Corona, Cheesecake & Testing The Mirage of Lease-Debt Equivalence

What even is debt, really?

Coronavirus has challenged a lot of our assumptions about financial markets and society, and one of the ways I have been thinking about it is that it has collapsed time and accelerated the inevitable with a variety of different business practices.

But beyond that, it has also created an environment where companies are able to play high stakes poker with each other in order to keep a bigger chunk of what’s left of the economic pie for themselves.

One of the most interesting cases of this was when The Cheesecake Factory announced that it would simply stop paying the rent for all of its locations.

Times are tough, and there’s no doubt that The Cheesecake Factory is being taken out to the woodshed just like almost every other restaurant right now.

Through that lens, refusing to pay its rent looks like the moves of a company on life support, desperately trying to hold onto cash to weather the economic ice age quarantine has brought.

That’s not necessarily a terrible assumption, and if I had to guess, there’s probably a lot of truth to it.

But what if The Cheesecake Factory is also playing another game? What if there are darker motivations here than just fighting for economic survival?

What if The Cheesecake Factory is making its landlords an offer they can’t refuse?

That may sound kind of bizarre. In traditional financial theory, after all, lease liabilities are considered to be the equivalent of debt, meaning CAKE’s landlords are also its creditors.

And creditors typically are the ones who have bargaining power; after all, if Cheesecake refuses to pay its rent, they can just extract their pound of flesh from the company in bankruptcy court.

In that way, real estate landlords in general would basically just be owners of unsecured debt portfolios that they can put leverage on.

If the net present value of a lease liability is truly equivalent to debt, there would be no more of a reason to dread bankruptcy court than any other creditor beyond the risks of having to pay your own interest while not getting paid on your own “debt” claims.

But what if that’s actually not true, and Cheesecake knows it?

Because, spoiler alert, it’s not true. It’s a fiction of sorts promoted by financial theorists and academics that has little basis in reality. Why?

Section 502(b)(6) makes it very clear why, by capping the allowable claims of landlords at the greater of one year’s worth of rent or 15% of the remaining rent owed over the lease term to a maximum of three years worth of rent.

Certainly, that is a claim… But The Cheesecake Factory had an average remaining lease term of 16.6 years as of its last 10-K.

My arithmetic is not so good having been taken out of the 4th grade, but I’m just gonna go ahead and take a stab that the NPV of 16.6 years worth of rent is a lot higher than the cap instituted by Section 502(b)(6) would ever let landlords collect.

The remainder above that amount? It’s disallowed. In other words, it is a contingent liability that does not exist if The Cheesecake Factory decides to tell its landlords to get bent and rejects those leases.

Here’s an example of a lease that was rejected in the bankruptcy of Mattress Firm to demonstrate the point of the sort of haircut a landlord might take more clearly.

This is all very academic, I suppose, except for the fact that this puts CAKE in a very interesting situation to extract concessions from its landlords.

The commercial real estate market was already exhibiting death throes before this; good luck trying to find a new tenant to take over the CAKE leases in the midst of mass quarantines.

CAKE may be in dire straits, but its landlords are worse off because they are stuck between accepting CAKE’s refusal to pay rent and risking receiving a pittance of value in bankruptcy court.

Because of the long term nature of its leases, it seems to my amateur and untrained eye that CAKE holds most of the cards here. If Corona is only a temporary disruption, it will be to the landlords’ benefit to eat a few months of lost rent in order to maintain the long term value of the Cheesecake leases.

To me, it seems like smart thinking by Cheesecake Factory CEO David Overton to tell his landlords that he won’t be making his April rent payments. By doing so, Overton is also going to shift the “Overton” Window of belief of what “debt” truly is.