In Pursuit of Value - The changing drivers of Valuation
Gustav Klimt. Crop of Adele Bloch-Bauer, 1907.
Climate Change, Technology, and the move from Products to Services.
An edited version of this 6,900 word essay first appeared on the Propmodo website, March 3, 2020.
The Map Is Not The Territory
Ron Johnson was hand picked by Steve Jobs to build the Apple Stores. At the time the very idea of a computer company (in 2001 Apple was still known as ‘Apple Computer’) opening a retail store was considered borderline insane. A commenter in Bloomberg magazine wrote ‘I give them two years before they’re turning out the lights on a very painful and expensive mistake’.
As we know it did not turn out like that. By 2011 Apple stores were by far the most productive in the world on a sales per square foot basis, blowing the long term No 1, Tiffany & Co, out of the water. Today, they remain the gold standard in retail, to the extent that the company, rather hubristically, has taken to referring to them as ‘Town Halls’.
Jobs had picked Johnson because he already had one triumph under his belt, the resurrection of Target in the late 1990’s. So, post the raging success of the Apple Stores, it is no wonder he was sort out in 2011 to perform his magic on the dowdy old department store chain JC Penney. His pitch included, it is said, references to ‘stores within a store’ along the lines of Apple Apps. He envisioned the end of discounting, great customer service, immaculate displays, and the best products on the market.
His plan was rolled out at speed and several billion dollars were spent, no expense spared.
The new stores flopped immediately, and by 2013 Ron Johnson was gone. He had mistaken the map for the territory. His map of how retail looks, conceived and refined at Apple, was entirely wrong for the territory that was JC Penney. His map of how to create great retail, an abstraction that provided the framework for action, was not wrong as such; it was just wrong when the environment changed. He hadn’t suddenly become stupid, he just failed to see that his prize winning map, that had made him a hero, a legend, was not reality. It was a way to get from A to B, not THE way to do so.
Reading this story made me think of the real estate industry. Coming from a tech background, and being heavily involved today in the PropTech world, I am all too aware that many of the new, would be ‘disruptors’ see the industry incumbents as luddite, slow, unimaginative and altogether ponderous. Being somewhat older than most of these upstarts, with commensurate experience, I see it very differently. The industry behemoths of today are pretty much as described, but that is by design, not ignorance. The best real estate companies are perfectly optimised for the way their world has worked. They have been in the business of selling oranges to people asking for oranges. They haven’t tried to sell them bananas. Their map of how real estate works has served them well. If it ain’t broke, don’t fix it.
The problem though is that there are a lot of very successful, very wealthy Ron Johnsons in real estate. With beautiful, gold plated maps of a territory that is morphing into something very different, right before their eyes. But they cannot see it. If they don’t look harder it is likely history will rhyme, as Mark Twain said.
A new map is needed.
‘Our World Is On Fire’
This was Greta Thunberg’s opening tweet of the new decade. Five words that succinctly explain why the elephant in the room for the real estate industry is climate change. Ms Thunberg might drive a certain type to distraction, but she is the bearer of a new map, and a new map that across the world is being snapped up and adopted as ‘the new new’. Whether you agree or not is no longer relevant; not agreeing is like bringing a knife to a gunfight. You are going to lose. Howl at the moon all your like - if you want to make money, or not lose it, you have no choice but to take climate change very seriously.
Paradoxically, Adam Smith is riding to the rescue. Because it is his dictum that:
‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’
that is the underlying force that, hopefully for all of us, will mean we can both ‘save the planet’ and actually do well by doing the right thing.
Larry Fink, CEO of Blackrock (with $6 TRILLION of assets under management) has just laid this all out clearly. His annual letter to shareholders is entitled:
’A fundamental reshaping of finance’
and has the sub-heading:
‘Climate change is driving a profound reassessment of risk and we anticipate a significant reallocation of capital’
He goes on to write about how climate change (to him we are well beyond the stage of debating ‘is it real?’) will impact municipal bonds, whether 30 year mortgages are possible in many areas most at threat from rising sea levels, how insurance may become unobtainable for many, and the impact on inflation and interest rates if the cost of food climbs from drought and flooding.
‘Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk.
Last year he wrote:
‘a company cannot achieve long-term profits without embracing purpose and considering the needs of a broad range of stakeholders…. Ultimately, purpose is the engine of long-term profitability.’
This received a great deal of attention and much tub thumping, but frankly ‘climate risk is investment risk’ is 100X more powerful. When the man at the helm of a powerhouse like Blackrock says:
Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.’
the writing is on the wall. The old map is being ripped up.
Demographics is also about to impact on this subject (Demography IS Destiny) - Millennials aren’t so young anymore (up to nearly 40) and they are moving into corporate positions of power. Whilst most ‘Millenials are …’ comments are trite nonsense it is true (according to a large Deloitte study) that as a group the under 40’s do put more weight on ‘improving society’ than ‘generating profit’. Most likely because they’ll have to live with the consequences. Either way, again as pointed out by Larry Fink, the world is currently undergoing:
‘the largest transfer of wealth in history: $24 trillion from baby boomers to millennials. As wealth shifts and investing preferences change, environmental, social, and governance issues will be increasingly material to corporate valuations.’
All of which indisputably means that an industry responsible for one-third of global greenhouse gas emissions, and that consumes 40% of all the world’s energy, has not only no choice but to take this very seriously but is going to be under the most intense scrutiny over the next ten years. There will be some carrots used, but if the industry does not comprehensively up its game, then very many, very large sticks will also be used. Indeed, these are already being used, with New York City mandating that large buildings (above 25,000 sq ft so not even that large) should reduce emissions by 40% by 2030. Not that surprising perhaps as what do we expect when the real estate industry is responsible for 66% of greenhouse gases in the city.
Back to Adam Smith though, this is a great opportunity. Greed, and fear, are very powerful forces. Morgan Stanley released a report in September 2019 entitled:
‘Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice’
It concludes:
‘Our survey confirms that sustainable investing is now part of mainstream financial strategy. Given the record adoption rates and interest levels the poll reveals, the question is no longer whether sustainable investing is here to stay, but what are the opportunities and challenges for further growth? On both fronts, our findings send strong signals from investors to help guide the field’s evolution.
As understanding of sustainable investing approaches deepens, large majorities of investors are seeking more product options across investment vehicles.’
As said above, to fight this is to bring a knife to a gunfight. Far better to see that those who fail to address the sustainability of their assets (with vigour, not just lip service) are destined to destroy a lot of value, whilst those who truly embrace ‘Next Gen’ real estate are going to build powerful Brands and lord it over assets that attract the best customers. Doing the right thing is the surest way to profit in real estate in the 2020’s.
Aligning with the best businesses always makes sense, and in terms of climate change this will apply in spades. Who is a company like Microsoft, who announced in January that they are aiming to be carbon negative by 2030, going to want to do business with? Or the 500 B Corporations who committed at the Madrid Climate summit to reduce net greenhouse gas emissions to net zero by 2030 (20 years ahead of the targets set in the Paris agreement)? Who is going to share in the €1 trillion being made available by the EU’s Sustainable Europe Investment Plan to finance green initiatives? Who is going to attract funding from Fifth Walls Carbon Impact Fund?
None of which is to suggest that reducing the carbon impact of real estate is an easy task. When building a new highly sustainable office building leads to embedded carbon that’ll take 60 years to repay we know we have a mammoth challenge on our hands. However, ignoring the challenge is guaranteed to destroy value, whilst addressing it will, at worst, preserve value, but at best, open up the chance to create really significant value. Whoever cracks the code of how to build and operate buildings dramatically less carbon intensively than today, is looking at a vast market to sell into.
Looking at the devastation in Australia, the flooding in Jakarta and the increasingly common ‘once in a lifetime’ climate events one can’t help but think the exhortation of JFK in the 1960’s would be not unwelcome at the start of the 2020’s:
‘We choose to go to the Moon in this decade and do the other things, not because they are easy, but because they are hard; because that goal will serve to organize and measure the best of our energies and skills,’
Oh, and because we could make a lot of money out of it.
Sustainability is Table Stakes - Other Drivers of Value
The prerogative to take Climate Change seriously is, truth be told, a game changer for the real estate industry. It really is a big thing. To create value though, requires many other new or growing factors to be taken into account.
Technological Change
The economist Carlotta Perez has written (in her book Technological Revolutions and Financial Capital) about how investment in technology tends to follow a certain pattern. You see a huge buildup of investment in infrastructure and tools, what she calls the ‘Installation’ phase, and then this is followed by a surge of adoption, what she calls the ‘deployment’ phase. However, between the two there is a lull, usually involving a financial crash and subsequent recovery. She says of this pattern ‘nothing important happens without crashes’.
We may be experiencing a crash, at least of sorts. The WeWork debacle (destroying $40 billion of ‘value’), the stock price declines of Uber, Slack and other loss making tech companies are indicative of a realisation that many of the VC backed business models of so called ‘Unicorns’ are actually as mythical as that name suggests. Or might well be. The jury is still out on the entire ‘Gig Economy’, and in general there is a large wave of ‘Techlash’ rolling over the entire technology industry.
Either way, crash or not, we are definitely in the ‘deployment phase’ of the Fourth Industrial Revolution, as defined by Klaus Schwab, founder of the World Economic Forum. And for real estate that matters. A lot.
There are four ‘Platform’ companies that we can confidently say are going to be increasingly important to the entire Western economy and they are Apple, Google, Microsoft and Amazon. China / Asia have three of their own - Baidu, Alibaba and Tencent.
For a deep dive into how these are the 20th centuries Ford, GM and Chrysler of the 21st century see Ben Thompson’s essay ‘The End of the Beginning’ (https://stratechery.com/2020/the-end-of-the-beginning/)
These companies are enablers of a complete re-engineering of our economies. Apple provides a billion people with iOS to power the supercomputers they have in their pockets. Google does the same with Android for the 75% of non Apple users. Plus, through its search engine, access to pretty much ‘all the worlds information’ as was the dream of Larry Page when he and Sergey Brin founded the company. Trillion dollar Microsoft provides cloud computing through its Azure service, and Amazon handles just about anyone not using Azure with its own AWS cloud computing capabilities. Amazon is also, of course, ‘the everything store’, commanding 40% of all online shopping in the US.
These four companies have more power than any others in history, and are foundational to how the world works today. Just about every business is built, and operates, on top of software, hardware and services that they provide.
Precursors to these four were IBM, in the days of mainframes, where our computers were in the buildings where we went to work. Then Microsoft moved those computers to our desks, but still in the buildings where we worked. Now though, our computers are on our person; we have smartphones, tablets, laptops, watches and ‘Airpods’. Our documents are all in the cloud, and mostly we have fast connectivity between ourselves and them. Wherever and whenever we want to connect.
Computing, as Tim Cook says, has never been more personal. We have disconnected place from knowledge. We no longer need to be in any given place to access anything we want. This really is the personal computing era, and the only likely change over the next ten years will be the growing ability of our environment to ‘talk back’ to us through the deployment of 5g and countless billions of tiny sensors.
Whenever we try and forecast how the real estate market will develop it is essential to take this ‘personal computing’ into account, as it fundamentally changes the nature of demand. Across all sectors. We do not need an office to do our work, or a physical shop to do our shopping. We do need a roof over our head but where this need be is fluid.
What we all want though, is to actually want to be somewhere. Maslow’s hierarchy holds true. We all have physical needs and require safety. We want to belong, we crave esteem and we all want to be the best version of ourselves. When many of our basic needs can be easily dealt with by our phones, we actually need more human interaction than ever. The worrying growth in loneliness, mental illness and suicide suggests as societies we are failing. Does real estate have anything to do with this? I think it does: people spend 90% of their time inside, in the built environment. How that environment is designed and operates must have an impact on us. Churchill said ‘we shape our buildings and then they shape us’ - has this ever been more true than today?
There is much talk of smart buildings and smart cities: if these started from the premise that the welfare of all the people in these buildings or cities is the most important thing, then I think we’d all be better off. As we’ll see, like there is money to made in taking climate change seriously there is much value to be created by putting people at the centre of your thinking in real estate.
Offices
Old work is leaving the building. What is old work? It is anything that machines (computers, robots) can do faster and better than we can. That means any task that is structured, repeatable or predictable. McKinsey in 2017 reckoned this amounted to 49% of all the tasks people are paid to do around the world.
So, what are we humans going to do in the office? The answer is all the things that machines are not good at: Design, Imagination, Inspiration, Creation, Empathy, Intuition, Innovation, Abstract & Critical Thinking, Collaboration, Social intelligence, Judgement. Now admittedly many of us are not actually that good at these either. But, and this is the critical point, these are skills that humans have the capability to excel at, and they can be taught. If we are to have any hope of remaining relevant then it is incumbent upon us, as business leaders, to train the people we work with, and for us, as individuals, to commit to lifelong learning and development of these human skills.
We all need to understand technology up to a certain point, but the notion that we all need to be able to code is absurd. Even the largest software companies actually employ not that many coders, and unless you are very very competent, a computer will shortly be able to code itself better than you can.
What are needed are the human skills listed above, an understanding of ‘how technology works’, and then the capability to work in what Paul Daugherty of Accenture described in his book, Human + Machine, as ‘the missing middle’. This is the area between Humans and Machines, where you are explaining to the technology teams what is required from a human perspective, and to the human teams how technology can ‘augment’ them. For example, in one direction, why a chatbot should not say ‘No’ but ‘Sorry Antony, I did not understand what you meant, can you please explain some more?’ to, in the other direction, how a Natural Language Processing algorithm could read those 3000 leases for you and extract all the data-points you need. The machines will only take over if we do not develop our human skills and make the effort to understand how to leverage all the computational power at our disposal.
Currently many, if not the majority, of offices are designed for the ‘old’ work described above. What we need, and where the value is to be created, is spaces and places designed for ‘new’ work. Places that catalyse these human skills. It really is not hard to see why non-traditional office spaces, from flex offices, to hotels, to clubs, to libraries, are always so busy; these spaces are aesthetically more conducive to human work. They ‘feel’ better, and that is the starting point to creating value. Create spaces where people ‘feel’ good and you’ll be creating premium space. There is already considerable research about how our environments impact our cognitive function, and as our cognitive capabilities become ever more valuable, so will space that helps us be as effective and productive as possible.
We all know what it feels like to be in a great space, appropriate for the task at hand. It is not hard to see why everyone wants to be in the best spaces. Perhaps not everyone can afford the premium to do so, but there is an awfully large market out there of people who will/would pay a premium for better space.
What does not really exist yet are the companies capable of delivering really great space. On an ongoing basis, with real time analytics of quantitative and qualitative factors and the ability to continually optimise the space, based on those analytics. I.e companies who treat the workplace like software, where ‘Build, Measure. Learn’ is the norm (in real estate we stop at ‘Build’). What we have today are six sub sectors combining to deliver a workplace. We have (not even always) real estate people, then network providers, then data analysts, then workplace designers, then HR departments and finally people with hospitality skills. All of these are components, ingredients, in the mix of creating a great workplace. But they largely do not work together, do not share data, and do not stay with a space after it is finished. Is it any wonder roughly half of office users say their workplaces do not enable them to work productively. Or that, on average, office desks are unused 50% of the time.
The greatest creation of value within the office market will be when all the ingredients of a great workplace are managed together, on an ongoing basis, and used to continually optimise the space for the specific ‘jobs to be done’ of the people in that space. When a workplace runs at 75% occupancy with 75% of people saying it enables them to perform as productively as they are capable, we will have got somewhere. JLL use 3-30-300 to describe how a company pays $3 for utilities, $30 for rent, and $300 for their employees. The real estate industry focusses on the $3 and the $30 when they should be focussing on the $300 - how can we, in the real estate industry, enable each person in our buildings to be as productive as they can be? And how much is that worth?
The Office Market is something of a ‘Category Error’ - that is what we have to sell, but it isn’t what anyone wants to buy. No business wants an office, what they want is a productive workforce. It’s like manufacturers of drills - no-one wants a drill, they want a hole in the wall. We need to be thinking about how we can create, and curate, places that enable productive workforces. We need to stop thinking about selling people square feet, we need to be thinking about selling people a great user experience. As luxury car manufactures do not sell miles per gallon or extended warranties, but rather image, prestige, status and ‘luxury’, we need to be thinking about building Brands that stand for particular user experiences. Brands tailored for the known wants, needs and desires of particular audiences or sectors. Brands that represent places and spaces they want to be in. Really want to be in. More than anyone else’s space or place.
User Experience = Brand & Brand = Value.
Retail
This is the tough asset class. As we’ve said, no-one needs a shop to go shopping. And increasingly they aren’t bothering to. Is there hope for the retail sector? Yes there is, a lot of hope, but only if a great deal changes. If retail stays largely as is, then it is a death star.
It will change though, probably only partly due to incumbents but largely through new entrants coming in to the market. That is not necessarily a criticism of incumbents. Frankly it is much easier to start a new retail company than turn around an existing one.
So what are the ingredients for creating value in retail real estate?
First off you need to start from the premise that retail is not just (or even primarily) about shopping. There are five ways physical retail can work:
You become a destination, a place so fabulous that people come for the experience, the glamour, the grandeur, the fun or whatever emotional button you are trying hardest to push.
You act as a fulfilment centre. The last mile is a known known issue. How do we get our goods into the hands of customers the quickest? As often the quickest wins. This will come down to increasingly sophisticated networks of distributed, often small, fulfilment centres, artfully (AI driven) dotted around a city, with each one close to one group of customers. Rooftops, infill sites, unused underground car parks and other ‘odd’ spaces can be used to set up small fulfilment centres. There are even companies that will design, fit out and run fully automated, robot enabled mini centres for you.
Through either exceptional local, human knowledge or, more likely, through the use of AI and multitudinous data sets you run stores than are highly tuned to the particularities of a given location. Where your stock, your pricing, your assortment is exactly what the local market is after. Mostly, stores are generic, with little customisation. These have a bad future awaiting them.
Or you run stores that are either very cheap (too cheap to ship) or for everyday purchases. Both of these are somewhat immune to online competition. For now at least (see the rise of Subscription services to get an idea where competition might come from).
Finally, you use retail as an attraction to increase the value of residential assets. Whilst only applying to owners with significant estates, increasingly retail stores will be curated in such a way as to enhance the character of a neighbourhood. Often this will mean not signing up the highest paying, but most interesting, retailers. Subsidising the new, or quirky, or most enjoyable to visit retailers.
In all cases, your store will be very data rich. About the local area, your customers, how they shop, what they touch, pick up or lookup. In short your job is to customise and optimise your store to suit your customers; the more you know the more you’ll be able to do so. The three areas within retail where AI is most applicable are: personalised product recommendations, assortment and pricing optimisation.
None of the above (generally) is under the control of the owner or manager of the real estate of course. What is under their control though is knowing how well their existing or prospective tenants fit one of the five use-cases above, and how good their data skills are. That will go a long way to informing a sensible leasing strategy.
We need to change how we think about physical shops. Originally and until recently they were a distribution channel, a way to get mass manufactured goods into the hands of customers. Mail order provided another channel, to an extent, but nothing like the new channel that is online and e-commerce. Mr Bezos will send me just about anything I want and I do not even have to get up off my couch to order it.
So what then is a physical store for? The new reality is that a physical stores purpose is the same as an ad on Google or Yahoo; it is a ‘Customer Acquisition Cost’. It is a way of getting a new customer. But it has two advantages over online. The first is that, per customer, it is probably cheaper than online (Google, Facebook & Amazon have a vice like grip on online advertising and can and do ratchet up the costs to sellers) and secondly, unlike an online ad, if I run a smart operation I can probably get a prospect to spend 10-20 minutes in my store. I have a chance to showcase my wares, explain my Brands unique selling points, and collect a great deal of data about this new customer. Try getting someone to watch a 10 minute advert on YouTube.
Once I have inspired a new customer offline, I can revert to serving their needs online. Preferably all through one platform that gives me a 360 degree view of every touchpoint with each customer.
This is why many online brands are moving offline. Not because, as many people in retail think, they have discovered that online does not work and ‘shops are best’. Shops are a customer acquisition cost and a way to collect rich data.
Again, where does real estate sit in this situation? How does real estate add value?
In several ways.
If you have spaces to let there are several technologies that can help you understand the psychographics of your neighbourhood which can then be used to cross reference with offline brands looking for space. What Brand suits this space? This has been done for years but it can be so much more detailed and granular with todays technology.
Work with Pop-ups. From individual trials all the way up to companies like Neighbourhood Goods who run a department store entirely comprised of pop ups. Hard to get bored at that store.
Or if you run shopping centres you could do something similar to Macerich at Tysons Corner Centre. They developed a concept called Brandbox where they dedicate a sizeable section of the centre and have a rotating roster of new retailers every six months. Critically though, they solve the problems lots of offline retailers have in terms of knowing next to nothing about real estate. Macerich take care of everything; shelving, data and foot traffic, RFID tags for inventory, marketing and even helping with staffing. This is similar to the concept discussed above re offices - hardware + software + services. Real estate as being about much more than real estate. Landlord as partner, co-creator rather than just rent collector.
In Germany a company called _blaenk do a similar thing to Brandbox but they take over unused stores and then ‘advance the point of sale, to the point of experience’. ‘Send us your products, we do the rest’.
Real Estate as Hardware + Software + Services….. = Value.
China is way ahead on much of this. In 2016 Jack Ma, then boss of Alibaba started talking about ‘New Retail’ which he described as ‘making it easy to do business anywhere’. The point is to merge online & offline into just ‘Retail’. To think of digital, media, commerce and logistics as four facets of one single entity. Where everything acts as a feedback loop to everything else. Alibaba is involved in some 80% of all online retail in China, but it also operates thousands of physical retail spaces, including the supermarket chain Freshippo, where you can do everything from buying a lobster and having it cooked for you in-store to ordering online and having it delivered in 30 minutes if you live within 2 miles.
The difficulty for real estate people in this world though is that the likes of Alibaba, and Amazon, do all of this themselves. The real estate input is just to provide the commodity, dumb box where it all happens.
Industrial
Industrial is also a tricky area. Yes industrial landlords have done very well over the last few years, due to the rise of e-commerce creating new and greater demand, but as with serving Alibaba, what can they offer customers, beyond a big dumb box? The bigger customers do it all themselves, so the added value areas have to be in thinking how they can assist either transitory customers or relatively small ones. So we see (once again) the provision of hardware + software + services; to enable the likes of Travis Kalanick to set up his Dark Kitchens, or Americold and similar to fit out dedicated warehouses for cold storage. There are also interesting companies providing ‘Robots as a Service’ or wholesale conversion of roofs as solar farms.
Similarly we are likely to see a growing repatriation of manufacturing to the West (when it is only robots in a factory the cost of labour is no longer material) and a rise in the use of on-demand 3D printing machines. But again, where does real estate fit in? Most of the value is in the Services.
Industrial value will have to come from either highly efficient, lean organisations dealing just in real estate, or through companies moving into becoming ‘Warehouse as a Service’ operators that offer customers a panoply of on-demand services, much as Amazon do with their cloud offering AWS.
Residential
As renting becomes an increasingly high percentage of the residential market (not necessarily through natural demand but pure economics) we are likely to see two things. First, how residential gets planned, designed, constructed, marketed, operated and sold or let is definitely going to go through the ‘remove friction, enable discovery’ wringer. Where any part of a workflow, at any stage, is harder to do than it should be, ‘someone’ figures out how to remove that friction. And then where, or when, necessary information to complete a task is not available, ‘someone’ figures out how to make it available. Obviously in such a disjointed industry this is no mean task, but sooner or later the parts will come together. The solution cannot only be institutional house flipping like the iBuyers, where you remove the friction by simply embracing a ton of risk. That seldom ends well.
The second, and really big, trend in residential will be the plethora of new businesses based on ‘bundling and unbundling’ a range of services to provide a product or service that suits a particular segment of the audience. Current examples are Sonder, Lyric, Ollie, Oyo, Niido, Selina, The Kohab. This will mirror the flex office market where the same dynamic will apply, as described above. Where the business owner either develops a product/service based on the known needs of existing customers, or creates an entirely new Brand customised and optimised for the wants, needs and desires of a target customer. Think Medici Living or Starcity designed for singles against Kin, a Brand developed by Tishman Speyer and Common aimed at families. Essentially they are in the same business but they have differentiation and competitive advantage and the concomitant pricing power that affords them. They are not selling commoditised, dumb boxes.
Sure this is going to go through a lot of iteration as companies ‘Build, Measure. Learn’ to get to a business model, and UX, that really works. But the opportunity to reframe the rental market as a service rather a product business is great. The bar is being raised. As with dreary (even if high spec) offices, why shouldn’t customers expect something better?
Real Estate as Hardware + Software + Services….. = Value.
Future Proofing Your Portfolio - The 7 KPI’s of Value
The seven KPI’s below are generic across asset classes.
Connectivity. You need connectivity in three dimensions. First, physical in the sense of transportation links etc. Secondly, any asset has to have exceptional digital connectivity - you cannot operate in the modern world without it. And thirdly, intellectual connectivity, as in how large is the talent pool of intelligent, well educated people in your area. An elitist dimension perhaps, but we live in a world where there are increasing returns going to talent so investing where the most talent is makes sense.
Modernity requires Density. Much of the ‘as a service’ or ‘on-demand’ world of services requires relatively high density to make the unit economics work. So if you are selling to an audience that wants these services, you have to be operating in relatively dense locations.
Flexibility. Stewart Brand wrote his famous book ‘How Buildings Learn’ in 1994, partly as a critique of architecture that was inherently inflexible. Since then the need for flexibility has grown 10X; we have little idea how our assets will be used in 10 years. Designing and building for flexibility should be an absolute requirement of any new building. Similarly, divest out of assets that are not flexible; they will come back and bite you. The only question is when.
Productivity / Pleasure. These refer to the Office and Retail sectors. Offices have to be able to be configured/optimised/operated in a way that maximises the productivity of people who use them.Those that, for whatever reason, impair cognitive function (and cannot be fixed) have a decent chance of becoming stranded assets that no-one wants. Buy them to repurpose but sell them if that is not your business. With Retail assets the critical point is whether they match one of the five use cases above but more specifically, for stores whose purpose is to be a store, will anyone be able to make visiting them enough of a pleasure to persuade a shopper not to just push that ‘One Click’ button from the comfort of their home? If not, they are dead as retail assets.
Health & Wellbeing. Given the poor air quality of so many cities should it not be possible to leave a building healthier than when you went in? You have control over the environmental factors in your asset; to what extent do they aid, or impede, the health and wellbeing of the people using them?
Sustainability. The fastest way to destroy value in the 2020’s will be to own unsustainable assets.
Data, Privacy & Ethics. There is a general breakdown of trust between the tech industry and their customers. We are all, to varying degrees, concerned about how companies like Facebook invade our privacy and monetise our personal information with gay abandon. Within real estate we should not need to invade anyone’s privacy. But it will happen; either through design or simply sloppy network security. And when it does the backlash will be intense. So it is vital for asset owners to address how they collect, store, manage and maintain data about their customers. There are great things you can do with more data in real estate but, as laid out by The RED Foundation, in handling it you must be accountable, transparent, proportionate, confidential & private, lawful and secure. A lot of value rests on it.
Conclusion - The Upending of Investment?
Real Estate investing is becoming increasingly complicated, as hopefully explained above. The hardest thing to do will be to stay roughly as you are, as if we still lived in a largely linear world. Because we do not; the world is increasingly exponential and you have much more chance of either destroying a lot of value or creating a lot of value. Maintaining value will be the hard thing.
So, as we pursue value, how to sum up the new drivers of valuation.
First it must be acknowledged that apart from the sustainability issues around climate change (you absolutely cannot duck this) it is legitimate to ignore all the commentary above about non real estate factors in the real estate industry. For many in real estate being a real estate developer is what they should continue to do. Deal with everything real estate; sourcing deals, designing buildings, achieving planning permissions, and good old fashioned adding value through repurposing or redevelopment. Stick to the hardware side of the industry and move on, letting others deal with the ‘software + services’. This will be the best route to creating value for many. If you are a product company, and want to remain a product company then fine; just don’t think you can do the ‘software + services’ unless you are committed. Being a services company IS different.
This aside, there are eight conclusions we can draw that will help us in our pursuit of value:
Technology is changing the nature of demand - it impacts on the work we do, how we shop, how we live and how we expect to live. Supply will need to change to match this demand.
The Real Estate industry is changing from being about selling a Product, to delivering a Service. That means operationally, culturally, and financially real estate companies are changing. Diversely skilled, multi-functional teams are becoming increasingly critical to business success.
Understanding the wants, needs and desires of users of our spaces and places, and how we can best assist them in their ‘jobs to be done’ is a foundational driver of real estate value.
Investment can only be passive if ‘low risk/low reward’ is the aim.
Investment by spreadsheet is dying - the particularities of individual assets matters. All buildings are not the same, despite what their numbers look like.
In many areas the age of real estate investment having Bond like characteristics is coming to an end, as overall income, rather than just rental income, becomes the metric that matters.
Moving to real estate ‘as a service’ is meaning assets can generate significantly higher income, but who benefits? The operator of an asset matters like never before. Aligning the interests of owners, occupiers and operators will become a critical factor in creating value.
And finally, we might well be seeing operators becoming more important, displacing even, Landlords. To maximise yields, ‘the money’ needs to work closely with operators, and operators can probably add real estate skills easier than real estate companies can add operational skills. Potentially we could be seeing a major reworking, a major redesign, of the real estate value chain.
Regardless of everything though, real estate investment is still a great industry to be in. According to the Financial Times in October 2019, ‘Bonds worth $15tn — roughly a quarter of the debt issued by governments and companies around the world — are currently trading with negative yields'. This is unlikely to continue, and when it stops, where else can you deploy very large sums better than in real estate?
Onwards and upwards!
Antony
January 2020