A Shared Space Revolution – Part I

Urbanization is before us. Cities are a gamechanging technology, and while they’ve been around for millenia, in our most mobile moment, they’re becoming even more attractive and important. The UN expects 2 in 3 people globally to reside in cities by 2050 (it’s already 8 in 10 in North America). So expect cities to get more crowded, more expensive, and yet more exciting, as time passes.

Urbanization dictates huge changes in how we interact, share, connect and live together. Cities are a major new frontier for technologies under the ‘Smart Cities’ banner. But as a technology in and of themselves, cities are perpetually in beta. One of the components of the forever-beta test is how we share space. Old components of this technology, including parks, shopping districts, and streets evolve here and there, but have remained in their primary form, seemingly forever. We value them, and visit them often. But population density increasingly requires us to bring the way we share those spaces into the much more private realms of internal space.

We’re seeing this happen. In fact, it’s what the ‘sharing economy’ is all about. AirBnB, WeWork and Uber, at a core level, are each about sharing areas once thought private just 15 years ago (namely your home, office, and car). We should expect our sense of private and public space to continue to change more rapidly in the coming years. Expect them to bleed together.

 

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Landed in the 6ix

After 11 years away from the Province of Ontario, I’m pretty proud to be back. In a small way, I feel like I’ve missed some of my home province’s best moments. Either way, there’s no question that Ontario generally, and Toronto in specific, has grown up a lot while I’ve been gone. Pushing 6 million people, ranking in the top 4 cities in North America in tech talent, and boasting an incredibly international and cosmopolitan population, this is a city with a buzz.

Despite these virtues, there’s so much work to be done, and that’s what I’m particularly excited to be a part of. This is a city that didn’t know what co-working was until about 20 minutes ago. It’s got two of the best pieces of urban transit infrastructure in the form of its two subway lines, and yet most of Bloor street has two-storey buildings lining it, with tons of potential to support Toronto’s continued growth. There’s so much upside.

But by far, I’m most excited about the fundamentals of this city, and my home country and province. To name a few:

• A population welcoming of immigrants and ‘others’
• A society that vehemently supports rule of law, and routinely ranks lowest globally on indexes of graft and corruption
• Home to educational institutions that are ranked among the best in the world
• Clean air, clean water, and a pretty consistent commitment to protect them
• Balanced respect of collective and individual rights
• A stable economy, currency, and trustworthy institutions stewarding both
• Free healthcare for all citizens

Canadians are philanthropes in the truest definition of the word. Such a disposition is exactly what generates the canvas of cities and communities which I am so excited to be apart of, and to help build. I know I’m late to the party, but can’t wait to jump in.

Encouraging Homeownership?

Whaddya say we give about $77 BILLION to the middle and upper middle class to help them buy homes?

If from a standing start, the policy considerations started out that way, I doubt it would be particularly popular. Nevertheless, that’s roughly what America does every year through a tax deduction called the Mortgage Interest Tax Deduction.

Basically, the idea works like this: When you pay your mortgage, you pay the bank Principal (usually) and Interest (always). The interest is the cost of borrowing the money – it’s a personal expense like utilities, your mobile phone bill, or food. But it’s an expense only born by those that can afford to, and have chosen to, buy a home. Now to encourage you to take the risk of buying a home (the perceived justifications for this we’ll come on to) the US government allows you to take that interest cost and deduct it from your income to reduce your taxes.

Here’s how it works…

Tim earns $100,000 per year. Tim owns a house that he bought for $900,000, for which there is an $800,000 mortgage. With an interest rate of 5%, Tim’s annual mortgage interest is $4,000.

If the income tax rate is 40%, under normal circumstance, Tim would pay $40,000 in tax, and be left with $60,000. With a mortgage interest tax deduction, the $4,000 Tim paid in mortgage interest is deducted from the gross $100,000 earned before taxes are calculated. Thus, it’s as if Tim only earned $96,000, and would thus pay $38,400 in tax, keeping $61,600. The benefit of the deduction is $1,600 more in Tim’s pocket!

Now consider a few additional points:

1. The bigger a mortgage you take on, the more you save. Americans can declare mortgages worth up to $1 million (including on second homes such as ski lodges or summer homes).
2. Therefore, rouhgly speaking the wealthier you are, the more of a benefit this represents.
3. This is a particular incentive to those that live in parts of the US with higher home values, and thus bigger mortgages.
4. The benefit can only be declared if taxes are ‘itemized’. This effectively means that it only helps those with incomes and deductions high enough to exceed basic personal allowances (in various jurisdictions, individuals don’t pay tax on the first, say, $4,000-$11,000).
5. It’s usual to allow businesses to deduct expenses like interest from their profits before charging corporate tax, but mortgage interest is one of the only deductions offered for personal income tax purposes. Like I said before, you don’t get to deduct your utilities or mobile phone (save to the extent that you use them for business).

So with a basic understanding…why is this in place? The initial implementation was a vestige of the pre-WWI US economy. In 1913, the US enacted income tax, which featured a deduction for all forms of interest (not just mortgages but other loans too, etc.). But the income tax also only impacted income over $3,000, a level earned by only 1% of the US. The sense in offering a deduction was that those earning over that were likely declaring business income from farms or other small family businesses. In this case, offering a deduction for personal interest encouraged business investment.

Fast forward to 1986. Amendments were made to income tax deductions that stopped deductions for interest….except mortgage interest. A real estate lobby was strong enough at that point to encourage this to continue on the premise that homeownership was an important social end for the stability of communities and the wealth of American families – a premise long challenged and one I struggle with personally as a strong proponent of rental housing. This is largely the basis for the maintenance of the deduction today. See this recent press release from the National Association of Realtors on the subject.

Here’s why I struggle:

1. There’s very weak evidence that this deduction actually stimulates homeownership. Indeed Canada doesn’t have the deduction, and has a higher homeownership rate than the US. Granted Canada offers other incentives like nil capital gains tax on the sale of the personal residence….but the point remains.
2. I don’t really understand why homeowners cause stronger communities than renters. Indeed few challenge the strength of German or Swiss communities, and they have far lower rates of homeownership than the US (c.52% and 44%, respectively vs c.64% in the US and c.67% in Canada).
3. At low rates of income, American’s can’t really take advantage of the deduction anyway, so I don’t see how it’s support for the aspirations toward homeownership.
4. If indeed it does somehow support homeownership, it’s a demand-side subsidy, which would have the effect of driving prices up, rather than a supply-side subsidy (creating more housing) which would make the cost of housing actually cheaper for more people to access.

I think the National Association of Realtors’ release supports my point. They argue that  homeowners are wealthier (allegedly 45x that of renters), and concern that prices could fall by as much as 10% if the deduction is dropped (feels high given my worked example above, but let’s say they’re right). I think the intentions here are pretty transparent…wealth transfer to the middle class…but why?

By contrast, the budget for Housing & Urban Development, the department that supports affordable housing initiatives for those priced out of housing altogether (as both renters and homeowners), looks like it will be just c.$38bn this year…vs. a subsidy worth twice that for people like me who would likely endeavour to buy homes regardless of the deduction.

This one’s a big sticky subject, but as ever….would love your views.

The reading list:

1. NYT – Who Needs the Mortgage-Interest Deduction, 2006
2. Atlantic – Taking Aim at the Mortgage-Interest Deduction, 2017
3. NAR – House Delivers Tax Hike on Homeowners,  2 Nov 2017
4. Glaeser + Shapiro – The Benefits of the Home Mortgage Interest Deduction, Jan 2003
5. Wikipedia – Home Mortgage Interest Deduction

HBC/WeWork : True Mixed Use

It’s hard to miss the cadre of established companies tripping over themselves to secure mindshare and wallet-share from Millennials. There are few companies more ‘established’ than the Hudson’s Bay Company (TSX: HBC), 3 years short of its 350th birthday, and firmly one of the oldest companies in North America (if not the world). But if you take a walk through many of their retail environments, you can feel the age…and I don’t mean in the elegant, awe-inspiring sense, but rather in the worn-carpet, low dropped-ceiling-height, tatty metal racking sense. If you really want a sense of the difference, visit the Bay before a trip to London, and then nip into Selfridges (Canadian owned by the Westons) or Harvey Nick’s. Night and day. It’s not remotely a surprise to me, then, that HBC struggles with self-actualizing Millennials who prefer good service and far sexier shopping experiences like Zara, Urban Outfitters, etc. HBC’s website proclaims it ‘Canada’s Iconic Department Store’ – the middle two words are about as exciting to Millennials (like me) as the words ‘Fax Machine’.

ASIDE: If the might of the Millennial consumer interests you, Goldman has a great infographic overview for you.

Nevertheless, what HBC does have is AMAZING real estate. It’s stores in Vancouver, Calgary, Toronto, and Montreal are, as hockey-fans say, “centre ice”: fantastic locations, and great bones for just about any use (maybe save residential). Indeed when Richard Baker bought the Bay in 2008 it was ostensibly about the real estate. Though the Bay now joined the company of Lord & Taylor, and Saks Fifth Avenue, it was quite clear shortly after Baker acquired the Bay that the real estate may be worth more than he paid for the whole the company. 10 years later, as the conventional brick+mortar retail sector shrivels, that looks to have been extremely important, let alone shrewd.

But a quick walk through any of the Bay’s stores reveals a compounding problem. They’re way too big for the demand they serve, and most of the best locations are multi-storey (the flagship Toronto store is 6 storeys above ground…when was the last time you bought anything on the 6th floor of a building?). You don’t need much data to see that sales per square foot on the upper floors are awful. Just walk up there at peak non-Xmas shopping times (say a Friday PM in October) and count the shoppers (read: tumbleweeds). This under-use is really a travesty, not just for the Bay, but also for the cities in which these buildings exist.

This is why I love what HBC + WeWork have just announced.

The announcement centres on Rhone Capital – a partner and investor of WeWork – acquiring the Fifth Ave NYC Lord & Taylor store, but that’s just a real estate deal. WeWork is growing like a weed, has a huge amount of capital available to it, and is addicted to its home market of NYC. If WeWork is news to you (it will be to many in Canada), I suggest you see what Wired Magazine recently shared. HBC can use this deal to prove real estate values on its books (apparently, WeWork are paying c.35% more for that building than HBC investors were told it was worth).  But it’s the c.$100m that WeWork’s partner Rhone Capital will invest into HBC, and the relationship with WeWork that ensues that I find really interesting. WeWork will start to lease the underperforming upper floors at HBC flagships in major Canadian markets (and possibly it’s Berlin flagship of Galeria Kaufhof), and fill them with literally hundreds of Millennial co-working office workers, immediately above the stores. How better to revive a retailer’s fortunes than to place their ideal customers literally above their heads? And remember, it’s not just a few static consumers moving in above. The tenure of the average WeWork occupier is roughly 2 years, so there’s some great turnover that will result here for the Bay, AND, if they get it right, all of the investors, customers, advisors, tire-kickers, event participants, etc., that go to-and-from WeWork on a daily basis will be driving footfall at the retail stores conveniently located below. That traffic would be a major multiple of the actual ‘WeWorkers’ occupying upstairs.

How does this all help WeWork? The insatiable demand for growth to maintain a $20bn+ valuation is helped dramatically. During their 7-year romp around the world they have saturated favoured markets like London, New York, San Francisco, Boston, and even increasingly Shanghai. But their penetration in Canada has been pretty low. Indeed their first Toronto location just opened in August after a lengthy battle with liquor licensing to enable their free beer taps (I kid you not). Exclusive access to HBC upper floors immediately adds some of the most central, lively locations in the top markets in Canada, including Granville Island, Vancouver; Queen + Yonge Sts, Toronto; and St. Catherine’s Street; Montreal.

I’d think of the deal summary as follows:

WeWork gets:

1. An incredible new flagship building on Fifth Ave, NYC
2. Exclusive access to some of the most centrally located real estate in Canada in internationally recognized micro-locations
3. The addition of multiple relatively important markets in one fell swoop
4. An indirect ownership stake (through its investor, Rhone Capital) in what is probably an undervalued retail/property company

HBC gets:

1. The ability to repay over $1bn in debt (very imporant!)
2. A new deep-pocketed strategic investor
3. Reduced cannibalization/competition for its premier Saks Fifth Avenue store (by diminishing the presence of its Lord & Taylor store around the corner)
4. The expedient addition of Millennial consumers to the attics of its retail portfolio across Canada, Germany, etc.
5. Association with one of the fastest growing Millennial-oriented brands in the world
6. Direct investment to refurbish some pretty tired real estate by a company with its own in house design capabilities that can use data to optimize flows and potentially support the primary retail business at some point

Ok…you’re clearly a booster of this deal. What are the risks?

The new partnership has to get the buildings and refurbishment right. HBC will have to ensure that direct access through and to the stores are incorporated, in a way that doesn’t overburden stores with thru-traffic, but still captures the spend coming to the building every day.

The property folks reading this will note that leasing to co-working carries risk. In an economic downturn, all the start-ups and small businesses that occupy co-working are at risk, and thus the covenant of a co-working provider could be seen as dangerous. This is a discussion for another post (spoiler: I only partially agree), but I will say that it doesn’t feel like there’s a lot of downside here to HBC. WeWork’s inward investment will improve the space. WeWork tends to achieve occupancy day 1 of 70%+ (the Richmond St W location in TO opened >90% full given pent up demand, which is likely consistent with other HBC markets), and they tend to open quickly, so the benefits should arise soon. I’d also note that WeWork are pressing hard into what they call the enterprise market – basically flexible office space, on short lease terms for larger corporates like McKinsey, the Guardian newspaper, Pepsi, etc. that want more interesting space for Millennial staff, with less direct operating involvement. The large floor plates in the HBC buildings will probably accommodate this market nicely, so the Bay gets the right workers in the building, but with far better quality companies bringing them in (and WeWork grows a relatively high margin business for itself).

Finally…zoning. I haven’t read about how this will work, but I’d expect that each of these properties are zoned for retail and not office. It could be that the department stores have zoning flexible enough to incorporate other commercial uses, but that will be stipulated city by city. My expectation is that this is well thought through by the parties, and that the cities will want to see these buildings more productive, supporting businesses in their business districts, but it’s almost certainly a piece of work and delay risk.

Enough out of me…would love your thoughts.

Going forward, I’ll try to provide some more reading for you, for those interested in more of the details:

• Bisnow: “This WeWork Deal Could Breathe New Life into Struggling Departments Stores“, 24 Oct 2017
• Exchange of letters between HBC and it’s activist investor, Land + Buildings
  • HBC 24 Oct 2017
  • Land & Buildings 1 Nov 2017
  • HBC 2 Nov 2017 (response)