Updated: May 17
July 15, 2020
My wife Pat and I have just celebrated our sixtieth wedding anniversary. It has been a wonderful ride – despite the fact that there has not been a single year (maybe not a single day) of our marriage free from really terrible events or conditions that have impacted the lives of millions in this country and the world.
Assassinations (John Kennedy, Martin Luther King Jr., Malcolm X, Bobby Kennedy, Anwar Sadat come to mind); wars and international conflicts (the Cuban Missile crisis, the Vietnam war, the Six Day war and the grinding Middle East conflicts that followed; the Yugoslav wars; wars in Iraq and Afghanistan are obvious examples); horrible strife within nations (the genocides in Cambodia and Rwanda, Mao’s Great Leap Forward...and twenty million dead as a result); the Irish Troubles; terror attacks (Oklahoma City, the Beslan School hostage crisis, 9/11). And then there was the “once in a lifetime” economic dislocations of the Great Recession and beyond over the course of which, among other things, seven million or so people in the U.S. lost their homes.
These are just the briefest of examples. If I put time and research into the task, I could produce a list that runs for pages. And each of you could do so, too.
Is there any doubt that during the last sixty years there hasn’t been a moment in which something really terrible was happening, somewhere? Or that we have had to live with the consequences of terrible moments past? And is there any doubt that the last sixty years was a representative period? That is, has there ever been a time in the history of the world when something really terrible wasn’t happening, somewhere? And yet, and yet...here we are.
With the benefit of hindsight we can now understand how so many past events have played out. But we can only guess at the consequences of the pandemic – for predictions, as we all know, are largely worthless. It is unfortunately true that the only thing that is predictable about predictors is their consistent inability to produce accurate predictions. I don’t have this ability (as I remind myself whenever I am tempted to talk about the long term consequence of the pandemic). So no predictions ... just a plausible scenario (just one of a number of possible outcomes, each having some probability of occurrence).
What we are experiencing now is certainly a “terrible moment.” And when the history of this “moment” is written, and outcomes known, my scenario suggests that one consequence will be that we will have lived through a period that will come to be known as the “Great Revaluation.”
Revaluation is a neutral word for the process by which some, often traumatic, condition results in the devaluation of personal, business or national assets. We are already seeing this process at work as many great business names are filing for Chapter 11 protection. Most of these companies will emerge from Chapter 11 still operational but with substantially re-worked debt, present ownership owning no or substantially diminished equity and a smaller labor force. We are also seeing this process at work as many thousands of smaller companies, public and private, have had to shut their doors. Many will not open again. This is revaluation in action.
Revaluation doesn’t have to mean Chapter 11 or any other form of bankruptcy proceeding. It effectively happens in individual lives whenever there is a (usually significant) realized loss which will have a permanent, or at least a long term, effect on the value of an asset or the balance sheet of which the asset is among the holdings. There are countless personal examples.
Suppose, in 1999, twenty percent of your net worth was in dot-com companies, all of which then went out of business in 2000. Your assets (absent other current debits and credits) would have been devalued by 20% and your balance sheet revalued accordingly. Suppose that in 2008 you owned three rental homes for which you paid $2 million with total mortgage debt of $1.5 million. When the impact of the Great Recession (lost job, lost tenants) made it impossible for you to continue mortgage payments, you lost these homes. You experienced a $500,000 balance sheet devaluation. Suppose you own 100% of a company that is experiencing financial stress. You need more equity but can’t afford to invest yourself. Others agree to invest in return for 50% of the post investment equity. This results in your ownership being diluted by 50%. (We won’t go into such subtleties as to why your new 50% may be worth more than your old 100%. How that might or might not be the case is a subject for another day.)
My scenario proposes that a material economic consequence of the pandemic will be population-wide, and will lead to enduring behavioral changes that will translate into what will amount to a revaluation of billions of dollars in assets, wherever and however owned.
Example: People will reduce the number of meals they eat out, with corresponding declines in restaurant sales (absent material menu price increases which, if put into effect, will compound the problem). People have gotten used to “eating in” for long periods of time and many are finding this congenial. Also, people who have been in a position to adapt more or less painlessly to stay-at-home orders are discovering that whatever else may be said for a period of enforced internal exile, one happy consequence is that bank accounts are larger than they might normally be.
There may be another reason why restaurant sales will suffer. The necessity for social distancing may or may not go away but the memory of social distancing will be with us for many years. This will translate, I believe, into restaurants feeling the pressure to maintain some degree of social distancing to satisfy customers.
If a combination of reduced customer “usage” and fewer customers per seating results in, say, a 10% reduction in what had otherwise been a traditional pattern of food and beverage sales, the result, assuming the 10% “effect” is experienced by most restaurants in a particular region, would be significant across the universe of constituencies within which the business functions. All (employees, vendors, landlords, taxing authorities, ownership) would be materially affected.
Virtually all businesses operate, more or less, with certain fixed costs. Payroll, rent, insurance, advertising and so on. In the restaurant business, after adding the cost of goods sold, expenses generally exceed 90% of sales (and this is before calculating necessary capital expenditures – which I will ignore for purposes of this example but which cannot be ignored in real life). The last 10% or so is crucial...in any business. It’s the profit.
So if opening again with the hope of business as usual translates into little or no profit then it can’t be business as usual.
Will employees agree to a 10% pay cut? Can vendors survive a 10% reduction in sales? Will landlords agree to a 10% reduction in rent? How will the taxing authorities deal with a reduction in tax receipts? Will ownership work for nothing? One thing is certain. The restaurant, without a change to its operations, is not going to be worth what it once was – no matter how skillfully ownership navigates the turbulence. Revenue down? Enterprise value down (as restaurants, like many other businesses, are valued on a multitude of gross revenue).
Another example, worth slogging through for it illustrates how quickly values (in this case property values, but in principle, all asset values) can decrease (or, given different circumstances, increase), deals with real estate. You and your partners own a 100,000-square-foot office building for which you recently paid $45,000,000 with 30% equity or $13,500,000 down. The difference was funded by a loan of $31,500,000, the terms of which required annual debt service (principal and interest) of $1,900,000. The building has almost always been fully leased. The average current monthly rent is $4.00 per square foot, so that after a small vacancy allowance your collected rent is $4,500,000 annually. After operating expenses and a reserve for capital expenditures (not including debt service), your annual cash basis cash flow is $2,700,000.
Every business has at least one easy-to-apply valuation metric. In the case of “untroubled” investment real estate it is the capitalization rate. The capitalization rate is another way of describing what owners can expect to earn on their price, before debt service and before tax effect. In this case, the price is $45,000,000 and the cash flow (sometimes called net operating income) is $2,700,000 – so you and your partners bought the property to yield 6%. Six percent is the capitalization rate for this purchase.
I expect that, as the result of the pandemic and the experience that many tenant/employers have had with employees working from home, there will be widespread re-thinking of how best to house the workforce, particularly the office workforce. I can imagine that where productivity has not been impaired there will be a push for making home workspace permanent. Employers pay for less space. Employees eliminate all or most commuting and so save time, fuel costs, and auto depreciation. Potentially even child care becomes less expensive. Food costs go down. No more coming home late from the office.
Imagine that 10% of the office space in a typical urban market is vacated because of permanent work-at-home decisions. The result to office building owners will vary depending on loan balances, abilities to raise rents, abilities to reduce expenses, and so on. But it could also be painful for you and your partners.
You have cash flow today of $2,700,000 to pay your debt service of $1,900,000. This amounts to what’s called in the trade “debt service coverage” of 142%, a comfortable “spread.” But “tomorrow” that coverage changes. New collected rent is reduced from $4,500,000 by $450,000, which in turn reduces cash flow before debt service from $2,700,000 to $2,250,000.
If capitalization rates don’t change, the $2,250,000 at a 6% cap rate now values your building at (yikes!) $37,500,000, which means that you and your partners have experienced an unrealized capital loss of 55.5% (because the drop of $7,500,000 in value comes straight out of your equity, which was $13,500,000 and is now cut almost in half). For current financial reporting, this is certainly a revaluation. Is it temporary or permanent? Well, if the trend to home officing is permanent (and the occupancy ratios don’t change), this revaluation could be as well.
And to add insult to injury...you and your partners may find yourselves in violation of a loan covenant which stipulates that ownership must maintain debt service coverage of, say, 130%. With $2,250,000 of cash flow and debt service of $1,900,000, coverage is just over 118%. What can happen when debt service coverage falls? A bill for $2,650,000 as a loan principal payment can happen, for this is the amount, if you do the math, that will bring the loan balance to $28,850,000. (A dinner for two at the restaurant of your choice, on a date of your choice, goes to the first two people who tell me how I arrived at $28,850,000 – so stay alert. See the “fine print,” below.)
If you have read this far, and are like most people, you may have found these examples and the related numbers tedious. But the moral of this story is critical. I have sought to establish the possible economic consequences of behavioral changes arising from the pandemic, as experienced at the individual enterprise level, and also to suggest that these examples are representative of the pandemic’s impact on thousands of businesses across the U.S. economy, to say nothing about the rest of the world.
All that said, from an investor’s perspective, it is by no means all gloom and doom.
In any possible economic scenario there will be losers ... and winners (companies, sectors, and particularly nations). There has always been a focus on international assets among many investors. This focus will be enhanced as some nations and their economies prosper relative to others.
In this scenario I would expect that the attraction of passive/index investing will diminish. Why? If asset devaluations are coming down more or less across the board, then we can expect that average returns for any particular sector or asset class being indexed will be reduced from historical averages. Going forward, to the extent that investors enjoy “outperformance” it will be on the basis of the outperformance of their individual stock holdings and their selection of outperforming sectors and asset classes.
As a complement to a plan of (conventional) asset allocation, I believe that there will be a new (or enhanced) emphasis on alternative assets, at least alternatives to conventional stock and bond holdings. Alternatives, understood broadly, means assets (liquid or illiquid) that can be expected to perform well but whose performance is not correlated to these conventional investments. My favorite alternative is real estate, but “alternative assets” could also mean venture and private equity, long/short and market- neutral funds, managed futures, and reinsurance products, all of which our portfolio management team considers for our clients’ portfolios.
Inflation? Well, if you believe the yields on long-term government bonds have any predictive value (note to self: recall skepticism regarding predictive value of predictions), you would have to conclude that material inflation is not currently in the cards.
Widespread asset revaluation, in and of itself, can be a good thing (but tell this to those who suffer its consequences). From a macro perspective (the proverbial “30,000 feet”), asset revaluation can look a lot like creative destruction, from which new initiatives, new enterprises, new careers and new opportunities will arise – always have, always will – in housing, transportation, technology, energy, healthcare, agriculture, education, city planning, entertainment, government ... the list is endless.
We who make our living in the financial advisory and investment business have always been committed to three objectives: 1) stay on top of our current game; 2) read, as best we can, the signs of the times so as to maintain a reasonable feel for what is coming; and 3) bring what we know and what we believe to the service of our clients.
FINE PRINT on my dinner offer: firm policy places a limit on gifts, so I have to cap the total “prize” at $200 per couple. The prize will go to the first two e-mails to arrive in my inbox (email@example.com) with the correct explanation. (WEIL employees are not eligible, of course.)
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