The worlds of cyberspace and physical space are on a collision course. Will one annihilate the other or will they meld to create a more efficient commercial real estate industry?
The metaphors that these two worlds borrow from each other suggest how intertwined they actually are. E-commerce people use "bricks and mortar" to describe any company that hasn't figured out how to use the Internet. Property people have glommed onto "clicks and mortar" to show that they really do "get it." In fact, the world of e-commerce is loaded with images and ideas borrowed from the built environment. There are portals, chat rooms, shopping carts, storefronts, data warehouses and - of course - plenty of windows.
What should an institutional investor in real estate make of all this? Will e-commerce and new technology change the way tenants use buildings and, in the process, change the risk-return characteristics of the asset class?
In any real estate market around the globe with enough technology power to earn the right to use Silicon in front of its name (valley, fen, alley, coast, prairie, forest, corridor, triangle, etc.) e-commerce is, for now, creating far more demand for commercial space than it is displacing. The tech cluster regions of the world are driving up prices and rents of commercial buildings at a breath-taking pace - not just Class A office, but also off-pitch incubator space, residential lofts and old warehouses, which are being converted to "carrier hotels" and "server farms." Tenants are desperate for space, and landlords find they are offered warrants as a sweetener to get into the most desirable locations - near venture capital firms and top engineering talent.
This clustering effect has been shown to boost the demand for space in markets as diverse as Bangalore, India; Cambridge, England; Issy-les Moulineaux, France; Munich, Germany; and Technopark at Chai Chee, Singapore. In the U.S. the clustering effect has been well-demonstrated for years in the original Silicon Valley, south of San Francisco, and along Boston's Route 128 market. Now, the same high concentration of tech firms and Internet startups can be found in Boulder, Colo.; Austin, Texas; Raleigh-Durham, N.C.; and suburban Washington.
In Europe and the U.S., the most interesting new source of demand is for equipment, not people. Telecom "carrier hotels" that house the switches for vast fiber optic networks and "server farms" where digital storage space is rented out for webservers are two of the fastest growing categories of tech buildings. Investors are concerned about the credit of some of these companies. The response from the tenants: "Don't worry, the equipment we are installing is worth 10 times what your building is worth." Landlords are not sure how they can take comfort from this situation - what will they do with millions worth of obsolete technology if a tenant goes under?
The tech-cluster regions are places where high-risk/high-return investing goes on, and this goes for startup seed capital as well as for real estate. The real estate is often undistinguished - great companies are often found in converted warehouses or "plain vanilla" boxes. The clustering of universities, talent and capital are conferring the greatest value to the real estate, not the architecture. Even though tech firms could, in theory, locate anywhere - they don't. They feed off the programming and engineering talent that remains rooted in specific places. The stakes of the game now are so high that real estate is a shrinking part of the cost structure in developing or launching the newest new thing.
Figuring out how to use the Internet to make money for clients and for ourselves will be the biggest challenge that real estate service providers will ever face. One of the best examples is in the race to wire buildings for broadband. Tenants are starved for bandwidth. They need it for video-conferencing, for fast Internet connections. A T-1 line that moved data at 1.5 megabits per second quickly became the state of the art five years ago. This is 20 times faster than the rate of the dialup modems that we use in hotel rooms or from homes. But now a T-1 line is considered a narrow pipe by data-hungry users who are moving to cable or the new fiber optics lines capable of 40 or 50 megabits per second (enough capacity to stream video and audio without trouble).
The demand for these fat pipes is changing the economics of location and creating some new revenue streams for landlords. Letting a broadband service company into your building won't create a huge amount of direct revenue for the landlord, but it could be the key to a rapid lease-up strategy. Just imagine a building where all the occupants are capable of boosting their online productivity per person by 50%. What would tenants do to get into a building like that? If a building gets wired for broadband and has access to the best ASPs and shared services, that's exactly the increase in productivity that employers expect to see. And, as 55 Broad St. in lower Manhattan shows, they'll pay for it quite willingly.
The old-fashioned world of real estate has to come far and fast to catch up with the "new economy." Investors and occupiers will benefit from the wave of innovation sweeping through the industry. The two worlds - the Internet and physical space - really are melding. The Internet will not displace the need for physical space, but it does force the real estate industry to adjust to rapidly changing requirements of tenants. Demand for real estate is rising in the "new economy," but not all locations or property types are sharing equally in the growth. Offices and industrial parks in tech-cluster regions are experiencing record absorption, while shopping centers have to accommodate retailers' new "multichanneling" approach to selling goods. Managers of apartment buildings are working on new online services for tenants; whether these fall into the category of tenant "amenities" or revenue generators for investors remains to be seen.
It is important for institutional investors to be aware of the changes going on within the real estate industry, because there will be winners and losers. Yet, there is no indication that the long-term financial attributes of the asset class - contractual income with an equity-like residual - really are being re-engineered in any significant way. In the final analysis, e-commerce and broadband connections are enjoying a brief period where they are the focus of a great deal of attention in the world of real estate. In time, however, these new technologies will be taken for granted, just as other "new" technologies - the telephone, the high-speed elevator and air conditioning - all have became standard equipment in any commercial building. Ironically then, despite all the changes going on, the fundamental investment characteristics of the asset class are not likely to change in any significant way. Lease income will rarely, if ever, grow as fast as earnings in other growth industries, but the volatility of the income streams and the changes in the underlying property values also will remain much lower than the volatility of these same growth stocks.
A few "new economy" landlords are looking to recast the traditional lease in favor of more creative "risk-sharing" approach - where the landlord shares in the risk and the rewards of the value creation taking place in their buildings. If this model is widely adopted, the financial attributes of real estate could be in for a real change. But, any such change would take many years to bring into practice and would put landlords in the position of evaluating far more than just the creditworthiness of their tenants. Perhaps the largest impediment to any major shift in the risk-return attributes of the asset class comes from the principle of asset/liability matching. The equity and debt used to fund long-lived capital assets like commercial real estate currently rely heavily on longer duration income streams. Any change in these income streams necessitates a parallel change in the finance mechanisms that capitalize buildings. Such changes may be in the offing for a few incubator buildings, but buildings that house most of the nation's economy are not likely to migrate to a risk-sharing model anytime soon.
Jacques Gordon is international director, LaSalle Investment Management Inc., Chicago.
