A Megatrend in the Making
In 1800, shortly after the onset of the Industrial Revolution, 94% of American lived in a rural setting. Almost all of them were farmers or ranchers.
100 years later, that figure had dropped to 60%. Technological advances during the 19th century that facilitated industrialization made farming less dependent on manual labor.
That same wave of technological innovation spawned a generation of oil magnates, steel barons, and railroad bosses. To build their fortunes they employed armies of engineers, accountants, and lawyers that worked in office buildings under the watchful eyes of imperious supervisors.
That dynamic had the desired effect of attracting investment capital, some of which went into constructing office buildings to house even more “knowledge workers.” By 1990, only 25% of American lived in a rural setting.
The other 75% resided in or near urban centers to facilitate commuting to their places of employment. As a result of that dynamic, vast fortunes were made in commercial and residential real estate development.
The residue of that evolutionary process is readily visible as you drive by any major city in the United States. Sprawling suburbs surround a densely populated city center connected by highways, railroad tracks, and subway systems.
To be sure, urban centers are not going away anytime soon. They offer employment, restaurants, sports arenas, and theaters that many people find appealing.
But one aspect of their genetic makeup is undergoing drastic change. A new wave of technological innovation is lessening demand for commercial office space, the long-term ramifications of which are difficult to predict.
Room to Spare
The onset of the coronavirus pandemic forced most employers to temporarily close their offices. The virus is transmissible through close human contact, rendering office cubicles and shared workspaces useless.
But thanks to recent innovations in cloud computing, employees could log in from home and perform the same duties there as they could in an office. After a while, a lot of them came to like it.
Working from home meant less money spent on commuting, office attire, and restaurant meals. And from their employers’ perspective it also meant less money spent on office space, cleaning services, and supplies.
That explains why the amount of unoccupied commercial office space in the United States reached an all-time high of 16.4% during the second quarter of this year. That is higher than its peak rate fifteen years ago during the global financial crisis.
By 2026, a third of all office leases in the United States are due to expire. And with employees stubbornly refusing to return to a traditional office environment, many employers will not renew their leases.
That sets the stage for the next megatrend in real estate development. If that space is not going to be used for housing workers, then it will be redeveloped for some other purpose.
Already, some cities are converting office buildings to multi-family housing. There is a shortage of affordable housing in America, as residential real estate prices soared during the pandemic.
However, converting an office building to living space is problematic and can be prohibitively expensive. In some cases, it is cheaper to knock down an office building and start over from scratch.
I don’t know how it will turn out, but I do know this. By the time it is over, vast sums of money will be made and lost.
I smell a “quick strike” investment opportunity. Wall Street has a long history of overreacting to new megatrends in the making.
On September 21, real estate investment trust (REIT) W.P. Carey (NYSE: WPC) announced that it will divest all its commercial office property within the next six months. Less than one week later, its share price was down 15%.
However, the commercial office property in question only accounts for about 15% of Carey’s annualized based rents (ABR). In short, Wall Street is behaving as if Carey will get no financial benefit at all for those properties.
We already know that is not the case. As a result of this transaction, Carey will transfer $169 million of existing mortgage debt to the new entity that will own those properties. It will also receive some payment for those properties from the proceeds of that entity’s initial public offering.
Unless there is more to this deal than Carey is saying, WPC is oversold and should rally in the weeks to come. It opened this week below $57 after starting this month above $65. That leaves enough room for a nifty little options trade.
A few days ago while WPC was trading near $57, the call option that expires on November 17 at the $55 strike price could be bought for $2.50. A call option increases in value when the price of the underlying security goes up.
If WPC makes it back to $60 by the time this option expires, the return on investment would be 100%. Of course, this option could also expire with no value if Wall Street keeps dumping the stock.
I don’t think that is likely to happen. Once the initial panic selling is over, Carey’s share price should gradually rise to reflect the true value of the proposed transaction.
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