The Real Estate Philosopher


The Latest Bubble

Sep 13, 2017

Here are further thoughts about Amazon and its effect on the retail world, which I have named “The Amazon Retail Distortion”.  See the article I wrote in my last Real Estate Philosopher.

I note that roughly fifteen years ago – in mid 2001 – Barrons wrote a perceptive piece that, in one article burst the internet bubble.  It pointed out that no matter how many “eyeballs” internet companies were getting, almost all of them only had a few months left of cash to burn and if they didn’t raise more money by then they were broke.  And so it was.  Between three and six months later virtually all of these companies disappeared in a puff of smoke.

Of course, I am not Barrons, and I don’t see Amazon going bankrupt any time soon, but I continue to wonder when the Amazon bubble will burst.  When it does there will certainly be a mass celebration in the retail world. 

Consider my last article where I made the point that Amazon has been given a now twenty-year gift from Wall Street and investors that it doesn’t have to make money.  And this still continues, incredibly. 

Their last quarter – which came out after my last article – put them at breakeven or worse when taking out stock based compensation and losing significant money if their cloud business – which has nothing to do with their retail business model – is excluded.  Indeed the article I read said they made 40 cents a share (for a stock trading at $1,017 a share), they expect somewhere between a small loss or a small profit next quarter, their income fell 50% from last year, and their operating costs were increasing.  The same article – incidentally – mentioned that Jeff Bezos was temporarily the world’s richest man…

Face it – Amazon makes no money in retail!

Yet retailers that used to make money – or are making money – are getting clobbered by it.

My – continued and reinforced -- view is that Whole Foods will reveal the lack of clothing of Emperor Amazon.  Consider a recent Wall Street Journal article entitled “Amazon Rewrites Rule Book for Grocers.”  The second paragraph starts with “while Amazon doesn’t need to make money from its grocery division yet, food sales are crucial for traditional players like Kroger, WalMart and Target….”  Seriously?  Amazon doesn’t have to make money on food but WalMart does?  Seriously?

And then a few days later what appears to be a “shocking” headline that Amazon is lowering some prices at Whole Foods crushes grocery stocks.  Again, I ask, seriously?

Whole Foods is known informally as “whole paycheck” and is struggling, so they lowered some prices.  Gee – wow.   I looked at the article and the price changes on some vegetables wasn’t enough to change my shopping patterns.  Amazon’s (brilliant?) strategy in groceries is to take on experienced behemoth players in a razor-thin-margin business and lower prices against WalMart?  Seriously? 

If you are going to bet on WalMart – which makes something like $15B in cash a year -- versus Amazon – which makes nothing – and you bet on Amazon, your bet has to be based on one thing; namely, that it will continue to have a free pass on making no money in its core business. 

My last article generated a lot of responses – some favorable and some implying I had no clue.  The ones telling me I had no clue mentioned that a huge percentage of Americans use Amazon and they are brilliantly run, etc.  My response is that even if that is true, Amazon is still losing money or at least not making money.  Plus, I don’t know why the fact that you use Amazon to buy a book has much to do with groceries.

Maybe the theory is that someday, once they have put all the retailers out of business they will have a monopoly and raise prices then?    

It is a lot like my partner coming in and telling me about a new client that wants our pricing so low that we are losing money.  He then says to me “Bruce, don’t worry, we’ll make it up on volume!”

I reiterate my prediction that Amazon’s ability to destroy the retail world is based on mis-placed hype and an irrational stock market valuation.  I do have to admit though that irrational stock market valuations can persist for a long period of time. 

My advice to retailers is the same as in my last article:

  • Don’t freak out – this is a temporary phenomenon – albeit a long one – it will end at some point, and I think pretty soon.  Sooner or later someone more respected than me – like Barrons maybe – will poke at the same hole in Amazon I am poking.

  • Set up your business so that you can survive until the Amazon Retail Distortion ends.

  • Perhaps follow the other suggestions in my previous Real Estate Philosopher articles; namely: (i) don’t try to be “better” than others and instead try to be “different” from others, (ii) sell only exclusive branded goods in your store, (iii) consider yourself as much in the distribution business as the retail business, and (iv) don’t go nuts setting up expensive structures to enhance the consumer’s “experience” in the store, which I bet will get old awfully fast and be intensively expensive and difficult to maintain. 


Teavana Case Spotlight:  You Must Serve Tea! 
D&S Real Estate Litigation Team Comments On Simon Property Group v. Starbucks Corp.

A big story in commercial real estate recently was the announcement that mall owner Simon Property Group is suing Starbucks over the planned closure of all Teavana stores.  As widely reported, Simon is seeking a court order prohibiting the closures and forcing Starbucks to continue operating Teavana in its malls.  Because we have fielded a number of questions about the case, and because retail leasing is a core specialty for us, the D&S Real Estate Litigation Team offers our clients and friends the following insights.

Some Background:  Almost all shopping center leases include clauses that require an inline (i.e., non-anchor) tenant to continuously operate its store premises during the regular hours of the mall.   These clauses serve to ensure that customers visiting the shopping center will find an open and vibrant retail community.  Because these leases also include percentage rent provisions, the continuous operation covenant also insures that the tenant, as the landlord's de facto business partner, as well as neighboring tenants, maximize sales.    

Separately, it is helpful to understand a bit about the remedies that courts can award in litigation.  Almost all civil cases involve monetary damages – that is, the court’s direction that a defendant pay money to the aggrieved plaintiff as compensation for the defendant’s wrongdoing or breach.  Courts can also order injunctions, which are directives that prohibit a party from engaging in conduct (or, conversely, which direct a party to affirmatively take actions other than the payment of money).  However, all injunctions, whether prohibitive or affirmative, require a showing that money damages are not adequate and that irreparable harm will result in the absence of an injunction.    

Typically, an operating covenant requires that the tenant keep the store open for business, fully staffed and with the most current merchandise, with the intent of maximizing sales in the leased premises.  The costs of staffing and stocking the store are usually significantly higher than the rent, so tenants take on these obligations reluctantly and carefully; but that is the cost of doing business in a shopping center.

The Complaint:  Simon, based in Indianapolis, started the litigation by filing its complaint in Indiana State Court – undoubtedly seeking a “home court” advantage.   The complaint correctly points out that by closing the Teavana stores, Starbucks would breach the “continuous operation covenants” in its leases.  Simon also tries to portray itself in a favorable light (as a “global leader in operating premier shopping destinations”, which has been victimized by the failures of multiple retailers), while also vilifying Starbucks as an otherwise thriving company that is more interested in squeezing out a few more dollars in profit in disregard of its contractual commitments.  Rather than seeking money damages from Starbucks, Simon seeks an injunction that would prevent the Teavana stores from closing – claiming that the closures will cause Simon irreparable harm for which money damages will not suffice.  In other words, Simon wants the Court to compel Starbucks to continue to operate a business that Starbucks no longer wishes to operate.

Analysis and Likely Next Steps:  Starbucks is likely to argue that any damage to Simon is quantifiable, and can be addressed with money – and thus Starbucks cannot be forced to keep the Teavana stores in business.  Simon will respond by asserting that there are numerous aspects to a successful mall that are not readily measured, such as the vibrancy of the mall (or, in the words of Simon, the mall “ecosystem”) and the nature of customers’ experiences.  While Simon’s position is creative, and while the court could be tempted by Simon’s position, the prospect of compelling a company to operate its business under these circumstances is a stretch.  The court is also likely to agree with Starbucks’ argument that expert testimony can be used by both parties to estimate whatever economic harm will result to Simon.

We suspect that this case will proceed on a relatively fast track.  Discovery is underway, and the court is scheduled to begin hearing evidence on the requested injunction on October 12, 2017.   We also expect that whichever party is unsuccessful at the trial court level will seek an expedited appeal before year-end.

Some recent commentary has suggested that Starbucks and Simon could reach a settlement, whereby the Teavana locations would be replaced with traditional Starbucks coffee shops.  While such a settlement might be in both parties’ interests in order to avoid the risk of an adverse court decision (and wider implications for other properties), it might not be too easy to achieve.  Mall owners are curators -- each tenant is carefully placed in line based on intended use and brand recognition to maximize consumer experience, and thus the tenant leases often require an in-line tenant to maintain a particular use or Trade Name.  Additionally, if an existing coffee shop within the mall was given the right to be the only tenant selling coffee, replacing a Teavana with a Starbucks would violate such hypothetical exclusivity and subject Simon to potential liability for breach.  Regardless of the difficulties involved, we expect that the parties will find a way to settle, with confidential monetary terms, as the stakes are otherwise too high for either party to risk litigating to the end.
 
What is our prediction?  We predict that Simon will use this to get a bit more money from Starbucks, which will not want to take a chance – even a long shot – that Simon will get lucky.  Indeed, Simon has little to lose by filing the case – worst case they pay some legal fees.  Best case they get lucky.  Starbucks, however, has significant downside if Simon prevails.  So we predict that the case will then settle with an undisclosed amount paid that is (moderately) more than Starbucks intended to pay and is technically due under the leases.
 
Further Information:  Like many law firms, D&S has a leasing practice.  At D&S, our leasing practice centers around “retail” leasing.  We focused on this niche because there are issues unique to retail leasing that not typically found in customary commercial leases.  Continuous operating covenants are but one of them.  And, indeed, making sure our clients (landlord or tenant) do not find themselves in a litigation situation when things don’t go as planned is a primary consideration vis a vis continuous operating covenants.  For these and other reasons, we can, and we do, add significant value to our clients with this niche practice.  If you are an anchor tenant considering your rights, or a landlord with similar concerns, or even an in-line tenant wondering what might happen in the current retail climate, it makes sense to give us a call.  Our retail leasing team deals with this all the time and our real estate litigators routinely handle lease disputes.  We also have a unique and market-leading approach to real estate litigation.  Please click here to view our Real Estate Litigation Practice brochure or contact any of us directly. 

Eric Menkes – Retail Leasing Partner
212-692-5522; emenkes@dsllp.com

Kirk Brett – Real Estate Litigator
212-692-5525; kbrett@dsllp.com

Risa Letowsky – Retail Leasing Partner
212-692-5526; rletowsky@dsllp.com

Timothy Pastore – Real Estate Litigator
212-692-5982; tpastore@dsllp.com


Real Estate Market From Real Estate lawyers

A friend of mine recently asked a significant number of the top real estate lawyers in New York City what they perceive as the state of the New York City market.  This is what they said.  I  note that the responses were delivered anonymously and, accordingly, I can not vouch for the accuracy; however, no one would have any motivation to mislead.  I note the disparity of views is interesting.  [Also, I do not espouse any of these views except number 10 below, which came from yours truly]:

RESPONSE #1

We are seeing a slowdown in development deals. Land prices are down and so very few owners are willing to sell at prices developers can afford to buy, now that condos are virtually not financeable no new condo land purchases.  Rental construction financing is exceedingly conservative and only loaning 50-55% loan-to-cost, which results in a requirement of huge equity or a mezzanine loan requirement.  Lots of beginning distressed land deals where bridge financing is expiring.

RESPONSE #2

Public REITs have remained active making acquisitions both of individual assets and of portfolios through M&A activity.  This has generated related financing work.  At the same time, foreign investors have continued to make debt investments in real estate.  Non-bank lenders have remained active lenders.  We have seen an uptick in clients investing through (and seeking capital via) preferred equity structures.  Although there is not a discernible pipeline of deals lined up, we have seen considerable deal flow throughout the summer.  Our clients remain cautiously optimistic about the health of the market through the end of the year.

RESPONSE #3

I am seeing tremendous competition among mezzanine lenders.  It is definitely a borrower’s market.   Where banks are sourcing the entire deal, they are frequently requiring mezzanine lenders they bring in to take the mezzanine pieces to “share” the deals, even where a single mezzanine lender would gladly fund the entire mezzanine loan itself (i.e., mezzanine lenders are pushing their relationships with the banks to get into these deals and get pieces).

RESPONSE #4

Things are still happening, not as fast and furious as before, but still moving.  Foreigners are still buying commercial investment properties in the middle market, and luxury residential is slower but by no means dead.  The truth is that the wealthy continued to buy straight through the last recession and I see no reason to think they will stop if the market fades.  In fact, it seems to drive their investment, as they rush toward hard assets.  I also am seeing a lot of commercial leasing activity in NYC especially in the office sector.  Now, outside of New York City -- particularly in Connecticut- both the investment and the luxury residential markets are slower, but I think that has something to do with the state of Connecticut’s poor finances.  But in New York City and other capital centers, there is still momentum, at least in my end of things. 

RESPONSE #5

On the retail leasing side, seeing some food and apparel tenants struggling and asking for concessions/threatening to go dark/file for bankruptcy.  On the development side, seeing smaller players re-evaluating affordable/rental projects and cashing out.  On the condo side, units under $2M still selling/competitive

RESPONSE #6

Notwithstanding a fair amount of doom and gloom in the press, our real estate and finance groups remain busy.  On the dirt side, most of our clients are value-add players, and they seem to be able to find opportunities.  We focus mostly in the office, retail and multi-family sectors.  Some industrial becoming hot now as well, mostly in the boroughs.  We represent both sponsor and equity groups, and our clients are doing deals on both sides, so we’re doing the dirt, financing and JV work.  On the finance side, we represent a host of non-traditional lender groups, most of whom are very busy, given the withdrawal of many banks, especially on the construction side.  Our clients are actively making bridge, mezzanine and pre-development loans, as well as traditional construction loans.

RESPONSE #7

We are seeing a drop off of deal flow across our network (multiple offices in major cities).  Not enormous but notable.  Hours are off by about 10% from last year in each office, with remarkably little fluctuation by office.  Personally, I have been seeing a greater number of term sheets for both debt and equity deals that do not go anywhere.  Clients seem to be working hard to find deals but not having as much success.

RESPONSE #8

In terms of what there is to see from the middle market niche where I sit, lots of agency lending, some bridge lending, little CMBS lending, and not much on the equity side.

RESPONSE #9

Class A and B+ office still doing well in NYC and across US – lease up times are longer than they used to be but rents are holding steady.

Retail is hurting – you don’t see the huge rents and the retailers seen to be few and far between – but our mall tenant side practice is holding its own.

I see very little distress.

The toughest market is the condo construction loan market but even there, at the right LTV and with the right project and developer, things are getting done.

I am seeing more complex deals, i.e. deals that need zoning approval or assemblages that take time or complicated ground lease deals – you don’t see the quick hit and flip that you saw over the last few years.

There is very little of sellers saying “it’s my way or I’ll go to the second bidder.”   The market has become more even between sellers and buyers. 

I actually like markets like this since lawyers are able to add value on complex deals and relationships matter as opposed to overheated markets where anyone with a checkbook can buy and flip. 

We are very busy both in transactional and leasing.

RESPONSE #10

This year we see many clients that find deals and the deals “almost” go forward.  They usually fail for pricing reasons.  We have had more “almost” deals this year than we have seen in a long time.  We are optimistic that this is about to change.  We cannot prove it but “feel” that the pricing gap is starting to narrow bit by bit. 

RESPONSE #11

While New York City remains quite a real estate bubble, everyone will acknowledge:

  • There are far fewer investment sales, in New York City as well as nationally.

  • There are too many new high-end condominium projects – no one is buying on Billionaire’s Row, and nearby.

  • Retail, from sleepy town strip malls to Fifth Avenue boutiques, needs to be repurposed, permanently.

  • Traditional construction lending has ground almost to a halt.

  • Residential rents are softening, widely.  Rent regulation will not likely ever go away, in New York City, for sure.  There will be increased vacancy, but not in the category that matters most -- affordable housing.

  • Office space is densifying; such that, instead of new leases with expansion space built in, tenants are taking less space for more staff.

  • EB-5 is in crisis. It is filled with fraud allegations and imprecise execution; there are also real concerns that the funds will not be there when needed, especially inasmuch as the majority of the EB-5 investors historically have been from China, where it is becoming increasingly difficult for the EB-5 investors to part with their own money.

  • Interest rates are rising.

  • Regulation is stifling lenders, in construction finance and beyond (be wary alternative lending sources).

  • Hospitality is overbuilt; and that sector is consolidating.

  • Both E-commerce and a tele-commuting workforce will foreseeably impact commercial real estate.

 

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As the Managing Partner of Duval & Stachenfeld – a 70-lawyer law firm in mid-town NYC known as The Pure Play in Real Estate Law – I am inviting you to join The Real Estate Philosopher™. This will consist of my thoughts and also thoughts of friends and colleagues.

It will not be published in any traditional media – it will go only to friends of our firm. The purpose here is very simple – to put forth thoughts in the real estate world that are different, provocative, and challenging of accepted wisdom. Hopefully, nothing said here will be mainstream thinking.

You may be wondering how I am qualified to write on these topics since I am “just” a lawyer. However, I have an unusual place in the real estate world. As the managing partner of The Pure Play in Real Estate Law (one of the largest real estate law practices in NYC), I interact with an incredible number of real estate players. This ranges from small real estate shops with nothing but a gleam in their eyes, to some of the largest real estate institutions in the world, and everything in between. This gives me a unique and global perspective and allows me to act as an amateur philosopher in the real estate world. This has always been my hobby and it is what I love doing.

Regards,

Bruce Stachenfeld
a.k.a The Real Estate Philosopher™

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