While WeWork looks to have been a giant headache for its shareholders, it is the gift that keeps on giving for the financial press. We don’t want to be seen as piling-on the embattled company, but there’s no doubt that this saga has been a topical one. So this month we’re again going to discuss some of the issues raised by the headline-grabbing business.
There are thousands of companies around the world in which we could potentially invest. As a result, it is useful to have a mental checklist of attributes that would cause a company to be quickly eliminated as a potential investment. Valuation is an obvious one: if a company looks to be too expensive, there’s no point learning the nitty-gritty of its operations. Questionable accounting practices are another one: if we can’t trust a company’s financial statements, what can we trust? But in the case of WeWork, we believe it had an even more fundamental flaw: its entire business model.
WeWork is a lessor of shared office spaces. It provides a real-estate solution for smaller start-up companies or individuals who need an office but don’t have the resources to either: (1) build out an entire space themselves or (2) commit to a long-term lease. On the surface, this sounds like a pretty good idea!
WeWork doesn’t own the office buildings in which it leases out space. The company itself is also a lessee; it commits to renting larger office spaces from the building owners. WeWork then subdivides these spaces into smaller areas for its own customers to rent. Like most commercial tenants, WeWork commits to long-term leases with the building owners. As disclosed in its public filings, the average term of its leases is 15 years. It then subleases that space to customers for a much shorter time: an average term of less than two years.
When the economy is expanding, this mismatch between the length of WeWork’s contracts as a lessee and the length of its contracts as a lessor doesn’t matter. If a customer on a short-term lease doesn’t renew, WeWork can easily find a new customer to take the space. And as WeWork was founded in 2010, it has only ever experienced an expanding economy.
However, an economic downturn could be disastrous for WeWork. In such a scenario, not only would existing customers be less likely to renew after their short-term commitments end, but it would be much harder to find new customers to take over any vacant space. Meanwhile, WeWork would still be on the hook to pay rent on its 15-year lease commitments.
The financial jargon used to describe this is an “asset-liability mismatch”: the liabilities of WeWork’s lease payments to the building owners are much longer than the assets of its short-term rental agreements with its customers. A mismatch between assets and liabilities isn’t necessarily a problem on its own. Banks have a mismatch between long-term assets (such as mortgages) and short-term liabilities (such as deposits in savings accounts). Pension funds and insurance companies have similar asset-liability matching considerations. But banks, pension funds, and insurance companies all have a history of managing these mismatches effectively.
Shared-office-leasing companies, however, do not. IWG PLC (IWG-LON), formerly known as Regus, is one of WeWork’s biggest competitors. The company was founded in 1989 and grew steadily over the next decade. Then, as the dot-com bubble grew, so did IWG’s office footprint. After the bubble burst, however, IWG’s revenue went down with it: the company filed for Chapter 11 bankruptcy protection in 2003 when it was unable to pay the rent on its own long-term leases.
Investing on borrowed time
Asset-liability matching isn’t just an abstract concept for corporations to worry about. Individuals should keep it in mind too. This is especially true when it comes to borrowing to invest. Also called “buying on margin”, brokers will provide clients with loans to purchase marketable securities. However, these loans typically do not match up well with the assets they’re used to purchase.
We have a long-term investment horizon of approximately five years because we believe that history has shown that this is the length of time it takes for underpriced securities to realize their intrinsic value. Within that five-year period, an individual security can (and probably will) temporarily decrease below our original purchase price. We don’t mind; we can wait.
For investors buying on margin, however, waiting is not an option. A margin call could be triggered if the stock price falls and causes the value of the account to fall below a pre-determined amount required by the lender. When a margin call occurs, the investor must either deposit more funds into the account to bring the value back above this required level or sell shares to raise the funds.
Thus, there is a big mismatch between the long-term nature of assets such as equities and the short-term nature of liabilities such as margin. This is why we would not recommend buying on margin.1 Alternatively, if you could somehow find someone that was willing to loan you funds that don’t need to be repaid for, say, 30 years, that would be a pretty compelling way to finance the purchase of some equities!2
When costs are fixed, any incremental cash flow goes straight to the bottom line. WeWork has benefited from this fact with the growing demand for its shared workspaces. Equity investors buying on margin have benefited from this during the ongoing bull market. Additionally, homeowners across Canada have benefited from this as housing prices have increased. But leverage works both ways. And if liabilities – which must be repaid no matter what – are not properly matched with cash-flow-producing assets, the downside risks can be disastrous.
1Yes, this is investment advice.
2This, most-definitely, is not investment advice.