Warning Signs From a Business on the Brink of Collapse

Editor's note: U.S. housing is in the midst of a major boom – but we're steering clear of office real estate. Joel Litman, founder of our corporate affiliate Altimetry, is doing the same. This Weekend Edition, we're taking a break from our usual fare to share a recent piece of his, adapted from the Altimetry Daily Authority e-letter. In it, he explains why one failing business could be the domino that tips the office real estate sector into collapse...

Membership is down... Occupancy rates are falling... And shares have cratered 90% this year...

That's the situation embattled coworking business WeWork (WE) faces today.

The company was once seen as an exciting innovator that could revolutionize the way we think of office space. Then, a difficult initial public offering ("IPO") tanked valuations.

And when it finally went public in October 2021, WeWork had to adapt to a corporate world forever changed by the pandemic.

Suffice it to say, it failed the test. The company recently warned that it may go out of business.

One of the most well-known companies in office real estate is officially sounding the alarm. If and when WeWork goes under, it could cause a ripple effect across the broader office real estate market.

Today, we'll take a closer look at the challenging environment surrounding WeWork – and the broader office real estate sector.

Offices have reopened... Yet folks aren't rushing to fill them.

Around 30% of workers in the U.S. still operate under some form of hybrid work environment.

Companies are now reevaluating the need for large office spaces. Many have opted to downsize to save money and adjust to having fewer employees in the office.

This has put a lot of pressure on office space owners like WeWork. These companies struggled during the pandemic and are still struggling today. They have empty buildings... and no one interested in renting them.

WeWork never managed to adapt to the work-from-home shift. It bet on the growth of shared workspaces, investing heavily in new office spaces. Occupancy in its workspaces fell from above 70% in 2019 to just 50% in 2021.

In an effort to stop the bleeding, WeWork has been exiting leases since 2021. It's scaling back its portfolio and reducing costs.

Those measures weren't enough. Management is concerned about operational challenges and excessive debt that the company is struggling to pay off. And second-quarter earnings failed to meet WeWork's own guidance from three months ago.

While the stock has been on a one-way trip down since its IPO, this year has been exceptionally awful for investors. The company is officially grasping at straws... Last month, it announced a 1-for-40 reverse stock split to avoid getting delisted from the New York Stock Exchange.

Many investors believe WeWork's issues are company-specific. They don't realize that this is an industry-wide problem. WeWork could be the first to fall... But we doubt it will be the last.

Folks have stopped paying attention to the lingering issues for office real estate. With declining occupancy and looming debt maturities, investors have been waiting for a catalyst.

And with WeWork approaching bankruptcy, they might finally realize that it's time to get out of this sector entirely.

Office real estate investment trusts ("REITs") spend billions of dollars purchasing and managing office real estate. Like WeWork, many of these companies are stuck with empty buildings, piles of debt from purchasing those buildings, and no sign that new tenants are coming anytime soon.

These issues have plunged WeWork to the brink of bankruptcy. Office REITs may soon follow.

WeWork could be the first domino that kicks off a collapse in the office REIT industry... Yet the market is choosing to ignore these signs.

We can see what investors expect from the sector through our aggregate Embedded Expectations Analysis ("EEA").

The EEA starts by looking at average stock prices across office real estate. From there, we can calculate what the market expects from future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well the industry has to perform in the future to be worth what the market (or a prospective bidder) is paying for it today.

At current valuations, the market isn't at all concerned about the outlook for office REITS. In fact, investors are gearing up for a surge in these companies' returns.

Aggregate Uniform return on assets ("ROA") for office REITs dipped below 3% last year. The market expects that number to turn around, surpassing 5% by 2027.

Take a look...

WeWork is a warning that office real estate faces significant headwinds. The world of office work has been forever changed by the pandemic... And those challenges aren't going anywhere.

Yet somehow, investors think the market for office space rentals will get stronger in the future.

Office REITs have been hurting since the pandemic... And given low occupancy rates and looming debt maturities, we expect the pain to continue.

Work from home is now a staple of the American economy. This trend will continue to cap returns for office REITs and real estate businesses like WeWork.

All eyes are on WeWork's next move... And it remains to be seen if the company can claw its way back into anyone's good graces.

In the meantime, considering the headwinds facing office spaces – and the market's overall lack of concern – we'd stay away from this industry.


Joel Litman

Editor's note: In 2009, Joel warned investors about 57 different companies that were about to go bankrupt... And 50 of them collapsed within days. Now, he's stepping forward with another major warning. On Wednesday, September 27, he's sharing why his signals are flashing red – and revealing a "backdoor" strategy that could show you high double-digit income and triple-digit gains through this crisis... Click here for more details.