Hello, and welcome to the Download. I'm your host, Dave Richardson and it is Stu’s days, on an actual Tuesday which is rare, Stu. Actually, I think this is two weeks in a row. We're on a streak.

That's right.

And since last week's podcast was the highest rated one we've done ever, we should probably try to keep Stu’s days on Tuesdays because people like it.

Just before you went to the Blue Jays opening day, you pulled down the podcast, right? That was the big combo last week. A double header, so to speak.

Right. A double header. Across Canada, there's one thing that's pretty consistent. People love the Blue Jays and people love Stu’s days. It also was the shortest one we've done in a while too. So that might have actually been the reason behind the popularity of that one.

People like brevity.

People like brevity. But let's go long today, Stu, because we got lots to talk about. The earnings season is coming. And one of the interesting things about earning season in the US is that you get the big banks and some of the smaller banks as well who report at the front end of earnings season. And of course, nobody knows the banks better than you. So what did you see between the big and small banks and just overall off the earnings that were reported from US banks?

Well, we started off with JPMorgan and it was a very strong result, living up to the billing of all the different financial periods of time that JPMorgan has been through. But a great example— it's something that we have across our portfolios—, but when banks have multiple business lines, there's lots of different things that come into play to create the earnings. And during periods of volatility, your trading numbers are quite large sometimes. When you're a big bank, you tend to receive deposits during periods of stress which allow you to make some more money. And the display of heft was certainly there on JPMorgan. And the other big banks have been not quite as good, but generally similar. In some of the regional banking areas, I wouldn't say the numbers have been necessarily bad, but we've seen a continuance of some of the things that you worry about going forward: their commercial real estate exposure is larger as a percentage of their assets than the big banks. And they saw a little bit more of, not so much deposits that left outright, but what they call cash sorting. So they went and found higher interest solutions, which pressured some net interest margin. And just this ongoing discussion around what will the regulatory environment look like for these banks in the next two or three years. You have lots of them. In all likelihood, there'll be some form of consolidation to some degree. They play a very vital role in small and mid-sized business in the United States. Canadian banks tend to go soup-to-nuts when it comes to the Canadian economy, but in the United States, those small and mid-cap banks really take care of small and mid-sized businesses. So they're really important. But there's a couple of things that get in the way of figuring out what their profitability will look like down the road. The first is some of this commercial real estate, and they'll have to take some loan losses on it, in all likelihood. The second is the regulatory environment. The third is, what will their net interest margins look like. So there's a lot of things at play, and the accounting rules make it a little bit difficult in the near term also to merge them together. We didn't really get any conclusions on that front, but nor did we really expect them in many respects.

I've actually spent quite a bit of time in western Canada over the last couple of weeks and in smaller cities, and this guy from Toronto comes in and goes: what's going on in the big towers in Toronto? You work in a big office building; are people back at work? What's the environment like in downtown Toronto? We could say the same thing about New York City or Chicago or any big city where obviously COVID has had an impact. Not everyone's back the same way as before. What's going to happen to commercial real estate if things never do return to normal? And that's what you're talking about in terms of the risk that some of these smaller banks have in the US. And really, all banks would have some commercial real estate, but is commercial real estate something that we really should be concerned about?

Well, yes and no. Not to say banks look out for taking loan losses, but they build their businesses knowing that there's going to be some loan losses. So even in the context of a mortgage against a building, pre-COVID. Dave, say you bought a building for $100, I lent you 60, so I lent you 60% of the value. You and maybe we thought that building was going to cash flow, say $6. So 6 divided by 100 got you what they call a cap rate. So that's a 6% cap rate. You borrowed money from me, 60% of it, and 40% was your equity. And maybe that $6 of income has fallen to $4. And as a result, maybe that new $4 of income demands a slightly higher return. So maybe on the $4— I'm just doing this here as we speak— they want a 7% return with that $4 of cash flow. So the value of that business for this moment in time has probably fallen down to the value of the mortgage. 4 on 60 would be 6.75% return. So the bank is going to do a couple of things. They're either going to go back to the building owner and say you have to put some more equity in and pay down some of your loan. Or they're going to take the building back. There's a variety of different solutions you can think of. But even in that scenario where you've seen a drop in cash flow and a widening evaluation, the person who wrote the mortgage is only off by a couple of bucks. And now of course, there will be transaction costs and all sorts of things. So they're still going to probably lose some money, but they're not going to lose it on every building as well. When you talk about office, you have three different categories. You have «trophy», you have class A and then you have the rest, class B, class C and what have you. And you talk about what different geographies they're in. So if you're in a trophy asset in New York, or if you're in a trophy asset in a major metropolitan area, those buildings are still very strong. Rents are rising in some of those buildings. And there's been new construction over time. They talk about the amenitization. You like your coffee, right, Dave? Does my building have a fancy coffee shop? Does it have a gym? Does it have all these amenities that bring me to work? In the trophy assets, they do. They're in a league of their own. Then you get into class A, which has still very strong underpinnings, and you think about, am I going to go back to work? I am, but how often are people going to go back to work? I think we talked about this before, but my dad used to say, you don't build a church for Easter Sunday, but you do have to build an office building for Easter Sunday. You need to have enough capacity so that on Tuesday, Wednesday, Thursday, everyone that wants to come to work has a place to sit, and there's a great environment that encourages brainstorming, productivity, all sorts of things. So even when you're downtown on Mondays or Fridays and you say, oh, it's kind of dead down here, that doesn't necessarily mean it's bad for some of that class A real estate. But then as you move out and you've got some consolidation and you’re going to have some reprogramming of jobs and things like this, there certainly is going to be some buildings that bear the brunt. And the question on those fronts is a couple of fold. We talked about that math: if I have to keep it as the exact same function and I just have to rent it at a lower rate, then all I got to do is revalue the building and the mortgage drives on. There was an article in the Wall Street Journal yesterday about turning ten floors of Rockefeller Center into a hotel. You can look at repositioning all sorts of real estate, and there's other categories that are booming. Self-storage, apartment, all sorts of things. So we tend to look at the real estate in a variety of ways. Cash flow metrics, for sure, but we also look at it on what we call enterprise value to buildable foot. That's like the land value. If I had to knock it down and start from scratch, could I build something else that would be interesting and make money at that valuation? And in lots of cases, that's true. In Toronto, we got some office real estate that's stuck in the $200-300 per square foot neighborhood, and then a fancy hotel in the middle of Yorkville sold for $2,100 a square foot. Real estate can be very unflexible in the short period of time but can be more flexible in the longer period of time.

Yeah. And that's what people need to think about. These things are always evolving. Maybe this is one particular one that just stands out and you go, wow, this has to change, because the way we work is going to change. Maybe not as dramatically as we may have thought a year ago, but it's still shifting a little bit. But things will adjust, and the market takes over and drives the change that makes sense for how you repurpose these buildings and take advantage of the real estate, the land assets you have by rebuilding. So it's a concern and there's going to be some change and shift, but it's just too simplistic to say no one's ever going to go to work anymore and that all those buildings are worthless.

I believe so. I think there's lots of good work done at home, but there's lots of great work done in the office, too. So it does seem like hybrid is going to be the future.

Yeah. I just want to point out, Stu was live on the podcast doing calculations with his financial calculator. That makes history. This is the only podcast ever where the guest star has done a complex calculation on his calculator while talking and doing the podcast. So Stu, congratulations. You are a trophy building just for that.

Well, on the one hand, my calculator is carbon neutral. It’s solar. On the other hand, I should be able to do 4 divided by 60 in my head, but you make me nervous, Dave.

I know there's a lot of pressure when you're doing this. When you have an entire day named after you, that's a lot of weight to carry on your shoulders, but you do it well. And this was really interesting. I learned a lot, because I think I had too simplistic a view of how this evolves. And I think you likely opened up a lot of people's eyes to the way this could play out. A little disruption, but it could end up being quite fine. And there's a lot of smart people who are going to figure it out along the way.

There's definitely a lot of focus on it. There's no question.

All right, Stu, we’ll shorten it up here this week too and, and we'll check in with you next week. I think we're going to talk about materials.

Great. Thanks, Dave.