NAREIM Spring POV: The Future Is Invading
The futurist Alvin Toffler once pointed out that, “Change is the process by which the future invades our lives.” Based on the amount of disruption that the commercial real estate industry has faced and begun to adjust to in the last few years, it certainly feels like we’ve been invaded by the future. After the National Association of Real Estate Investment Managers (NAREIM) spring meetings, much of the discussion centered on how real estate is being invaded by the future.
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Spring may be well underway in a lot of markets, the panic of the last few years may have subsided a bit, but there is still quite a bit of uncertainty and volatility. GDP growth is going up and down almost quarterly, employment growth looks good one month, problematic the next and the European debt problems change from manageable to crisis and back again almost daily. At the same time, more structural changes in global capital markets, in technology and in the use of property itself may very well create new winners and losers in the long term. Perhaps there is something more going on than “merely” a recovery of debt and capital markets. Perhaps some fundamental changes are taking place.
Despite the regular ups and downs of commercial real estate markets, the last few decades for commercial real estate have been relatively stable as more and more institutional capital and professional operators grew in share. But this kind of predictability may be a thing of the past.
Consider another time of dramatic change and how it may have played a role in commercial real estate. In 1450, when Guttenberg started his first printing press with moveable type, there wasn’t much of a commercial real estate industry. Beyond a few small merchant towns, most significant property was owned by monarchs and their court.
The printing press was initially seen as a technology for producing bibles cheaply. There was no commercial media at that time, little manufacturing, very little retail beyond the square in front of churches, no professional writers, and very few, if any, people who made their living as “knowledge workers”. But with printing, one had to start manufacturing paper. Global trade increased, because books were much easier to store and transport than food and the wealthy elite and religious leaders in every country could read Latin. Stores were built – as it was most likely difficult to store and sell books out of the back of a wagon. University towns were built so more people could read – and eventually write. Leaflets and newspapers became popular as literacy spread farther and wider than anyone thought possible. This created further demand for factories, shops, offices, homes and of course, for more capital to create those buildings.
It could be argued that the printing press was instrumental to building the modern commercial real estate industry. New technology creates new real estate demand, and now we may be on the brink of another change in technology that can transform demand dramatically.
The Internet was initially seen as a communication device for researchers and the military…but once everyone else got a hold of it, just like the printing press, things began to change. Right now, everything we write and say can be accessed anywhere in the world from a computer or smart phone. The significance is that the human race is not only more connected and more literate than it ever has been, but also that modern communication behaviors change our need for space.
Law firms today are leasing a third less space than they did ten years ago, because their law libraries have been replaced by databases. Tenants, instead of signing up for bottom of the market long-term leases at low rental rates, are opting for shorter more flexible leases as their business plans continue to change. Young people are moving into smaller apartments, as their record and book collections can fit into their pocket. Retailers are completely rethinking their shop floors as they adopt on-line/in-person hybrid approaches. Location has become more important as people migrate to cities and prioritize proximity to opportunities and other people over square footage.
As discussed by NAREIM members this Spring – users of real estate are changing and therefore the nature of fundamental demand is changing – investors need to take note:
- Technology matters and it changes fast. Prospective tenants walk through your space watching the bars on their cell phone – even if they want less space per person, they want more wireless connectivity than ever before. You can’t just buy an old building and hold for 50 years – it is becoming more obsolete every day.
- Workplace productivity drives leasing – the effectiveness of space has become more important than the size. No one is storing paper any more. According to Ed Glaeser, Harvard Economics Professor and author of “The Triumph of the City”, “Knowledge has become more important than space.”
- With job growth and people living closer to urban core, retail and office will continue to be challenging in the fringe markets. The office is no longer close to where the CEO lives – it’s downtown where everyone can easily commute.
- Gen Y is most likely to move into “B” apartments in the coming years, less so in “A”.
- Flexibility is more important than volume of space. Leases are getting shorter and more flexible. Tenants want taller ceilings, fewer walls and more windows.
- Environmental sustainability is here to stay. The class “A” tenant demands it. LEED or Energy Star have become more of a requirement than an option for the best properties.
- Brick and mortar retail is where you demo products – the Internet is where they buy. That means smaller space for tenant, more flexibility, more emphasis on location. Retail is a showroom.
The geopolitical and macroeconomic environment is also changing.
- Labor productivity continues to climb – higher than it’s peak before the credit crisis, but we are still down on jobs. At this point, as labor force re-tools itself to new jobs, returning to fuller employment will take considerable time.
- Europe’s recession will continue to drag US markets down, and what happens there will continue to matter.
- The political uncertainty in the US is an issue. If tax cuts are all allowed to simply expire at the end of 2012, it can’t help but have a significant impact. And yet, next to nothing is likely to take place in Washington for the next several months other than election year rhetoric.
At the same time, capital is changing:
- Defined benefit pensions are increasingly losing out to defined contribution plans, while very few people (perhaps 15%) anticipate being able to retire. Commercial real estate options for the typical 401K investor are mostly limited to Real Estate Investment Trusts (REITs) and their inherent volatility as publicly traded stocks may not appeal indefinitely to a retiree.
- Concurrently, defined benefit programs will continue to grow – but slowly. Distribution continues to be the largest challenge for defined contribution. Non-Traded REIT’s have proven that there is a demand for non-liquid institutional quality real estate investments, but the cost of distribution in that model may be too high. We have to figure out a more efficient way to aggregate retail level investors.
- Global capital flows are increasing, while a rising middle class throughout the world means that capital is coming from around the world. Investors need to look beyond US Pension Plans. Investors also need to look beyond the US for investment opportunities as well.
These changing market dynamics dictate that investment managers need to evolve too. Investment management firms need professionals with the broadest range of experience possible – individuals that are flexible, that can communicate effectively and that can connect the dots. Multiple languages, multiple skills and open mindedness is becoming more and more important. Investment managers have to become more flexible, more scaleable and more global. It may be time to refine internal processes, to use more outsourcing and mobile technology to better deliver transparency to investors and better evaluate and manage risk.
The relationship between General Partners and Limited Partners will continue to evolve as expectations of yields fall into line with current reality. Controls, transparency, predictability and structures are all part of what investors are looking for in managers, but at the end of the day, it still comes down to trust and alignment of interests.
Some may be looking for a time when commercial real estate will “return to normal”, but that may not be a realistic hope. As the Greek Philosopher Heraclitus once said, “No man ever steps in the same river twice.” Commercial Real Estate has changed and continues to change. The challenge for real estate investment managers, then, is to understand how best to navigate and capitalize on change as the future continues to invade our industry.