Merger of Smaller Rivals Shouldn't Damage This Commercial Real Estate Powerhouse

Private-equity-backed commercial real estate firm DTZ, which owns Cassidy Turley, has agreed to buy Cushman & Wakefield in a deal that is expected to close in late 2015. Although we view DTZ’s combination with Cushman as slightly negative to global leaders

We think demand for commercial real estate services will continue to accrue to global providers that can serve clients with a complete range of offerings in all of their markets around the world. While we have long viewed CBRE and Jones Lang LaSalle as leaders in this regard, we think Cushman will eventually emerge as a third major force despite integration challenges and possible disruptions from the merger.

Cushman-DTZ is expected to have more than $5 billion in revenue, putting it on par with Jones Lang LaSalle but still behind CBRE’s $9 billion in revenue last year.

That said, we do not expect CBRE or Jones Lang LaSalle to remain stagnant. Both are likely to continue to further consolidate their industry, through both incremental acquisitions and strategic hiring—the firms could even lure workers from Cushman and DTZ if there are disruptions from the merger. Top talent will want to continue working for industry leaders, and CBRE and Jones Lang LaSalle have the brands, broad offerings, and global scale to be attractive destinations.

Although we expect competition to intensify somewhat for truly global deals as Cushman solidifies its capabilities, we expect pricing to remain rational. Moreover, the presence of a stronger third provider could accelerate the adoption of newer industry offerings, such as property and facilities management.

Jones Lang LaSalle Is in a Strong Position Organizations are increasingly willing to outsource the noncore tasks of managing their property needs, but they prefer to consolidate their relationships with as few vendors as possible. Jones Lang LaSalle is one of just a few firms that can handle all of a company's global commercial real estate needs.

By providing services to all the participants, including tenants, owners, and investors, Jones Lang LaSalle can leverage its global network and infrastructure investments across a larger client base. And professional brokers want to align themselves with large, well-respected, and well-capitalized firms like Jones Lang LaSalle, because the perceived quality of a broker’s firm can influence clients’ buying decisions.

Although leasing and sales markets have recovered nicely around the world in the wake of the global financial crisis, Jones Lang LaSalle has also focused on corporate facilities outsourcing. This business has been expanding recently, which we think will continue. The service is gaining traction in Europe and Asia and continues to be strong in the U.S. market, where it was initially adopted. Furthermore, as Jones Lang LaSalle’s capabilities have expanded geographically, it has won more accounts with global mandates. We like this business, since its multiyear contracts provide some stability compared with the more cyclical results of its leasing and sales businesses, which are more tied to transactions.

While the cycle strongly influences near-term results, we think commercial real estate can generally deliver low-single-digit growth rates, supported by slight expansion in square footage and rate growth near inflation. Combined with opportunities for Jones Lang LaSalle to win incremental share because of its global reach, broad capabilities, and respected brand, as well as the further adoption of corporate outsourcing, we expect it to achieve higher-than-average long-term growth.

Scale and Brand Create a Wide Moat We think Jones Lang LaSalle operates a wide-moat business, with competitive advantages attributable to its well-respected brand, impressive scale, and increasingly high customer switching costs. We think it will be difficult for competitors to disrupt Jones Lang LaSalle's strong competitive position over the coming decades.

Second only in size to peer CBRE right now, Jones Lang LaSalle is a recognizable brand in the global commercial real estate industry. The firm's many industry awards and recognitions include mentions by Forbes as one of America's Most Trustworthy Companies, by Ethisphere as a World's Most Ethical Company, by the International Association of Outsourcing Professionals as a World's Best Outsourcing Advisor, and by Watkins Research Group as the number-one Corporate Real Estate Provider.

Furthermore, Jones Lang LaSalle has rapidly expanded its business over the years, through both internal growth and strategic acquisitions, to develop the range of services and geographic coverage its largest clients demand. This scope and scale position Jones Lang LaSalle among just a handful of firms we think can realistically bid for the largest commercial real estate deals, giving it access to a larger market than smaller peers that specialize in either a particular service or geography.

Although it is difficult to quantify, we think Jones Lang LaSalle’s incremental revenue allows it to leverage certain fixed costs, such as its global office network, market and economic research, and certain technology and systems, to achieve higher profitability than its smaller peers that operate with similar global ambitions. We estimate that its operating margin and reported adjusted EBITDA margin are a bit below CBRE’s but exceed the group of next-largest peers.

As Jones Lang LaSalle has recently expanded its corporate outsourcing business, we think its customer switching costs have also increased. When it wins corporate outsourcing business, it essentially takes over the real estate function from its client, often hiring its client's old in-house team en masse. It would be a challenge and potentially disruptive for a client to switch outsourcing vendors or bring the function back in-house, and Jones Lang LaSalle, like peer CBRE, enjoys client retention rates in this service line that exceed 90%.

While Jones Lang LaSalle’s largely people-based business is unlikely to reach the eye-popping operating margins or returns on invested capital of some of our moatiest firms under coverage, we think it will be able to earn positive economic profits for decades. Returns on invested capital, including goodwill, have averaged 18% over the past decade, a period with both cyclical highs and lows for the commercial real estate industry. In fact, our ROIC estimate for Jones Lang LaSalle in 2009, the trough of the last cycle, was a very respectable 8%, which still compares favorably with our 8%-9% estimate for its cost of capital.

In 2009, when Jones Lang LaSalle’s revenue fell 8%, it was able to contain its costs, which also fell 8%, which demonstrates how its people-based model cuts both ways. In good times, its professionals share in the upside, essentially capping margin expansion potential and ROIC growth for the firm. But in bad times, its professionals share in the pain, preserving reasonable profits, cash flow, and ROIC for Jones Lang LaSalle.

Heading in the Right Direction Property and facilities management, corporate outsourcing in particular, is becoming an increasingly important part of Jones Lang LaSalle's business, which we like, because it's less cyclical than many of the firm's traditional brokerage operations. Although cyclicality affects Jones Lang LaSalle's results in any given period, we think the effects of cyclicality are muted over longer periods. Specifically, we think most of Jones Lang LaSalle's markets, particularly leasing and sales, can grow on a long-term trend line at low-single-digit rates, linked to global macroeconomic expansion. We don't think cyclicality can disrupt the prospects for global macroeconomic expansion or commercial real estate's growth alongside the global economy.

Still, Jones Lang LaSalle’s prospects are tied directly to the cyclical commercial real estate market. Results are likely to rise and fall with the industry's prospects, especially in its leasing and sales businesses, with results generally linked to transactions, which can cause some short-term volatility in results. Another credit crunch, tighter lending standards, or rising interest rates could push commercial real estate activity far below those seen in recent years, hurting Jones Lang LaSalle’s financial results.

Jones Lang LaSalle operates a people-intensive business, which presents the risk that top performers will demand greater economic rents from the firm, which could dampen financial results. Of the commercial real estate firms we cover, Jones Lang LaSalle has the greatest international exposure, so a slowdown overseas or a strong dollar might also hurt its results. Furthermore, with its focus on the world’s largest commercial real estate markets, Jones Lang LaSalle’s results may lag the industry if strength moves from primary markets to secondary or tertiary ones.