No one ever runs the sensitivity case for pandemics.
Now that we’re here, I think anyone who operates in physical space should be very afraid to see what happens when they put the assumptions around the “Pandemic Case” into the model.
All public spaces – restaurants, offices, theme parks, hotels, condos – drive revenues and profitability around density and throughput. For years, we’ve typically optimized these environments to service the most people in the minimum amount of time.
Indeed, business schools teach how to optimize a restaurant’s throughput as part of the core curriculum to demonstrate the importance of throughput to the business model.
Now those models need to be refactored, and I suspect when more realistic assumptions go in around density and throughput, business cases will suffer.
A big part of the problem is how we value assets and greenlight projects. All projects have hurdle rates to get approved, tied to their sponsor’s cost of capital.
Analysts plug assumptions into the model and say, here is “what you have to believe” to justify a valuation. Since everyone wants the deal to get done, “What you have to believe” becomes what everyone believes. Models are built, deals are done, projects are approved.
Analysts everywhere can quickly see which variables can be tweaked to get to make the model work and generate enough profits to get approved. Increasing utilization is always the killer way to increase a model’s return.
For public space, utilization is measured from throughput. If you can service 30 parties an hour, with a bit more work and a bit tighter tables, maybe you can service 36. Cash flow increased by 20%, which could be the difference between a 10% loss and a 10% profit.
Even entrepreneurs, who may have an army of young analysts to vet their business plans, will fall prey to the same temptation. People are optimistic and want to pursue their projects.
What started as a theoretical exercise has real world consequences. The net result is that we’ve been crowding more and more people into smaller and smaller spaces.
COVID blows that up. Physical spaces will need to be refactored, reducing throughput and density. Many assumptions may have been unsustainable pre-COVID. Under social distancing – with 50% reduction of capacity and six feet distances – they definitely don’t work. Moreover, even after the pandemic, consumers may not want to go back to crowded spaces for a long time.
In some cases, restaurants will move to grab and go, increasing throughput. Retailers who survive can shift to pickup to try and maintain sales per square foot.
But it is really hard to make work. And companies that make the transition will be in a very strong position to renegotiate with landlords, since not everyone will make it.
At the end of the day, the rent might simply have to go down, leading to reduced asset prices.
The market appears to be already reflecting this, as Retail REITs are down more than 40% YTD through April. Some of that is probably bankruptcy risk given the current liquidity challenges, some of that is the continuing secular decline in retail, but I also suspect folks who understand this stuff better than I do are running their pandemic and post pandemic cases.
As a postscript to New Yorkers everywhere, the alternative to lower rents will be even more empty storefronts – a blight that was hurting New York City even before the pandemic.
Getting the city up and running again will likely depend on rebalancing rent and space.
The Great Refactoring 