Arnold Kling

Do Sports Franchises Make Money?

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Toward Better Debate... Free Market or Artificial Mark...

Austan Goolsbee writes,


Take the Sonics. The team may have lost $60 million while Mr. Schultz owned it. But he bought it for $200 million in 2001 and sold it for $350 million five years later. So he ended up making something like $90 million (taxed at the favorable capital gains tax rate, no less) on top of the fame, prestige and free tickets he got while he was owner.

If the Cubs do, indeed, sell for $1 billion, Tribune will have earned an annual return of almost 15 percent since it bought the team for around $20 million in 1981. Given the company’s recent problems, it’s probably the best investment it ever made.


In the past, I have used sports franchises to illustrate the formula that the profitability of buying is equal to the rental rate plus appreciation minus interest cost.

For baseball teams, the rental rate minus the interest cost is negative, so that they are cash-flow negative. But, as in the fruit-tree example that I used illustrates, a capital asset can be cash-flow negative and still profitable.

I wonder if the hotel business is similar. And does anybody know why hotel chains swap properties so often? (I mean in the sense that a hotel will re-open under the name of a different chain.) I assume that there's a tax issue lurking somewhere under the mattress, so to speak.

UPDATE:

Mark Steckbeck emails me with some questions:


First, if a baseball team has a negative cash flow and its profitability hinges on appreciation...aren't MLB teams a classic example of a bubble?

I don't think so, but I may be wrong. But look at it this way: suppose that the cash flow before interest expense is $100 K, but with $120 K interest expense the cash flow is negative. If the cash flow before interest expense increases at x percent per year (this could be pure inflation), then the value of the asset (the franchise) has to go up at x percent per year also, even with no bubble.

Mark continues:


Second, better opportunities make professional sports participation less desirable for both athletes and fans. In terms of athletes, greater employment opportunities increase the opportunity costs for higher skilled individuals, increasing the number of lesser skilled (read: less functional, lower culture, etc.) individuals to fill the ranks of professional sports teams. If a high school athlete has a 1:100k chance of becoming aprofessional athlete and earning, say, $2.2 million, that works out to an expected income of $22 annually. Hardly a prospect for which someone with the intelligence to become an accountant or lawyer or economist will spend much time pursuing.

Sports have always been the province of those with low opportunity cost. They have always been rarely pursued by people with other talents. I would say that, if anything, since the 1960's the earnings of top athletes have gone up, so you might see more lawyer-accountant types in sports now than 50 years ago.

Finally, he says:


But it's also the case that alternative entertainment venues reduce the demand for tickets to professional sports events and participation in organized youth sports...It seems to me that professional sports franchises are becoming a riskier investment, especially baseball.

As we move toward a long tail environment, the business model for professional sports will have to evolve. My guess is that, looking at entertainment as a whole, the market share of pro baseball, pro football, and pro basketball is probably in for steady decline. The trick is to survive as niche businesses. My sense is that they are adapting, for example, by trying to create a "total entertainment experience," with the luxury boxes, the loud music, and the expensive concessions. I personally liked baseball a lot more when it was just plain baseball, but fans like me aren't what pays the bills.


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CATEGORIES: Business Economics



COMMENTS (11 to date)
Vincent Clement writes:

One reason for a change in brand could be a better franchise agreement with a competing chain.

Carl Marks writes:

They may have extracted as much depreciation as tehy are allowd under tax purposes, but if they swap then they can started deducting depreciation all over again.

This does not only happen with hotels. Large corperation will do this with their buildings; after they have finished expensing depreciation, they willl sell the building and then lease it back from the buyer under sequential 1 year terms. Sun Microsystems recently did this with their MA headquarters, so when earnings come out you should see a big jump in their unadjusted profits.

So yes, it is a tax issue (these things are best not thought of, they can expediate teh hair loss process, and what probably happened to Arnold)

Floccina writes:

You have to discount for inflation which comes to one of my pet peeves. If inflation is defined by the increase in money rather than the CPI, inflation has been significant. It has undermined savings for individuals. Individuals over the last 10 years would have done better to put all their money into housing, a consumable asset, rather than saving and investing income earning assets. I think that this has a lot to do with the rising price of the Sonics.

Inflation of the money supply pushes up the price of assets while globalization which holds down the price of goods that are importable.

Now if one is like me, a saver who likes to live in a nice home more than buying cheap imported items this inflation is bad.

Floccina writes:

BTW sans inflation few things should appreciate.

KipEsquire writes:

The "hotel industry" is actually three separate industries:

1. owning properties
2. franchising
3. managing

A "fourth" might be concessions, residential occupancy, etc.

Although #2 and #3 might be performed by the same company, #1 is almost always separate from the others. Marriott International, for example, owns almost no real estate.

Switching franchises can be initiated by either the franchisor ("your property no longer meets our standards") or the franchisee ("I can improve the property and re-brand for a higher RevPAR*").

---

*"Revenue per available room," the standard metric for measuring "room rates."

The thing that drove Schultz to sell the Sonics was that he was losing money every year because he couldn't sell luxury boxes to corporations for entertaining their customers. The reason for that was his competition--Paul Allen's Seahawks, and the Mariners--had brand spanking new facilities, at taxpayer expense, that were more attractive.

Ironically, the Sonics are the most successful team in Seattle, with three NBA finals appearances, and one Championship (1979), and they're the ones not able to get a new facility.

Karl Smith writes:

The interesting question is why the base price for the asset is so high.

Typically, would think that an asset's value is the discounted present value of its cash flow. If the tree or the team has a permanent negative cash flow, then why does it have a positive value from which it can appreciate?

One possible answers is that it has consumption value. Owning a baseball team is really really cool. As long as someone is willing to pay that then the team can have a positive asset value and a negative cash flow.

That is, I can make money owning a team because ownership always has salvage value as consumption.


An interesting result that I think also holds with night clubs is that in a perfectly competitive market firms whose ownership provides consumption value must be cash flow negative. Since there is no economic profit in perfect competition the "rental rate" must be less than the interest rate.

Ajay writes:

I agree with Mark Steckbeck that this is a bubble. Sports franchises have appreciated to this extent because of two monopolies. One monopoly is that they are granted special status by the government and even get exclusive facilities built by taxpayer money. The other, more important monopoly is that of broadcast rights licensed by the monopoly cable companies and TV networks. These rights supply anywhere from 25% (NHL) to 65% (NFL) of the revenue to sports franchises. Note also that the greater publicity and awareness created by the explosion of communication networks over the last decade can double the revenues of even a laggard like the NHL. However, this is only a brief consolidation before the fall. The new communication networks will end up driving the audience to much more diverse fare, now that the TV infrastructure is no longer a monopoly, and the existing sports franchises will not be able to "adapt" by moving to a "total entertainment experience." As such, we're currently at the peak of the sports franchise bubble and it's all fairly sharply downhill from here.

Ted Craig writes:

On an economic basis, isn't it better to view a sports team as an asset similar to art rather than real property? I mean, the value is subjective and based more on ego than earning potential. Many more people in Dallas know who Mark Cuban is than know who Rex Tillerson is. Tillerson is the CEO of ExxonMobile.

Phil writes:

I agree with Karl Smith (as I have written here) that sports teams are expensive because of consumption value.

This is supported by the fact that that when corporations (which cannot consume) own teams, they are very profitable. The money-losing teams are almost all owned by individuals, who presumably tolerate the losses for the fame and fun.

Barry writes:

Simply "swapping" fully depreciated property in a 1031 tax free exchange doesn't help, as you get a carryover basis. (if memory serves). And if you sell for cash, you'll have tax to pay (whether recapture or simply capital gains depends on how aggressive your depreciation was.)

However...I wanted to mention the best investment the tribune made was probably in AOL.

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