MGM Resorts (NYSE:MGM) has quietly made a very big bet on the future of the Las Vegas Strip, and it could determine the stock's performance long term. Not only did MGM recently agree to acquire the half of CityCenter that it didn't own for $2.125 billion, but it also agreed to sell CityCenter's real estate for $3.89 billion to funds managed by Blackstone (NYSE:BX).
The move to acquire a key asset and monetize its real estate sounds smart on the surface, but it's adding more leverage to MGM's business. And if Las Vegas doesn't recover from the pandemic quickly, MGM will feel it.
The popularity of REITs in Las Vegas
Over the past decade, it's become very popular to sell the real estate of casinos to a real estate investment trust (REIT) stock, either controlled by the company or a third party. Penn National started the trend by forming Gaming and Leisure Properties in 2013. Caesars used the Vici Properties REIT to engineer the merger with Eldorado Resorts. MGM itself entered the arena with MGM Growth Properties (NYSE:MGP) in 2015.
Today, most of the Las Vegas Strip real estate is owned by one of these three REITs, with a few other asset owners scattered about. The deals have brought billions of dollars into casino companies but not without risk.
The casino business model reinvented
It used to be that casino companies would spend billions of dollars building a casino, take out debt to finance the project, and then operate and own the casino and land. As long as the company could cover operations and interest payments, it was a viable business model but expensive to get started.
Today, casino companies can sell the real estate of their projects for nearly the same cost as building the casino, leaving them with essentially new casino operations for free. MGM did this in Washington, D.C., Massachusetts, and now with CityCenter. The trade-off is a long-term agreement to rent the property back from the REIT for a monthly payment.
This sounds great but now companies no longer hold their own real estate to fall back on during hard times. In the financial crisis, for example, MGM sold Treasure Island (including the real estate) to help fund its own operations through the crisis. Over the last year, it sold the real estate under Bellagio, MGM Grand, Mandalay Bay, and now CityCenter for $12.7 billion. Real estate can be a very valuable backstop when times are bad.
Operationally, selling real estate can leave these companies with more operating leverage, meaning operating income rises or falls faster than revenue. That's great when revenue is growing but has risks if revenue drops.
The risk in MGM's REIT moves
In the last 15 years, we've seen two major disruptions to the gambling business in the U.S. The first was from 2008 to 2010, when the financial crisis resulted in a huge cutback in consumer and business spending, and the second was the COVID-19 pandemic. In both cases, MGM had to sell assets and debt just to make it through the crisis.
Now that MGM has sold a vast majority of its real estate, it doesn't have the same backstop in hard times. But it hasn't reduced debt to compensate for having higher operational risk, as you can see below. This is partially because MGM is consolidating MGM Growth Properties' debt. But the company has used most of the cash it has gotten from REITs to fund growth rather than pay down debt.
This strategy could pay off for investors if revenue grows in the coming years because the additional leverage will mean higher returns on the bottom line. But there's also added risk in a crisis. And we've seen that crises in Las Vegas happen more often than we might like, which is why MGM's bet on the city is a risky one for investors.