For the commercial real estate industry, the future is increasingly clear.
Technology will decrease the demand for real estate, accelerate its rate of obsolescence and reduce investment rates of return. As technology drives restructuring in every industry, virtual space (technology) will replace physical place (real estate) as the medium to transact business.
A dire prediction for the real estate industry's future? Not necessarily. Nor does this prognosis suggest institutional investors, including pension funds, should not invest in sound real estate companies with a vision of the future and the management to get them there. But the fundamental principles that directed investment in real estate as an asset class must undergo a drastic change, along with traditional portfolio theories, if investors are to achieve the risk-adjusted rates of returns they seek.
At the heart of this change will be a shift from viewing real estate as an asset class to an industry sector. At face value, this shift represents a fundamental change in mindset, redirecting investment from single assets or asset pools to well-capitalized public and private real estate companies capable of yielding investment returns commensurate with the best companies in other industries.
To avoid this necessity for change is to invite obsolescence.
The experience of the railroad industry during the last century is a case in point. In 1830, just 23 miles of railroad track connected a largely unsettled North American continent - within 10 years, that number had doubled, and exponential growth at a similar pace continued for more than 60 years. Experts at the end of the 19th century predicted millions of miles of track would connect America by the dawn of the 21st century. Today, there are only 400,000 miles of track and just seven (soon to be five) well-capitalized railroad companies.
What happened? In effect, railroad track became too expensive as a means to connect businesses with their customers. New and more competitive solutions emerged that were more efficient and effective than tracks.
The end of the 20th century now brings a new competitor to developers of and investors in physical place. That new competitor - technology - offers an alternative in the form of virtual space that is not simply driving change in serving customers, but also in work and management styles.
The implications for how companies use physical place could not be more significant. Investors already are responding to these changes, directing extraordinary amounts of capital away from real estate to technology. It is this trend that portends critical change for the real estate industry.
Not all investors, however, see the parallel between the demise of railroads and the advent of the car and plane, or the contraction of real estate and the advent of technology. But since 1986, investors in U.S. commercial properties have lost more than 50% of their capital. In contrast, those investors who allocated their capital to the industry that provided the future connections for business - technology - have been rewarded with total returns in excess of 250%.
What lessons can commercial real estate take from the railroad industry? A change in mindset is required.
The virtual connection
For much of history, physical place was the primary medium for transacting business whether by the original town-square traders and farmers, or more recently, buildings. The information age, however, ushers in a revolution with broad implications for how basic resources are used. Once thought of as primarily serving a management information role, technology has developed as the medium, or virtual space, in which more business is being conducted. But more importantly, the fundamental economic drivers have changed. Where once physical connections were the primary vehicle for commerce, it is today becoming virtual connections. Millions of instructions per square second or MIPS - the language of modern technology - has the power to replace square feet as a medium for transacting business.
With this, technology is enabling businesses to move from production and delivery of goods and services in physical place to sensing and responding to customer wants and needs in virtual space. Examples abound:
Customers are shopping differently: according to a 1993 Gallup poll, 40% of all shoppers used non-store venues; the number of hours spent shopping between 1980 and 1990 reached an all-time low; and same-store sales dropped across many retailing sectors between 1990 and 1995.
People are working differently: telecommuters have grown to more than 11 million; technology purchases are soaring while prices continue to fall; and productivity growth has more than doubled without new construction.
Since 1990, Investors are investing differently: net new capital flow into real estate increased only 2% to 3%; new capital flow into financial assets grew more than 30%; and investors are changing to financial assets to assure their future security.
Asset class or industry sector?
Commercial real estate's evolution through the centuries gave rise to its unique treatment as an asset class, rather than industry sector, under the guiding principle that tangible assets are the drivers of wealth, not customers. As a result, investors purchased and financed physical assets.
Ultimately, this mindset has betrayed investors as real estate has failed to perform to the standards delivered by investments in other industries. To develop a new model of real estate investment will require the recognition that real estate is an industry like all others, rising or falling on its ability to serve customers rather than source and deploy capital to build and manage buildings.
But first, a common understanding of the definition of asset class and industry sector is essential. Asset classes, which include stocks and bonds, represent types of investment instruments that have common traits, including risk and reward characteristics. In contrast, industry sectors may be defined as an aggregation of companies offering products and services to fulfill similar categories of customer wants and needs. U.S. commercial real estate, whose capitalization is equal to the sum total of 40% of that of all industries combined, evolved as an asset class from the outset because of its use of private, highly illiquid instruments. These investment structures were the result of a set of historic factors - all of which have been reversed in the past decade - that includes:
World War II gave rise to a command-and-control economy in which hard assets stood for long-term security because of their tangible and recognizable quality. In recent years, investment patterns reversed that perception. Hard assets have fallen in favor, while liquid financial instruments exploded.
Commercial real estate sought and received protection from the U.S. government in the form of tax incentives, the tax code becoming an instrument of protectionism. The 1986 Tax Act ended that era of favored tax treatment, slowing capital flows into the industry as the government moved to close industry loopholes.
Commercial real estate evolved as a local business serving local proprietors, which provided local products to local customers. Globalization is transforming local proprietors into national, if not international, enterprises serving customers worldwide. Movement of capital in financial markets mirrors those changes.
The return of soldiers from World War II spawned the baby boom, a generation whose emergence into the work force reached a peak in recent years. Demographics have reversed themselves as the first "boomers" are now reaching 50, slowing the rate of growth in real estate demand.
The thrift crisis sparked the creation of a viable public market for real estate stocks and bonds issued as REITs, REMICs and CMBS. Wall Street triggered the beginning of real estate's transformation from a separate and distinct asset class into an industry sector as investors sought ways to participate in commercial real estate as they did in all other industries, and found opportunities in excess of $100 billion.
Commercial real estate held a monopoly as the primary medium for transacting business for much of history. The telephone created the first assault on that primacy, followed by the emergence of the computer and other technologies that are rendering real estate's monopoly obsolete.
In short, all of the factors that originally shaped commercial real estate's status as an asset class have evaporated and the investment world has responded instinctively, even though investors' guiding principles have remained unexamined. All that is required now is that institutional investors explore the assumptions guiding commercial real estate investment in the past to set the framework for future portfolio theory. The framework will be based on the following evolution.
Two-quadrant investing: In the past, commercial real estate investment was limited to financing individual assets or pools of assets using private equity and debt instruments. Limited partnerships and separate and commingled accounts were based on investment in assets, as were mortgages or loans on the debt side of the equation. These instruments shared common risk and reward characteristics because of the way they were structured, not because of the industry (real estate) in which they were invested.
Four-quadrant investing: With the evolution of public markets for real estate debt and equity in recent years, the traditional two-quadrant investment model gave way to the four-quadrant model reflecting the development of public securities for investing in real estate. These include stocks in REITs and REOCs, as well as public debt instruments such as REMICs and corporate bonds. Nevertheless, this model is only transitional as approximately 3% of commercial real estate has been capitalized in the public markets as stocks and bonds, compared with 75% for all other industries. Also, in the two quadrants relating to private debt and equity, the instruments remain embedded in an historic paradigm of investing in individual or pools of assets rather than private companies. The guiding principle holding that commercial real estate is an asset class, rather than industry sector, remains in place.
Amended four-quadrant theory: To fully complete the transition, the four-quadrant theory of real estate investment must be amended to reflect the final shift from investing in assets to investing in commercial real estate companies using corporate finance structures. This includes corporate equity and debt in both the public and private markets, as well as private placement structures. In the process, the focus shifts from viewing the asset as the wealth creator to acknowledging the capacity of the real estate company and its management to serve customers, command market share and deliver shareholder value. Examples include investments by venture capital firms and merchant bankers on the equity side, as well as private placement of corporate debentures on the debt side.
New requirements for investors
As real estate transforms to the amended four-quadrant investment model, a critical question arises: do the current institutional investors have the necessary competencies to deliver the results? The answer lies in whether they are able and willing to accept the industry sector paradigm and thereby transform themselves.
In short, what is required is a 21st century view of real estate's role in the economy and portfolio strategies that reflect it. Technology brings into play three forces in relation to the emerging investment model for pension funds and other institutional investors:
Technology will reduce the demand for real estate and thereby its returns;
Technology will increase the availability of information that can be used to understand and profit from the changing environment; and
Investors that employ this information effectively will be more productive and profitable.
However, in addition to changing its investment paradigm, the commercial real estate industry must also adopt a contemporary view of its management if it is to compete in this new world economic order where all industries and nations compete. Commercial real estate companies must adopt the best practices of successful businesses in other industries, employing technology as a partner in providing products and services to customers. Institutional investors, in turn, will benefit by investing in well-organized real estate companies rather than investing in single assets or asset pools.
A 21st century view of real estate will require companies to:
Shift the focus from owning and financing buildings to meeting and exceeding customer wants and needs;
Develop and promote brand identity to generate customer awareness and loyalty, and thus create franchise value;
Empower and align management teams with independent boards to ensure survivability and economic prosperity;
Finance businesses, not assets, like all other industries, using stocks and bonds to provide capital markets solutions;
Invest in companies (through REITs and REOCs) with a vision of the future and the competencies to achieve it; and
Combine with similar businesses to create economies of scale, build market share and keep competitors at bay.
The result: Transition from a view of commercial real estate as an industry unlike all others to one that is the same as all others.
In adopting the best practices of all other industries, the real estate industry can radically change its effectiveness in serving customers and delivering the rates of return required by investors. Institutional investors can command these changes by demanding best practices be used as a standard in due diligence if they want to achieve economic returns commensurate with the risks.
In the end, it will be clear that the real estate industry's mindset has been the problem all along, and shaping a new model for the commercial real estate industry is the solution.