The Call Option on New York City's Future
buy the rumor, sell the news
Welcome to the latest edition of Buy the Rumor, Sell the News. If you’re new here, please consider subscribing. This is an occasional newsletter about finance, tech, the intersection between the two, and assorted other diversions.
The Big Tech Companies Bet Big on New York City’s Future
A number of large tech companies have recently expanded their office footprint in New York City. This would be the same New York City that James Altucher famously declared to be “dead forever,” and with which contention Jerry Seinfeld vigorously disagreed.
At first glance, this doesn’t make much sense. The rise in remote working and/or working from home has reduced demand for office space, especially in downtown city cores. Why, then, have the big tech companies signed leases for new office space in New York City?
A funny thing about the big tech companies is that their balance sheets are so large that they can afford to take very expensive bets. Their office space is a call option on the future of New York City. If New York City is able to recover from its present parlous condition, then the tech companies will be well-positioned. If, on the other hand, New York City remains stuck in a problem from which it cannot extricate itself, the tech companies can write off the expense of the leases. They have the balance sheet to finance this risk.
Read on for more detail.
The Fiscal State of New York City
Irrespective of who we agree with here, one thing is certain: the coronavirus is an exogenous shock to New York City’s finances. And there appears to be no political figure on the horizon who is equipped to contend with these problems. To review, consider a recent report from The Manhattan Institute:
Personal service costs, inflated by fringe benefits and inefficient work rules, are by far the biggest chunk of New York’s nearly $90 billion budget. Mayor de Blasio’s fiscal 2021 financial plan relies on a projected $1 billion in recurring annual labor savings that will require union agreement—but New York’s municipal unions have a long history of resisting such concessions, even in dire circumstances. In a symbolic move, the mayor furloughed himself and his staff for a week in mid-September. But a broader use of furloughs involving the unionized workforce would be litigated, if not cleared in labor negotiations. This probably explains why, even after winning approval from the city council for a supposedly balanced budget for fiscal 2021, the mayor continued to lobby for federal aid and threaten mass layoffs, and he renewed his quest for state permission to issue deficit bonds.
If The Manhattan Institute is too partisan an organization, consider a recent report issued by New York City’s Comptroller, Scott Stringer. On page 229 of the foregoing link, we find the following information:
For NYC’s fiscal 2020, which is different from calendar year 2020, the city collected $30 billion in real estate taxes net of refunds.
Sales and use tax collections, a lot of which flow from commercial real estate (thing office workers buying stuff), was $9.3 billion.
Income tax collections, a lot of which also flows from commercial real estate (think employees sitting at desks in offices), was $13.3 billion.
Because covid forced the closure of most offices in New York City, a large chunk of sales, use, and income tax collections disappeared in calendar year 2020. This is a large plug to fill. To understand why these tax receipts disappeared, consider:
Most office workers who work in New York City commute into New York City to do their jobs. If they are forced to work from home due to covid, then the income they generate is not taxable by New York City, since they are not present in New York City when they do their jobs. People who live in New York City still pay income taxes to New York City, of course.
Manhattan office workers buy a lot of stuff in the course of their days in New York City; that stuff for the most part has sales tax attached to it. Those sales tax receipts have disappeared since there are no more office workers in New York City. People who live in New York City will still pay sales tax on stuff they buy, but this doesn’t replace the office workers who don’t come into New York City because they’re working from home.
As I’ve previously written, when a city is faced with a sudden decline in revenues (tax receipts), it can’t, unlike a business, suddenly restructure the liabilities side of its balance sheet to account for a lower revenue number. Where businesses are generally dynamic and resilient, cities are sclerotic and brittle.
The Balance Sheet Question
Given all of the above, New York City is, if not quite dead forever, in Altucher’s arch phrasing, at least hurting in the short term. Why, then, have various tech companies signed leases for additional office space? Surely, with knowledge workers all working from home, demand for office space in New York City is in permanent decline, and the tech companies have no need of this space.
Well, perhaps. On the other hand, maybe New York City backs away from the abyss and rights its fiscal house.
The economist Milton Friedman, to whom I am not related, once wrote “inflation is always and everywhere a monetary phenomenon.” I’ve adapted this to “business constraints are always and everywhere a balance sheet phenomenon.” If you want to know why a company has made a certain decision, look to its balance sheet. If the company has a lot of cash relative to liabilities, it may be able to make certain decisions that don’t initially appear to make sense.
The Curbed New York piece I link to at the top of this post notes that all of the FAANG companies are looking for new office space in New York City:
But Amazon isn’t the only tech titan that’s been snapping up New York City real estate in the past year: With the exception of Apple (which is reportedly hunting for more office space in the city), all of the so-called FAANG companies—Facebook, Apple, Amazon, Netflix, Google—have recently inked major leases in Manhattan and Brooklyn. Google is slowly taking over parts of the Meatpacking District and Hudson Square, while Facebook has set its sights on Midtown; Netflix, meanwhile, will bring production space to Brooklyn.
What’s going on here? Do the tech companies not know that New York City is facing a historic shortfall in its revenues? Do they not understand that New York City’s municipal employees are protected by an intransigent union that makes operating and managing New York City a rather expensive endeavor? Should we all be shorting the tech companies’ stocks? Surely they’re idiots. Right?
Well, no. And here is where balance sheets become important. Consider that New York City faces a binary outcome:
New York City overcomes its present fiscal problems.
New York City does not overcome its present fiscal problems.
Framed in that way, we can see that the tech companies are making a bet on New York City’s future being better than its present. In other words, these companies are buying a call option on New York City’s future. A call option is a derivative that provides the buyer of the contract the right, but not the obligation, to buy the underlying asset at a pre-determine strike price. If the buyer of the option does not exercise the option, the contract expires worthless. The option here is a presence in New York City. The cost of the option is the office leases.
For most people, let alone most companies, the prospect of committing to office leases in New York City is daunting.
But the FAANGs are not most companies. Their balance sheets are so large that they can afford to bet on New York City’s future, and, if they’re wrong about their bet, they can also afford to lose all the money they spend on office leases.
To understand this more concretely, consider the size of Netflix’s balance sheet. I am focusing here on Netflix because it is by far the smallest of the FAANGs, in terms of its revenue, the size of its balance sheet, and its market capitalization. You can see Netflix’s balance sheets for the past few years here. In 2019, Netflix held $33.9 billion in total assets on its balance sheet, against $26.3 billion in liabilities.
That balance sheet can finance a lot of risk!
Even if we assume that Netflix would have to pay $100 million per year for its New York City office space, that is only 0.0029% of its $33.9 billion in assets!
In other words, the FAANGs are so large that they can afford to make a bullish bet on New York City’s future, and still be financially healthy if that bet turns out to be wrong.