Guest Commentary By Jim Ginsburg:
Last week in this newsletter, Messrs. Lothian and Kharouf argued the merits of CME Group’s sale of its iconic real estate holdings at the foot of LaSalle Street. At issue was whether CME should deploy its capital on real estate. Mr. Lothian says “buy real estate, not sell it.” Mr. Kharouf retorts: “CME isn’t a real estate company.” However, if one paid close attention to CME’s earnings presentation two weeks ago, they would have discovered that CME is a real estate company and it owns some “trophy” properties other than 141 West Jackson.
A decade ago, when electronic trading truly started to replace floor trading, investors began to look at the potential of for-profit exchanges. At that time, part of the attraction of an investment in CBOT was its ownership in the LaSalle Street building. The $150 million property could provide meaningful downside protection to an investment in CBOT in the event the exchange could not successfully make the transition from floor-based trading to electronic trading. Those were dangerous times for CBOT as it had not fully embraced technology. Their direct competitor, the electronic exchange Eurex, was handing out free iPods to traders in an attempt to steal the CBOT’s treasury futures business and the Clearing Corp, CBOT’s clearing house, actually “bet the house” that Eurex would succeed.
Unrealized at the time, was that the exchanges owned real estate more prized than the buildings housing the trading pits. This real estate was far more valuable than “Class A” office space and, in the burgeoning age of electronic trading, would become even more valuable in the future. Owned by exchanges was the real estate adjacent to where customer orders enter the marketplace.
During the heyday of pit trading, the member community knew that “pit real estate” that was adjacent to where customer orders entered the marketplace was extremely valuable. Being first to trade with a customer order was often the difference between success and failure– and key to being first was to be close to the order. Exchange members who wanted to “own” that valuable real estate did so, through a combination of seniority and relationships, as well as intimidation and muscle. Altercations, verbal and physical, for control of the pit real estate were common. So valuable was the real estate, that upon one trader’s retirement, he attempted to sell his prime, 2 ft. sq. “spot” to another member for $1 million.
What is now becoming clear from CME’s recent earnings presentation is how valuable real estate at the entrance to the marketplace has become in the current iteration of electronic trading. The success of many types of electronic trading strategies is still predicated on being first to a trade. For many of today’s top trading firms, having their trading computers close to the CME matching engine is critical. Now however, the valuable real estate near the entrance to the marketplace is not “owned” by a few burley members; it is owned by CME, which charges traders dearly to rent this prime space.
CME recently presented some information on the value of the real estate adjacent to the entrance of the electronic marketplace. In a slide on “co-location services,” CME states that it expects to receive $40-$45 million of revenue from the expanded co-location business in 2012. The Phase II real estate build-out will take place in the 2H 2012. In the not too distant future, CME expects to receive $100 million in revenue per year from these services. Assuming 50% of co-location revenue drops to CME’s bottom line and using CME’s current public valuation metric of 16x earnings, the value of this service to the CME will soon be worth $800 million, or approximately 5x the value of the LaSalle Street building.
While the importance of the CBOT building to the CME can be debated, there is no question that the bigger CME real estate play is taking place in data centers a short distance away from LaSalle Street. Location does matter and CME is effectively deploying its capital on prime real estate.
Vernon & Park Capital