The US commercial real estate (CRE) sector is experiencing heightened concerns due to increasing interest rates and diminishing credit availability. In the third quarter, US banks faced challenges from the CRE loans in their portfolios. For instance, Morgan Stanley allocated an additional $134 million for credit losses, in addition to the $161 million provisioned in the previous quarter, attributing this to worsening conditions in the CRE sector. Bank of America saw its nonperforming loans surge by $707 million, reaching $4.8 billion in the third quarter, driven primarily by CRE.

While it might seem like the entire sector is facing turmoil, it is important to note that CRE includes a wide range of assets. Segments like industrial, retail and hotels remain relatively stable, whereas offices spaces are facing substantial difficulties.

JLL reports that the US office vacancy rate has soared to 21%, a peak not seen in over 25 years as of Q3 2023. The imbalance between supply and demand is reflected in the 18.3 million square feet of negative net absorption, contributing to an annual total occupancy loss of 51 million square feet, although the vacancy rate differs significantly between the high-quality segment of the office market and the more obsolete ones.

Furthermore, the Trepp CMBS Special Servicing Rates for offices, which tracks the share of loans at risk of default, surged to over 8%, the highest since May 2017. This increase suggests more challenges ahead.

The sector also faces a huge refinancing hurdle. From 2023 to 2025, nearly $1.36 trillion in CRE loans will mature, a quarter of which are collateralized by office properties. Even with prevailing rates, new lending rates are likely to be 3.5 to 4.5 percentage points higher than existing mortgages.

The combination of high vacancy rates and rising interest rates complicates refinancing efforts. Lenders and CMBS investors have significantly tightened underwriting standards, pushing the loan-to-value (LTV) ratio to around 53%, the lowest in 23 years, and well below the historical average of around 65%.

This shift and higher financing costs could devalue office properties by around 20% for prime buildings and over 60% for lower-quality ones. While public market valuations are resetting, the private market has been slower to respond. A narrowing valuation gap between these markets is expected as risks persist.

The increase in office landlords defaulting on loans is concerning, with some properties falling below their mortgage values, prompting landlords to surrender properties to lenders. Even leading office owners like Pacific Investment Management Co. and Brookfield defaulted on their mortgages earlier this year. Most landlords have managed to maintain their mortgages due to typically long-term office leases, but as more mortgages come up for renewal, we expect an increase in defaults.

The typical capital structure in CRE is around 30% to 40% equity and 60% to 70% debt, with banks owning around 60% of the loans. Therefore, there is concern that the challenges in the CRE, especially the office sector, may trigger another banking crisis.

The basic problem is an oversupply of office space. Solutions like converting office spaces to residential use are being discussed, but only 10% to 15% of US offices are suitable for residential conversion. Government support may be necessary to incentivize and facilitate these conversions. Cities like Boston, New York, Washington DC, Chicago, Portland, Los Angeles and the Bay Area have already started incentivizing office conversions since the pandemic.

In our portfolios, we hold a few positions with exposure to commercial real estate:

IWG, which we talked about in a recent commentary, is the world’s largest provider of workspace solutions. While the growth outlook for traditional offices is in question, demand for flexible workspace has been growing, driven by the structural growth in flexible and hybrid working. Higher vacancy rates at office buildings also allow IWG to negotiate better lease terms with landlords. With a major competitor WeWork fading out of the landscape, IWG is well-positioned to expand its network.

Savills, established in 1855, is a leading global real estate advisor with expertise in various segments including residential, office, industrial, retail, leisure, healthcare, rural and hotel property, and mixed-use development schemes. Its revenue is diversified, with 40% from transaction advisory (30% commercial, 10% residential), and 60% from stable segments like investment management and property management. Despite a decline in transaction advisory business in the first half of the year, revenue growth in property management has kept its business relatively stable. Savills generates over 85% of its revenue from the UK, Asia Pacific, Continental Europe and the Middle East, with less than 15% from North America. Office occupancy rates are higher in Asia Pacific (79%) and Europe (75%) compared to the Americas (50%), suggesting less distress in these regions. Savills has a strong balance sheet to weather the current turbulent times.

The hotel sector, while hit hard during the pandemic, is recovering faster than offices. With international borders reopening and a surge in travel demand, hotel occupancies, especially in cities like London, New York and Tokyo, are improving and contributing to a strong investment outlook supported by fundamental performance.

Melia Hotels, a major holding in our strategies, is seeing strong bookings and improvements in occupancies and RevPAR. The company operates 350 hotels, with nearly 92,000 rooms globally. Despite its quality assets, it is trading at a significant discount to its net asset value, but increasing transaction volumes in the industry at higher multiples may reduce this discount.

We recently initiated a position in Hoshino Resorts REITs (HRR). Sponsored by Hoshino Resort, HRR has an extensive hotel portfolio, including upscale resorts and city hotels. Its flagship hotels managed by Hoshino Resorts show a strong recovery, with RevPAR 20% above pre-pandemic levels.

Despite ongoing challenges in the CRE industry, we believe the resilient business models and strong balance sheets of the companies in our portfolios will help them navigate these difficulties.

Within the emerging market universe, plenty of ink has been spilt on extreme pessimism regarding China and over-the-top optimism around India. Yet, as the following chart shows, small-cap stocks in Mexico have quietly been a top performer in the post-pandemic period.

Mexico’s unforeseen rise 

Growing tension between China and the US has positioned Mexico as an unintended beneficiary due to its geography and the trend among companies to shock-proof their supply chains through nearshoring.

Will this time be different? 

As noted in an earlier weekly, we recently met with companies across various sectors in Mexico and most of the executives we spoke to seemed convinced that the nearshoring wave was sustainable while also being realistic about the challenges ahead.

They have good reason to be pragmatic. The last time the economic stars aligned for Mexico via NAFTA (North American Free Trade Agreement) in 1994, the country delivered mediocre growth of around 2% and watched on the sidelines as China took full advantage of a shift in manufacturing from the West. The question now is if the outcome will be any different this time. 

The nearshoring challenge trifecta 

Mexico’s ascent as a key supplier to the US can be traced to three key events: Trump’s tariffs on China in 2018, the US-Mexico-Canada Agreement (USMCA) that raised the bar for North American product content requirements and pandemic-induced supply chain disruptions. These factors, coupled with deteriorating US-China relations, have led to Mexico surpassing China as a supplier to the US this year.

However, as emerging market investors, we know that structural tailwinds that are attractive and advantageous today don’t preordain good outcomes. Our conversations with Mexican executives at the recent LatAm conference gave us a good reality check on the constraints they face on the ground, from infrastructure and water supply to the political climate. 

Electric dreams, grounded realities

While Mexico generates sufficient power, it struggles with inadequate transmission infrastructure in its north that hinders industrial growth. We spoke to two industrial REIT developers that had to build their own power systems, passing those costs to customers. For perspective, Mexico’s state utility, CFE, built 150 kms of transmission lines in 2022 compared to Brazil’s Electrobras’ 8,679 kms. 

Parched prospects

Water availability is another constraint, especially in Nuevo Leon, home to the populous city of Monterrey and the large, water-hungry beverage industry that includes Heineken and Arca Continental, one of Latam’s largest Coke bottlers that extracts billions of gallons of water under federal concessions. As recently as 2022, Mexico had declared a drought in the state of Nuevo Leon and yet Tesla plans to open a factory there.

The political maze 

The final speed breaker to the nearshoring story could be politics and a volatile security situation by the US border. On the political front, Mexico’s President recently demanded that airport operators in Mexico reduce their tariffs even though they were bound by law via a concession system instituted in 1998. In terms of security concerns, the cities of Juarez and Tijuana, while strategically located across the border from California and Texas, have a history of gang violence and cartels profiting from piracy and counterfeiting.

Mexico’s unique competitive edge 

Despite these hurdles, Mexico offers several advantages, including lower labour costs compared to China, a younger workforce and significant investment in GDP, particularly in nearshoring and public infrastructure projects. 

Unlocking nearshoring potential 

With plenty of natural resources, a faster lead time and shorter distance to market, we think Mexico can continue to benefit from current trends with some policy support. Our Mexican holdings offer three different ways to access the nearshoring theme. 

Grupo Cementos de Chihuahua (GCC MM) – Primarily selling cement in the US, GCC also operates in Chihuahua. It benefits from strong volume demand generated by the region’s growing industrial sector, particularly maquiladoras and warehouses near the Texas border. Recently, GCC expanded its Samalayuca plant and now supplies cement to about 85 projects in Northern Mexico, serving clients like Foxconn, Wistron and Pegatron.

Regional SAB de CV (RA MM) – Known as “Banregio,” this Mexican bank specializes in lending to small and medium enterprises, with a strong focus in Neuvo Leon, its home state and a big beneficiary of the nearshoring trend. With about 45% of its assets in the region, Banregio is poised to benefit from the growth of industries supporting multinational corporations relocating to Mexico, thanks to low credit penetration and an expected easing cycle.

Grupo Aeroportuario Del Centro Norte (OMAB MM) – OMA, managing 13 airports in Central and Northern Mexico, sees its largest traffic accounting for nearly half of its total at Monterrey Airport. Despite recent concerns about tariff cuts, we remain positive on OMA both for its exposure to nearshoring and potential for growth in its commercial business. The company operates six airports closely tied to nearshoring, covering 33.5 million square metres of industrial gross leasable area, about 35% of Mexico’s total.

A crucial crossroads 

The real intrigue lies not in what Mexico has already achieved, but in what it could accomplish moving forward. Will it leverage its current position to create a more diversified, resilient economy, or will it repeat the patterns of the past? As global dynamics continue to shift, Mexico could be a big winner and serve as a blueprint for other emerging markets navigating the balance between risk and opportunity.

WeWork’s downfall and IWG’s ascent 

Last week, WeWork, once regarded as the world’s most valuable start up, declared bankruptcy. This decision followed weeks of speculation. WeWork’s mission of being the leading global co-working community came to an end due to its relentless pursuit of growth. Its initial misrepresentation as a tech company and consistent cash burn from unprofitable leases indicated overambition from the start. This development provides an interesting opportunity for one of our holdings.

With WeWork’s restructuring of its extensive 700-plus-location portfolio, IWG (IWG LN) stands to benefit from less competition and an opportunity to expand its own network. For years, WeWork imposed pricing pressures to attract members. Now, this industry-wide pressure should ease, to IWG’s benefit.

IWG, the world’s largest provider of workspace solutions, began its operations in Brussels over 30 years ago. With more than 4,000 locations across 120 countries, its early entry into the market has been advantageous. The company is currently trading at 5.44x EV/EBITDA, a notable multi-year low. It has demonstrated strong pricing power and momentum, with revenues up 14% in the first half of 2023, totaling a record £1.7 billion. The company has focused on revenue growth and free cash flow generation, which has helped strengthen its balance sheet by lowering net debt.

Several years ago, to boost its top line and margins, the company introduced a capital-light business model. This model is particularly interesting due to the lower CAPEX requirements because of sharing agreements with building landlords for office space renovations. IWG partners with landlords for management, operations and member recruitment in return for a management fee. Additionally, the model includes franchise agreements in two forms. The first involves master franchise agreements, where a partner buys out an existing IWG portfolio and commits to additional office roll outs, paying a franchise fee. The second form involves franchised locations in existing markets, where IWG partners with smaller franchise owners to open new centres in markets that IWG already has presence in. This strategy has gained traction, with 582 new centres opened this year compared to 421 in 2022.

For the last couple of years, IWG was affected by its association with WeWork, trading in parallel despite superior financial performance. Though the pandemic took a toll on the coworking sector, IWG continued to generate strong positive free cash flow and EBITDA margins consistent with the company’s historic levels. In contrast, WeWork was aiming to grow revenues, but showed negative EBITDA margins and free cash flow.

Source: Bloomberg.

Around September 2022, IWG’s stock price finally decoupled from WeWork’s as the troubles continued to brew for the latter. Following Q2 2022 results, it became evident that despite growing occupancy at WeWork offices, it continued to offer price cuts to members to contain retention rates unlike IWG that not only grew occupancy but was beginning to raise prices, a trend continuing to date.

In the current market, which still seems to favour some growth stocks with weak financials, we continue to prioritize companies with healthy balance sheets and promising profitable growth prospects.

Investment opportunities can be found in every industry, though some may be easier to get excited about than others. However, as many astute investors, including Warren Buffett, have noted, “boring” companies and business models can be just as profitable as those flavour-of-the-month stocks. This week, we profile ELIS SA (ELIS FP), a boring company that Global Alpha got excited for.

Based in Europe, Elis specializes in renting and maintaining flat linen, workwear and hygiene appliances. Founded in 1883 in France, Elis operated as a family business for three generations before going through several leveraged buyouts and ultimately going public in 2015. The company has 440 production and distribution centres across 30 countries and a workforce of over 50,000 employees. With 75% of its revenues derived from markets where it leads, Elis is a dominant force.

Elis caters to a broad spectrum of customers, from hospitals needing linen to industrial companies needing uniforms exposed to dirt or chemicals, to small kitchens preferring not to manage towel cleaning in-house. Elis’s full-service solution relieves customers of managing inventory, ordering replacements or cleaning – handling all of the buying, renting and logistics. Customers have the option of variable pricing based on usage and service frequency or a fixed rate, typically under four-year contracts. Revenue is split almost equally between corporate and smaller businesses.

The textile rental market has seen growth, gradually replacing customer-owned textiles in the last decade, driven by cost savings, efficiency, improved hygiene standards and ESG commitments. Elis’s competitive advantage is its scale; its model is most efficient in densely populated areas, optimizing logistics and maintain margins. Elis strategically expands through acquisitions, improving its geographical presence to best utilize its distribution centres. This strategy has been paying off. In 2009, Elis derived 80% of its revenue from France, compared to less than a third today. More recently, it also started operating in Mexico through an acquisition that immediately made it the country’s largest player.

It’s worth taking a moment to explore the sustainability benefits of Elis’s solutions. As companies become increasingly mindful of their energy and resource use, they are also paying more attention to the companies they outsource to. Elis holds up very well under this scrutiny. The company has implemented various initiatives and made commitments to reduce its environmental footprint. For example, it pledged to cut water consumption per kilogram of linen processed by 50% by 2025, using 2010 as a baseline, and it has already achieved a 43% reduction by 2022. The company has also vowed to lower energy consumption by 35%, transitioning its fleet to alternative vehicles and reusing 80% of its end-of-life textiles. None of its clients have the capacity nor the inclination to manage their linen and workwear-related environmental impact as effectively. Furthermore, Elis offers ancillary services that directly help clients in reducing their own footprint, such as reusable scrubs in healthcare facilities that reduce CO2 emissions between 31% and 62% compared to disposable scrubs, or cloth roller hand towels that reduce emissions by 30% compared to disposable paper towels.

What makes Elis an appealing investment for us? It stands out with significant market share, a strong brand and a sustainable competitive advantage. It operates a resilient, non-cyclical industrial service with a business model adaptable to external disruptions. From COVID-19 and energy price shocks to wage inflation, the company has adeptly navigated recent macroeconomic events, maintaining its pricing power and protecting profits. With its strong free cashflow and flexible cost structure, we believe Elis is well-equipped to manage debt, and engage in strategic M&A and share buybacks, positioning it to excel in both bear and bull markets.

While a linen rental business may not intrigue everyone, our focus remains on identifying quality companies at reasonable valuations, no matter the industry.