The map is not the territory
Ron Johnson was handpicked by Steve Jobs to build the first brick and mortar Apple stores. In 2001, when Apple was still known as “Apple Computers,” the very idea of a computer company 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 you already well know, it did not turn out to be a mistake. By 2011, Apple stores were by far the most productive retailer in the world. On a sales per square foot basis, Apple was bringing in $5,626, which blew the long term number one, Tiffany & Co at $2,974, out of the water, according to analyst RetailSails. Today, they remain the gold standard in offline 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 that in 2011, he was ready to again perform his magic on the dowdy old department store chain JCPenney. 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 JCPenney 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 JCPenney. 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, the very thing that had made him a hero, a legend even, was not reality. It was a way to get from A to B, not THE way to do so.
I can’t help but see parallels in what is happening in the property industry today. 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 Luddites, 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. Little do they know the territory is morphing into something very different. What happened in retail is happening to all of the real estate verticals, it is just harder to see. As my friend (or at least I imagine we would have been friends) Mark Twain said, “History doesn’t repeat itself but it often rhymes.”
We need a new map
The elephant in the room for the real estate industry may be climate change.Whether you agree or not is no longer relevant; not agreeing is like bringing a knife to a gunfight. Howl at the moon all you like, if you want to make money, or not lose it, you have no choice but to take climate change very seriously.
In Wealth of Nations, Scottish economist and moral philosopher Adam Smith said: “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 materially by doing the right thing morally.
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 (for to him we are well beyond the stage of debating “is it real?”) will impact municipal bonds, whether 30-year mortgages are possible in the 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,” he explains.
Last year, Fink 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 at the time, but frankly “climate risk is investment risk” is 100 times 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 are also about to impact this subject. 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 usually 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 this means that an industry responsible for one-third of global greenhouse gas emissions, and that consumes 40-percent of all the world’s energy, has no choice but to take this very seriously and is likely going to be under 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 square feet (so not even that large) should reduce emissions by 40-percent by 2030. Not that surprising perhaps, but what should we expect when the real estate industry is responsible for 66-percent of greenhouse gases in the city?
According to Adam Smith, 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.”
One of the biggest investment advisors in the world is telling us that there is an increasing market for sustainable investments. More importantly, it is foreshadowing that those who fail to address the sustainability of their assets are destined to destroy value. “Next Gen” real estate is going to leverage a corporate mission to build powerful brands and lord it over assets that attract the best customers. Doing the right thing is the surest way to profit over a long enough time span, in real estate and in life.
Aligning with like minded businesses always makes sense, and in terms of climate change this will apply in spades. Who is a company like Microsoft (they 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? 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 Wall’s Carbon Impact Fund?
None of this 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, while 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.
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 from it. 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 factors to be taken into account.
We are still missing pieces of the map
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. 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 and Slack, and other forms of loss are indicative of a realization that many of the VC backed business models, these so called “unicorns,” are actually as mythical as that name suggests. Or might as well be. Either way, crash or not, we are definitely in the “deployment phase” of the Fourth Industrial Revolution, defined by Klaus Schwab, founder of the World Economic Forum, as the mixing of the physical and digital worlds. 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 and Asia have three of their own: Baidu, Alibaba and Tencent. 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 75 percent of non Apple users. Plus, through its search engine, Google creates access to pretty much all the world’s information. 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-percent of all online shopping in the US.
These four companies have more power than any others in history, and are fundamental to how the world works today. Just about every business is built, and operates, on top of the software, hardware and services that they provide.
Precursors to these four were IBM, in the days where our computer mainframes were actually in the buildings where we went to work. Then, Microsoft moved those computers to our desks. Now, our computers are on our person. We have smartphones, tablets, laptops, smart watches and Airpods. Our documents are all in the cloud, and we have fast connectivity between ourselves and these devices, wherever and whenever we want.
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 to forecast how the real estate market will develop, it is essential to take 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 home to live in, but how we find, acquire, and use it is rapidly changing. Home might be an extended stay rental or a co-living space. It might also be an income generator.
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 satisfied by our phones, we actually crave more human interaction than ever. The worrying growth in loneliness, mental illness, and suicide suggests that as societies, we are failing. Does real estate have anything to do with this? I think it does: People spend 90-percent of their time indoors, in the built environment. How that environment is designed and operates must have an impact on us.
What might a new map look like?
There is much talk of smart buildings and smart cities. If these are based on the premise that the welfare of the people in them is paramount, then I think we will all be better off. There is money to be made in taking climate change seriously, and similarly, there is value in putting people at the center of your thinking in real estate.
In my opinion, there are seven generic key performance indicators (KPI’s) across asset classes within real estate that measure user experience. User experience equals brand, and brand equals value.
The first is connectivity. This means connectivity in three dimensions. Physical connectivity in the sense of transportation, ease of movement, and options for shipping and travel. Digital connectivity, the ability to find a fast and reliable internet connection—you cannot operate in the modern world without it. And lastly, 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.
The next is density. Much of the “as-a-service” or “on-demand” world 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.
Another increasingly important one is 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 tenfold. We have little idea how our assets will be used in ten 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.
Optimal usability is another KPI that determines how well a space facilitates both productivity and pleasure. Offices have to be able to be configured and operated in a way that maximizes the productivity of people who use them. Offices that, for whatever reason, impair cognitive function (and cannot be fixed) have a decent chance of becoming stranded assets that no one wants, unless it’s to repurpose them. With retail assets, the critical point is whether the act of physically visiting them is enough of a pleasure or necessity to persuade a shopper not to just push that “one click” button from the comfort of their home. A store’s ability to integrate omnichannel and provide exceptional customer experiences are the deciding factors of its fate. If not, they are dead retail assets.
Inseparable from what a space can do is how it can impact its occupants’ health and wellbeing, making wellness another key KPI. 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?
As I have harped on already, one factor that cannot be forgotten is a building’s sustainability. The fastest way to destroy value in our modern world with our modern sense of social responsibility is to own unsustainable assets.
Last but not least, we have data, privacy, and 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 monetize our personal information with reckless 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, lawful, and secure. A lot of value rests on it.
Real estate investing has always been complicated but, it is increasingly becoming more so. The worst thing we can do, albeit the easiest, will be to stay roughly as we are, as if we still lived in a largely linear world. Because we do not. The world is increasingly exponential. There is a much higher chance of either destroying or creating a lot of value. Maintaining value will be the hard thing.
So how can we sum up the new drivers of valuation? While you may choose to ignore all the commentary above about non real estate factors within the industry, you can not ignore the sustainability issues around climate change. Especially if you’re of the mind (like I am) that 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?