Of course, it is hard to know if one is truly in a bubble until after it pops.  And even if you could be sure that you are in a bubble, it is impossible to know when it will pop.  I am considering the signs of a bubble in wondering if we are in one now…..

The crash is now ten years old – does anyone remember anything about it other than how it was really smart to buy at the bottom?
Tax reform makes us all think that money will rain from the sky – and with a $1.5T tax cut, maybe it is raining money?
Bitcoin just hit $14,000 – I mean $16,000 – I mean $19,000 – and most people investing in it don’t really know what it is.  As an aside – and so I can be a humbug – I mentioned in my last Real Estate Philosopher article that if you wanted a good gamble, Bitcoin was a good place due to the Wave of Money still cresting out of countries with difficult political situations.  I admit I love when I’m right…..I hereby am not making any prediction about Bitcoin except that it is going to continue to be fun to read about it every day in The Wall Street Journal.
Stock markets keep hitting records and almost ‘never’ have corrections.  Does anyone even remember when the last bear market was? 
Elon Musk keeps getting billions of dollars for money-losing businesses and every time things get worse he just says we’ll invest in something else and the stock goes up.  Somehow Tesla is worth more than Ford or GM.  Really?
For Amazon, the latest article says it will be worth a trillion dollars next year – and, as I have mentioned in prior articles, after one subtracts stock based compensation Amazon has never made a penny.  I think that without the cloud side business, it has lost an awful lot of money, and continues to do so.  It is disrupting the real estate world because it doesn’t have to make money.
Unicorns – supposed to be mythical beasts – are now roaming all over the place, including populating the real estate world.  Most of them lose money and have never made money. 
Uber is supposedly worth $60B and (I think I was told) loses money on every trip – and it seems like a lot of parties are now going into the same business.  Indeed, little dinky companies like GM and Ford are going to compete with Uber.
Money gets raised for all sorts of things.  People are eager to invest in startups. 
Economists are bullish – I think unanimously bullish – no better indicator of a bubble than that.
Interest rates are still ridiculously low.  No one – and I mean no one – dares to even predict interest rates will ever rise again.  They are permanently low- right?
Everyone knows that the key to success in life is just put your money into index funds and ‘no matter what’ never sell.  Indeed ‘buy on dips’ has been the rallying cry, and only suckers sell any more.
Tax cuts for businesses will propel the stock market dramatically higher. 
Employment is at all-time lows but somehow inflation is tame. 
Overall there is greed and not fear in the markets.  I mean I admit it myself – I feel, well, “greedy.”  I “feel” like buying Bitcoin and have to restrain myself not to actually do that.  When someone pitches me a tech startup, I “feel” like investing – and, full disclosure, I just wrote a pretty big check only a few days ago into a tech startup. 
Also, when I read about a hot stock I “feel” like buying it.  And when a client approaches me about investing in a real estate deal I “feel” like saying yes.
Warren Buffett’s admonition is timely:  “Be greedy when others are fearful and be fearful when others are greedy.”  I bet Warren Buffet is fearful right now.
I ask you as you read this – are your investments in the black?  Are you eagerly looking for the next deal?  Are you stretching your underwriting standards just a bit?  Instead of distressed deals (your original business model), have you now ‘evolved’ to plain old ‘good’ deals?  Or have you further ‘evolved’ from ‘good’ deals to ground up development in order to hit your investment hurdle goals?
Do you remember what happened in 2001?  Many of us got caught up in the idea of investing in companies that didn’t make money.  It happened in early 2001 – Barron’s ran that famous report that showed all of the internet stocks and their cash burn and how many months they had left.  That made clear that the various emperors weren’t wearing any clothes and only about 90 days later it was all over.  Billions of dollars up in smoke and mirrors. 
What I always find fascinating is how fast fear turns to greed and greed turns to fear.  If there is a selling panic going on and someone yells ‘this is the bottom’ - then everyone piles in.  And if things go up too high and someone makes clear this is the top, there is a selling panic and everyone piles in there too.  Have you seen the movie Trading Places? 
This applies at market tops just as well when someone yells ‘look out below!’
Any day, any week, any month, any year, greed will turn to fear.
Okay, so if I am right, what will happen in the real estate world when greed does actually turn to fear?
The obvious answer is that those who got too far out over their skis will be hurt and those more prudent will not be hurt as bad. 
So, I say to everyone “stick to your long-term game plan.”  And don’t do the following:

  • Don’t let the animal spirits in the market change your underwriting.  To those clients who tell me mournfully:  “Bruce – I haven’t done a deal in over a year,” don’t let that push you to do something foolish.  Not doing deals is a moderate level bummer – doing a bad deal is a terrible, awful, horrible bummer that you regret for the (sometimes many) years you are stuck dealing with it – not to mention what it does to your long-term track record.

  • Don’t try to time the market.  You just can’t do it.  The goal should be long-term value creation, knowing that in the short run market swings will help or hurt you. 

  • Don’t put yourself in a high-overhead situation where you are pressured to do deals that are not good ones.

  • Don’t rush off to different geographies if the market you really know gets too expensive.  This is consistent with Warren Buffet’s admonition “If you can’t run your own business successfully it doesn’t make sense to then enter a new business you know nothing about.” 

  • Don’t ‘hunker down’ – I would never advocate that, as it implies you are trying to time the market based on the theory that it is too high now and it will go lower and, of course, you will know just the right moment to jump in.  Of course, keep on looking for good deals, which are harder to find and/or require different intellectual capital to unearth. 

  • Don’t sit by and let the brokers be the ones creating the value.  Instead of hoping brokers – or others – will call you with deals, I advocate that you be the one who “creates” the deals by figuring out a market anomaly – a non-obvious assemblage – a change of use – or another way to “create” the value in the deal. 

  • Don’t fool yourself into thinking that it is better to chase higher yields with higher risk.  If you do this, you haven’t really changed the risk profile of your business – it is really the same thing in the end in terms of expected upside.  The goal, of course, is to take advantage of situations in which the risk/reward does not balance but instead tips in your favor.

  • Follow the view that “competition is evil,” and avoid competition as much as possible.  As Michael Porter (and many other great thinkers emphasize) it is much more important to be “different” than to be “better.”

Before this article gets too long, I will end it with a lesson I recall reading after the 2001 market crash.  It was in Barron’s, I think, when someone wrote a piece saying:
      “We should have listened to Warren Buffett”
This time around, I don’t counsel hunkering down, but I do counsel not getting sucked in.  Bubbles always pop at some point. 
Since I always say one shouldn’t make predictions and then do it anyway, I will make a prediction about what will happen to real estate when the bubble does eventually pop: 
Development projects that are in mid-stream will get nailed; however, my sense is that, generally, commercial real estate with cash flowing assets will not get hit that badly and will be one of the ‘best’ places to be when the tide goes out. 

Sun Tzu and Operating Covenants in Retail Leases

By: Eric Menkes

As everyone knows, or has just recently learned, retail leases are ‘much’ trickier and ‘much’ more complicated than conventional leases.   This is because there are minefields in retail leases, such as continuous operating covenants, co-tenancy provisions, and exclusive use rights.  Putting them all together in a large project can be like playing chess in the future – and even if it doesn’t seem like it at the outset, there is a ton of money at stake depending on how well you – and your lawyers – can see what could happen.
It’s no secret that retail is in great flux right now, and that is playing out in all sorts of curious ways, especially in shopping centers, which are ground zero in the world of retail.
For example, what happens when anchors go belly-up? 
What happens when Amazon buys Whole Foods and decides to use the stores as on-line distribution centers, but other leases in the same project prohibit that?
What happens when a big gun, like Starbucks, decides to shut down an entire division and another big gun - like a billion-dollar mall owner, decides to fight back?

Right now all heck is breaking loose in shopping centers and malls and other places where there is a retail tenant mix.  Those who thought ahead are mostly doing okay and those who didn’t are being victimized.  Here are some thoughts from my retail leasing partners about a hot issue pertaining to Continuous Operating Covenants:

Landlords–especially shopping  center owners–often require their retail tenants to comply with a continuous operating covenant (i.e., the tenant must stay open for business for a certain number of hours and/or days).  The typical reasoning for this obligation is that:  (i) many retail tenants pay their landlords a percentage of their sales, so the store needs to stay open to maximize the sales; (ii) a shopping center is a co-dependent environment, where the highest foot traffic is generated if every store is open; and (iii) even office building owners want to have an active and busy storefront, since this helps fill the rest of the property with tenants.

For tenants, a continuous operating covenant is a significant obligation that is not undertaken lightly.  Rent is only one component of a retail business’s occupancy costs.  Hiring employees and maintaining current merchandise typically cost a good deal more than the rent, and these are painful obligations to meet when the business is suffering.

So what happens when a tenant breaches its operating covenant, even if it continues to pay the rent?  Courts are typically reluctant to enforce them:  it’s one thing to require a party to pay another damages, but it’s quite another to require someone to do something—so-called equitable remedies like specific performance are typically frowned on when damages will suffice.  That’s why most retail leases with operating covenants also include a liquidated damages concept:  if the tenant fails to open, then in addition to being in default, the tenant must also pay a specified sum for every day it fails to comply.  Courts have generally honored these provisions, so long as they are not perceived as being penalties.

Today, the retail industry is of course undergoing a major downturn, leading to significant tenant defaults, including breaches of operating covenants.  Some shopping center owners aren’t taking these breaches lying down, and they are not content to rely on collecting liquidated damages.  They are pushing the envelope by suing over breaches of the continuous operating covenant.  And surprisingly, some courts are agreeing.  It’s unclear if this is a judicial trend or just a response to a difficult economy, but in either case it’s got people paying attention.

Starbucks recently decided to shut down its Teavana tea chain, which meant shuttering some 379 Teavana locations.  Simon Property Group, the country’s largest shopping mall owner, wasn’t too happy with that decision and sued Starbucks, arguing that as a subsidiary of the massively successful Starbucks company, Teavana had the financial wherewithal to open but was nevertheless inflicting its selfishness on the poor mall owner.  Last month, an Indiana court agreed and required Starbucks to honor the continuous operating covenant in its Simon leases and keep 77 of the Teavana stores open.   Some have argued that this ruling was akin to indentured servitude.   But most observers felt that this was merely the finding of a hometown court agreeing with one of its state’s leading businesses. 

That was until a second court made a similar decision.  In early December, a Washington court granted a preliminary injunction requiring Whole Foods to reopen a store it had previously closed, finding that its lease did not permit it to close merely because it was not profitable; on the contrary, the court found the continuous operating provision enforceable and required the tenant to so comply. 

Is this a new trend?  Can a court force a tenant to stay open for business, merely because it committed to do so in a lease?  Taken a step further, can a court make anyone do anything, just because they said they would?  This certainly seems to run against conventional legal thought.  But then, we may not be living in conventional times.  Both cases will certainly be appealed to higher courts, so stay tuned. 

Like many firms, we have a significant leasing practice; however, we have made retail leasing the fulcrum of our leasing practice.  We have represented everyone in that sandbox:  shopping center owners, luxury street retail owners, mixed use project owners, big box tenants, in-line tenants, national and local retailers and restaurants. 

As the retail world is buffeted by these tempests, my team is not only available but impressively qualified to dig you out of trouble (if you are in trouble), capitalize on distressed situations (if you have capital to deploy), and to negotiate on your behalf (if you are just starting out).  I have been calling my leasing partners Restrictive Covenant Warriors  I am not sure they like that title but I am confident that they are the best in the business in retail leasing.  

The Recent Wave of Ground Lease Litigation Arising From Reset Provisions

As real estate markets get choppier, it happens more often that real estate players get into dispute situations.  In these situations we are pleased to have a powerful real estate litigation practice.  Our real estate litigators handle all sorts of real estate disputes ranging from partnership squabbles to foreclosures (offensively and defensively) to so-called “put-back cases” (both offensively and defensively) to so-called tranche warfare to bankruptcy-related disputes – and much more.  At D&S when a deal is in trouble we don’t just ‘turn it over to the litigators’ and wait around.  Instead, our litigators and real estate lawyers work together as a team to obtain good results for our clients.  Here is an article from our real estate litigators on the hot issue of Ground Lease Litigation from our real estate litigators referred to at D&S as “Strategic Warriors”.

In recent years, there has been an eruption of ground lease litigation.  The stakes are high in these cases, which have covered everything from urban office towers to far-flung shopping malls.  In a matter that we recently handled, a ground lease rent reset provision threatened to wipe out the entire leasehold interest held by the owner of an iconic office building in mid-town Manhattan.    

The main issue driving ground lease litigation is determining the value of “the land” when the rent for the ground lease is reset.  Ground leases generally have a term of somewhere between 50 and 150 years, and the initial rent may not be reset until decades after the lease is signed.  Since they concern events in the distant future, rent reset provisions may not have received adequate attention when the lease was signed.  Many leases simply state that the ground rent shall be determined based on “fair market value.” 

This vague language opens up a host of legal issues.  A threshold question is whether land value should incorporate the value of the buildings and improvements on the land.  Sometimes including the improvements will favor the land owner.  For example, the land under a remote shopping mall will generally have a greater economic value than a nearby parcel of vacant land.  This is not always the case, though.  The ground owner of an urban property with an older office building may argue that the land has much greater value as a development site, where the tenant could construct buildings with more lucrative uses, such as luxury residential housing.  Other issues include how land value is impacted by zoning changes or if the land is combined with adjacent parcels.  Resolution of these legal issues is highly case specific, depending on the terms of the lease, or possibly evidence showing the parties’ intentions when they entered into the lease.

Expert appraisals are another critical aspect of ground lease litigation.  The nature of land appraisals adds considerable uncertainty to case outcomes.  Competing expert appraisers usually disagree about applicable market trends, prevailing capitalization rates, and the financial feasibility of different land uses.  Small changes in assumptions in a discounted cash flow analysis, for example, will lead to widely divergent land valuations.

With so much at stake, it is essential to retain experienced litigation counsel, like Adler & Stachenfeld, who are well versed in the area.  D&S litigators have a major advantage because they can rely on their transactional colleagues, who have spent decades negotiating every conceivable aspect of ground leases.  The D&S litigators make their transactional counterparts an essential part of the team for every single manner – so they can make sure that their clients have the benefit of insights and arguments that “plain old litigators” could never come up with on their own.     

To discuss a potential ground lease matter, please contact one of the following D&S partners:

Your Capital Source Pulled Out of Your Deal?  Then Put Bruce to Use…

With the world shifting so fast, it is happening more and more that the money you thought you had for a deal vanishes at the wrong moment.  If this is happening to you, The Real Estate Philosopher might be able to help.
We have a slew of clients that are eager to invest throughout the capital stack.  This includes:

  • Common joint venture equity, i.e. as an LP

  • So-called “GP Capital”

  • Programmatic relationships

  • Platform investments

  • Preferred equity

  • Mezzanine and other high-yield debt

  • Construction financing

  • Bridge lending

So if your deal has a hole in the capital stack “Put Bruce to Use” and give me a call.  Maybe I can be of help by putting you in touch with one of my firm’s amazing clients.