Motley Fool Hidden Gems Investing - Mixed Signals From Real Estate and Regional Banks

Episode Date: June 7, 2023

The pressure on commercial real estate borrowers is amping up, but so is insider buying at the regional banks lending them money.  (00:15) Bill Mann and Dylan Lewis discuss: How rising rates and low occupancy rates continue to put pressure on interest-only commercial real estate borrowers. The follow-on effects that could hit regional banks. Why insiders at regional banks are buying up shares despite the pessimism.  (13:27) Ricky Mulvey talks with CNBC host Melissa Lee to talk about the new documentary "Making of the Meme King" and why founding a company is much different than turning one around.  Companies discussed: LOB, CHWY, GME, BBBY, BABA Host: Dylan Lewis Guests: Bill Mann, Ricky Mulvey, Melissa Lee Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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Lady, wait your turn! Get more of what matters to you with the new Kia EV5. See kia.ca for details. Kia. Movement that inspires. Dylan Lewis How office space went from a story about how we work to a story about how we finance. Motley Fool Money starts now. I'm Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst, Bill Mann. Bill, great to have you. Bill Mann

Hey, Dylan. How are you doing, man? Dylan Lewis Doing okay. Today, we are taking a look at commercial real estate and how it may affect regional banking. And Bill, the reason that we're talking about this today is we had a CNBC interview this morning where Treasury Secretary Janet Yellen said she thinks there will be some issues with commercial real estate. And this is something that we've been kind of watching for some time. And it's been one of those evolving stories as a lot of the world has changed with the pandemic. Seemed awfully breezy, didn't she? She did. Like, I don't know about you,

but I look around me and I see a lot of buildings. And so you know that there is a fair amount of value and investment built into them. And so I looked it up. I did some research before we spoke our speaking. I always appreciate that. Just a little. $20.7 trillion in commercial real estate estimated in the United States by values of 2022. So $20 trillion slug of money that's out there that is currently under the double or triple stress of having, number one, the echo boom from COVID with people remaining out of office, relatively low in office rates. And in 2022, moving into 2023, the fastest rate of increases of the federal interest rate in history. So it is creating a lot of stress for something that I do, again, want to stress

is a $20.7 trillion component of the U.S. economy. This is also one of those stories, Bill, where I think people can very tangibly see it playing out, right? I'm recording this from our office in Alexandria, and I can say, you know, the office environment around us, the campuses around us, are not nearly as populated as they once were. I think a lot of people listening to this show probably are seeing that in their own way, too. And this was so much a how we work and corporate culture story for 2020 and 2021. You mentioned the interest rate environment a little bit. in 2022 and 2023, this is becoming more of a financial story because these interest rates have climbed and are staying high. And as someone who maybe doesn't follow commercial real estate

as much, you learn very quickly the loan environment and the way that these deals are structured, very different than the traditional consumer mortgage. That's exactly right. And this is why it matters to us. Like we think, okay, there are big investors out there and they've built these buildings, or they're these building owners, and maybe they have a problem. But you have to think of the commercial mortgage-backed security market, or you have to think about commercial mortgages as being similar to bonds. Banks go out and loan for the buildings to be built, buildings to be maintained, the buildings to be bought. And as of last year, nearly 90% of those loans were done on what's known as an interest-only basis, which means unlike your

mortgage at home where you're paying principal every single month and slowly paying things down so that your last payment will be of equal size as your first payment, in the case of commercial buildings, they have interest only, and then they're going to come up to a period of time in which they have to satisfy the entirety of the loan by paying it off, which is harder to do when you have the level of vacancy at buildings throughout the country, as we've seen. Because as you know, vacancies, the flip side of that is the cash flows in for the buildings. And so we are looking at a massive potential reset in those valuations, which hurts the banks. And we're also looking at a rising default curve, which hurts the banks. And those are the same

banks that provide loans to us, that provide loans to small businesses, and they don't really know what to do with themselves. I think we've all kind of had to become banking experts in the last six months or do our best imitation? It is never good when we as individuals have to become banking experts, is it? No, it's not. It's a sign that something has come into the headlines that we're not used to seeing. I think to bring this around a little bit to some more of Secretary Yellen's comments from earlier today, she did reiterate that while there will be pain, she feels like the banking system has the capital and liquidity to handle the strain. Bill, I'm curious what your thoughts are and kind of what you're looking at

as you see the story play out. The system, sure, but that doesn't mean that all individual banks don't have an exposure that they would be able to handle. I mean, this is what's important about that interest-only component. And by the way, we've already seen it this year. You've seen huge borrowers and huge building portfolios like the ones held at Brookfield Asset Management that are kept inside funds. So it keeps the borrower harmless from anything, from contagion from these loans. But the banks are already taking title to these buildings. And I don't know if you know this about banks. They're not set up to be in the landlording business. They're not set up to be in the building speculation business. What they're trying to do is lend

and then take that collateral if those loans go bad and then recycle that collateral into more cash. And really, when she talks about the entire system having enough liquidity, the really important thing to note about the banking system is that it is a bunch of nodes. And as we saw with Silicon Valley Bank that one single node going into distress can cause contagion across a much wider subset of the financial system. You mentioned that banks are generally not in the business of holding assets. They don't like to be maintaining things and having physical real estate that they have to be in charge of. I think one of the other curious elements of this story and this landscape in general, Bill, is a lot of the banks that play in commercial real estate

are these regional banks that we've seen a little bit more pessimism around and people have been a little bit more scared of because of some of the banking failures we've seen. So how do you look at that space right now? So this is really important, what you're bringing up, because when you think of a regional or a local bank, they have a great deal of exposure, I mean, duh, to the area in which they are operating. So one of the things that these smaller banks have done is that they will have their lending areas, their geographies, be in some ways wider or in a different space for their deposit geographies. So like, for example, you'll have a bank in Ohio that will open up a lending office in Nashville, Tennessee, because there's a whole lot more

opportunity to lend for development, things like that, in Nashville, Tennessee, than there is in a rural part of Ohio. So when we are talking about the smaller banks, what you have to keep in mind is that those types of loans that are out there are huge components of some of these banks balance sheets. And the balance sheets, because these are leveraged companies, you will take a deposit franchise of $1 billion, say, and you will make loans on top of that of $4 billion, for example. It's a small bank, but that's an OK example. That when there is any kind of movement at all on the asset value, it can really impair the bank's capacity to lend. Bill, based on our conversation so far, I think we would be generally looking at pessimism in

commercial real estate and also pessimism in some of the banks that service those loans and make those loans available. One thing that I think is interesting in doing our prep for the show is I saw a story that I am trying to square with everything that we just talked about. And it is that insider buying at regional banks hit a three-year high in the second quarter of 2023. And I'm a little surprised to see that much activity and interest and ratio of buyers to sellers hitting a record high in Q2 when it seems like there's so much pessimism in the space. You know, I had a great interview a couple of days ago with Chip Mahan from Live Oak Bank, based in Wilmington, North Carolina, and he talked a lot about the areas in which they make

loans. Now, Live Oak Bank's stock has been hit, as has every other small and medium-sized bank in the country. When you think about banks, on certain levels, it is a utility, and then on top of that is a risk-taking enterprise. So it does not surprise me at all to see good bankers looking at their own books of business and saying, okay, we may be in for a little bit of trouble, but we're going to come out on the other side because we're well-capitalized and we know the types of areas where we give loans. So I would be a little careful to take too much signal from that because, as you know, anything that gets observed can, in fact, be gamed. So there's always the risk of an insider going, hey, if I buy just a little bit of stock,

then maybe people will think that our stock is cheap and we're not in trouble. But I think that there is a whole lot to be said for the fact that these professionals do know their businesses better than anybody else. And so in particular, when you see a CFO or you see a lending officer make a purchase on the open market of their own stock, that's something to pay attention to. We never want to blindly follow it, but it's always worth paying attention to. Oh, absolutely. Yeah. I mean, because it's money, right? What is it that Rune Aldridge said is that the answer to all of the next of your questions is money. Yeah, it's dead on. For folks that are eyeing some of these regional banks and perhaps seeing opportunity or being interested because

they've seen this insider activity, you mentioned looking at the geographic focuses and the diversity that some of these regional banks have. Is there anything in particular that people should be paying attention to in addition to that? Well, I mean, I think that to the extent that you want to become a banking analyst, there are there are capital ratios that you should pay attention to. I would also pay attention to and be very specific about how you go about reading a bank's the letter to shareholders. And they will describe very carefully there and then also in their in their financials, the types of industries and the types of areas where they are lending, I would be really careful of buying a bank that has seen over the last five years

a large growth in its CMBS portfolio. That's commercial mortgage-backed securities or direct real estate, commercial real estate. Be a little careful with those. But you can find banks that are making loans in areas where they have a lot of expertise, and it isn't necessarily going to be as sensitive to the economy as commercial real estate might be. Bill Mann, thanks so much for joining me today. Hey, thanks, Dylan. It's tough to be an activist investor, especially when you're invested alongside the government of the People's Republic of China. But that's not stopping Ryan Cohen from trying. Ricky Mulvey

caught up with CNBC host Melissa Lee to talk about the new documentary Making of the Meme King and why founding a company is much different than trying to turn one around. So, Melissa, it takes a certain amount of confidence to ship 30-pound bags of dog food to people as a business. Can you take us back to the founding of Chewy and maybe the original Ryan Cohen playbook of building and growing a business? I think, I mean, it takes a lot of confidence and it also takes a lot of confidence in light of the fact that a business had tried to do that before and that business went spectacularly bust during the dot-com bubble. I'm talking about pets.com. But, you know, when Ryan Cohen

founded Chewy, it was sort of a, I don't want to say inspired inspiration, divine inspiration but it was sort of like that. He had met the co-founder in high school through a chat room and they decided to get together and open a business. The original business was actually a jewelry store. And then one day he was shopping for pet supplies for his dog, a poodle, a little poodle, and discovered that he was much more passionate about this category and that he felt that, you know, he could enact change in this part of the industry. And, you know, the naysayers were were plenty, you know, he, it was difficult for him to find the startup money, to find people willing to back him. You know, as you mentioned, the economics of shipping dog food in the mail

were not great. And people had, had seen another business go bust trying to do the same thing. So there was that reluctance, but he had that passion. He was a sort of entrepreneur who wanted to, uh, you know, defy logic who, you know, thought out a game plan and really went with it, really went with his gut and with his heart. And I think that sort of is one of the hallmarks of Ryan Cohen's just sort of playbook of investing, but, you know, understanding Chewy and how that company was founded, how that company grew into a business is really key to sort of understanding who Ryan Cohen is. He thinks that he can go in there and take a look. He's an operational kind of person. You know, he built out these giant warehouses for Chewy. He decided that it was

going to be growth at all costs that he was going to win over the customer. You, if you had to refund, uh, you know, a customer for a broken bag of dog food and do that repeatedly, that's, that's what it took, uh, as long as you're generating cash to grow the business. So that was sort of what his mentality was that you could grow to greatness. And the thing about Chewy was that, you know, Chewy, unlike GameStop, you can't download dog food. You can download video games. And so that was sort of, you know, that was the threat that GameStop's story encapsulated. For Bed, Bath & Beyond, you might say, oh, maybe those businesses are similar. But Bed, Bath & Beyond was already really far down the line in terms of its difficulties

being much closer to bankruptcy than to its early growth stage. And so time was just not on Ryan Cohen's side for that one, for him to even hope to really enact meaningful change, operational change there. I think those are the key differences between Chewy and some of the other businesses he invested. I'm still left wondering with Chewy why Amazon didn't just take it out in the early days. There has to be something that Ryan Cohen understood about the pet business that Amazon did not. I think Ryan Cohen understood that if you win over the customer and you treat them really, really well, then they will be yours for life. We interviewed many, many customer service representatives as

part of this documentary to really understand what that secret sauce was. You hear repeatedly, oh, it's okay. It was okay for you to stay on the phone with the customer if they lost their pet and cry with them. It was okay to give them back their money if they're unhappy. No matter how many times they had to do that, that was all fine with Ryan Cohen. He even sent personal thank you notes to customers around the holidays just to say thank you for being a customer of Chewy. He sent personalized portraits, hand-painted portraits of people's pets to them. If you got a portrait of your Scottish terrier, you probably are a customer for life at Chewy at that point. That was the big difference between the nameless, monolithic Amazon

and this little startup that wanted to focus on people who love their pets. PetSmart then purchases Chewy for about $3.3 billion. It's the largest e-commerce acquisition of all time at that point. I don't know if this was covered in the documentary, but then he virtually puts all of his money into Apple and then inexplicably Wells Fargo stock. But then after that, does the meme stock fascination with Cohen start there, or is it when he gets involved with GameStop? I don't think that he was fascinated with meme GameStop's in, you know, I don't know if that's the right order. I think it's almost a chicken and an egg sort of thing because when he started investing in GameStop, that's when things really

started taking off. There was already sort of a community around it. And they really seized onto Ryan Cohen when they saw him get in. They knew that Ryan Cohen was this guy who made his own money, right? He started from nothing. He built up Chewy. He became a billionaire with that sale to Petsmart. And here he is, he's going to bring that chewy magic to GameStop. And so people wanted to believe it. He also encapsulated what this group of people on Reddit, apes, whatever you want to call them, what they believe. And they believe is that they wanted to defy convention. They wanted to sort of stick it to the man, you know, tell Wall Street that you are not going to dictate how things work we have a voice here so i think he was the perfect

you know figurehead at this exact time when the meme stock craze just started taking off it was like the perfect just culmination of events in 2019 and and beyond the hype what was the chewy magic for for transforming gamestop that he wanted to bring and Maybe why did that not work out as well as he anticipated? I mean, the Chewy Magic, Chewy was, you know, an e-commerce only business. And so for GameStop, one of his major criticisms, you know, if you read the letter to the board, was that they completely missed the boat when it came to online sales. So they missed the boat.

And during that time, they also missed this notion that people will soon be able to download video games. So they're risking just sort of an exit. They had this existential threat in front of them. And so people thought that Ryan Cohen could, because he was an e-commerce, you know, wizard entrepreneur, that he would be able to use that same playbook and turn GameStop around, reduce its bricks and mortar exposure, um, you know, and get operational efficiency going, change this to an e-commerce first company. But what people didn't understand, and maybe what Ryan didn't understand was that the video game business is not the same as the dog food business or the chew toy

business. Um, you can't discern it disintermediate dog food by downloading it. And that's the threat that GameStop was facing at that time. You still have to physically buy bones and collars and dog beds. There's no way to sort of just, you know, download that software. And so I think that there there was a case to be made for certain changes that could have been enacted using the Chewy playbook, but it was just a different ballgame in terms of the product that they were selling and the threat to that business. Harder to send a portrait of someone playing a video game. It's also the direct-to-supplier connection, where you can buy a PlayStation game directly from PlayStation, where you can't buy your dog food directly from the

dog food maker. But to give Cohen credit, he has made GameStop profitable. Even if sales are declining, and even if he's facing the monolithic competition, it is a company that is profitable on a cash flow basis now, right? Yeah, absolutely. His backers will point to that for sure. His critics would say, as you pointed out, sales are declining. So, how did you make the company profitable? You cut costs. And that's exactly, he closed a lot of stores down. And so, is this the kind of, quote-unquote, profitability or growth that is sustainable. I think that's still yet to be seen. One of the curious things that the documentary explores is what Redditors and

what investors wanted Ryan Cohen to be, and maybe who he actually was, and especially how that perception clashed with his actions in the case of Bed Bath & Beyond. Yeah. At that point, he was called on Reddit Papa Cohen, the Messiah, the Destroyer shorts, you know, all of these, these monikers that sort of portrayed him as, as this godlike figurehead in the Reddit community. And so, you know, when he went into Bed Bath and Beyond, it was viewed the same way. I mean, that day that this, you know, that he unveiled his stake, I think the stock was up something like 70% on that one trading session. So people were really looking to him as sort of leading them, um, also into Bed Bath and Beyond. They trusted him. They

wanted to follow him. They were investing their life savings, in some cases, their life savings into what he was buying. And so they went in as well, but there was a rude awakening in August of 22 when he decided that he was going to sell his entire stake. And so this is sort of the interesting part of the story, the interesting turn in terms of Ryan Cohen being perceived as this flawless godlike figure to perhaps somebody who might have an ulterior motive. Maybe not, But there are questions here around what his motives were when he went into Bed Bath & Beyond, put three directors on the board. And then there's a technicality here. He had to make a new filing, basically, refile, because the number of shares that the company had outstanding changed.

And so his stake looked like it went up. And so he refiled that. And part of that filing, he also refiled, um, his call positions in Bed Bath and Beyond way out of the money call. So basically a bet saying that he believes the stock was going to be, you know, X times higher and a far date out. I think it was like January or something like that. And it was August.

And so people saw that and they assumed this was all new news. And so the stock just went nuts. But what we found out a couple of days later is that he sold every single share right after that. And so the question is the timing of it. You know, is this just a coincidence? Did he do this on purpose to goose the stock before he sold it? There are all sorts of questions. I don't think many people, you know, according to the people we interviewed, like it's, it's questionable. They don't think that any, he did anything illegal, but at this point, it's not about the legality of it to this community and to the average investor who had believed in Ryan Cohen.

It's like, who are you? What are you doing? Are you taking advantage of us? Was this just a rug pull and you left us holding the bag? We try and go into that issue as well. It's always interesting to see what he says versus watching the hands, if you will. He bought a stake in Alibaba and is imploring them to buy back shares. Meanwhile, the share count under GameStop, I think, rose about 15% under his tenure. There always seems to be unrelated stories, if you will, that have connections with Ryan Cohen. Yeah. I mean, I think that's a really interesting point that you bring up. With Alibaba, this goes to, who are you, Ryan Cohen, as an activist investor? There's the question of, who are you

as this Reddit meme king? But also, who are you, Ryan Cohen, as an activist investor? With GameStop, the jury may still be out with Bed Bath and Beyond. He determined that he couldn't make the change. He sold out. Then he got into an Alibaba, had a minuscule state compared to the size of the actual company. And by the way, it's a Chinese company that's effectively, you know, influenced by the Chinese government. So who are you, the American activist investor, to come in and tell Alibaba what to do with its shares? And so there's a question about whether or not he's an effective activist investor as well. And so I think after being the real American success story with the wild success of Chewy, now there are all these questions emerging about Ryan Cohen's second

act. The documentary is Making of the Meme King. It's available on YouTube and cnbc.com slash documentaries. I really enjoyed it. Melissa Lee, thank you for your time and joining us on Motley Fool Money. Thank you so much, Ricky. As always, people on the program may own stocks mentioned and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thanks for listening. We'll be back tomorrow.