the commercial real estate from an active business who in turn take the cash and pay down debt. Instead, the business pays rent rather than servicing the debt. In some cases, it’s a way for companies that have paid down the debt to raise cash without borrowing funds. It’s a game that makes it all seem like a massive shell game where very little of value is being added to the equation.
For the buyer of a sale leaseback asset, the key is in understanding the business health of the selling company.
If we look at the makeup of the Oak Street portfolio, they’re about 35% retail, 50% industrial and 15% office. That’s not a bad asset mix as long as their exposure on the retail side is not at the higher risk end of the spectrum.
Wall Street firms have to be seeing the crazy multiples in the market and are going in search of yield. While so much of Wall Street is focused on arbitrage of paper assets, the underlying fundamentals eventually rule the day.
Another player in the sale leaseback space is Realty Income Inc. This REIT has 16.4B of assets in their portfolio. Their largest shareholders include various Vanguard funds and Blackrock. Together, these two own about 22% of the REIT. This REIT is trading at 51 x trailing 12 months earnings. Another REIT in the space is VEREIT. They’re trading at 31.55 x earnings.
No doubt you’re going to hear about the risk in real estate investing when you see the prices of these stocks fall. Understand that the value of the underlying real estate is disconnected from the valuation of the companies that own them. This is no different than owning Tesla stock or Netflix stock where the market price is disconnected from the financial performance of the underlying business. I’m glad that I’m firmly grounded on main street and not playing the Wall Street game.