WHAT TECH MEANS TO REAL ESTATE

 

When it comes to making investment decisions, most investors and their managers think in terms of what they already know and what already exists—rather than what they do not know and what does not exist. That orientation necessarily influences how investors and managers approach their investing decisions. Additionally, that orientation concurrently influences how investors and their managers consider the risks associated with their investing decisions.

Investing decisions and risk management, then, concern changes in such factors as those listed in Exhibit A – Elements That Are Customary Focus of Investing Decisions and Risk Management. The approach and factors listed in Exhibit A apply at multiple distinct levels of the investing decision process:

1. Investment policy
2. Deal analysis
3. Investment structuring
4. Negotiation
5. Risk management
6. Property/asset/portfolio management
7. Regulatory compliance monitoring
8. Investor reporting
9. Property disposition

The sustained deterioration, performance shortfall, or severe shocks to one or more of the factors listed in Exhibit A could have a material adverse impact upon property and enterprise performance.

Arguably, an effective risk management function would address the potential risks associated with the assumptions and premises upon which positive investment performance depend. Less explicitly considered, than these 'usual suspects' of risk management, are the implications of technology, both positively and negatively.

Tech is significant not only because tech can introduce new products and services, which threaten and 'disrupt' existing products and services as well as the companies that make and deliver them, potentially redefining and even eliminating existing industries, but tech also creates substantial demand for consumer goods and services—paid for by the spending of its well compensated employees—as well as extraordinary demand for property goods and services. 

This article is adapted from the forthcoming THE PROPERTY KNOWLEDGE SYSTEM by Stephen E. Roulac. Information available at the www.thepropertyknowledgesystem.com 

Ultimately, investing in action reflects the manifestation and critical thinking applied to a number of factors such as those listed in that may influence property performance.

Risk management, then, concerns 'managing' such known risks as those listed in Exhibit A. Risk embraces not just what is known, but what is unknown. Few investors, managers, executives, and fiduciaries consider the 'risk' of the very risk management process that they rely upon may itself pose a risk.

Presuming Its Normal

Risk management programs are usually premised upon the classic statistical concept of the so-called normal distribution, reflecting the presumption of a 'normal' world in which the inherent property of things mirrors the mathematical concept of the Central Limit Theorem, which holds that the large number of independent elements are, at the end of the day, 'normally distributed.'

In a normal distribution most items are reasonably close to the mean, with a very small number at the extremes, which attribute of the normal distribution is known as 'skinny tails', meaning there are very few data points at the extremes. This thinking anchors insurance pricing based on actual calculation and the modern portfolio theory investing strategies that derive from the assumption of the efficient market.

But not everything is normal and efficient: wars, city scale, natural disasters, ideas and such information transactions as book sales, exemplify phenomena follow what is known as power laws, which are characterized by 'fat tails', meaning there are many more points at the far ends of the curves. To this list, you can add new tech ventures. So rather than being 'normal', these phenomena are 'abnormal', meaning that rather than being typical and predictable, these phenomena are generally atypical and unpredictable.

Venture-capital-backed technology enterprises are more governed by power-law distributions than normal distributions. As legendary tech entrepreneur and venture investor Peter Thiel observed of venture investing, "actual returns are incredibly skewed." As venture becomes more significant, the consequences for the macroeconomy expand, really disproportionately so.

How Tech Influences Property

Tech driven demand for property goods and services leads to more demand, sometimes intense competition for properties to rent or buy, and inevitably higher property prices. Consider that tech momentum makes feasible multiple high-rise residential rental apartment projects in which a one BR unit goes for $6,000 per month, which would require a $300,000 annual salary, if rent is 25% of salary. But of course, not everyone in tech makes $300,000. And the economic viability of such project evaporates if the tech sector craters, as more than a handful of pundits predict is likely to happen.

At the extreme, these hyper demand forces can be extremely disruptive the lives of the very people who would work for these tech companies. On the surface, getting a tech job can become a dream come true for the ambitious professional aspiring to get in on the tech scene. But that dream can turn into a nightmare, even if you have your dream job. 

The problem is that the non-job aspects of the tech lifestyle can be a daunting steeplechase of access and affordability, so much so that living any kind of decent lifestyle out of work is problematic, if not impossible for many.

In the late months of 2016, an engineer posted a commentary on why after five years he was leaving his dream job at Facebook, the indulgent perks and benefits, and the six figure compensation package.

If a capable engineer were to leave a great job at Facebook or similar high-flying tech company, most often it would be to join a startup. But not this engineer. He had decided to leave Facebook because he could not afford to provide his family the lifestyle that was available to him working for considerably less money, in a less engaging job for a less prestigious company in Arizona, which he moved from five years earlier to accept the coveted Facebook position.

It was recently reported that renting an apartment in Silicon Valley was harder than getting admitted to Stanford University. Stanford demands that its applicants show the highest test scores, top grades, and a distinguished portfolio of extracurricular activities—and then only admitted 4.8% of the 43,997 applicants to the 2016 entering class. Indicative of the extreme competitiveness of the Stanford admissions process is that only 1 in 4 of those admitted had less than a 4.0 GPA and most had an 800 on at least one of the SATs. 

Tech Implications for Real Estate

Too little acknowledged—even recognized—by many real estate investors and managers, including some of the largest most visible players, is just how dependent real estate is on tech for housing demand, retail spending in mails, office occupancy, hospitality spending. Even less recognized are the implications of growing numbers of tech companies being funded at greater valuations—i.e., the much vaunted 'unicorns' of the billion dollar valuations, whose rarity is symbolized by the four-footed white animal with a horn growing out of its forehead but which in contemporary times seems to have morphed from singular rarity to ubiquity.

More unicorns impact real estate in several ways:

• Skew investor expectations towards higher returns.
 
• Create more apparent 'prosperity', leading to more people associated with those unicorns having more financial income and wealth to spend on property goods and services.
 
• Increase chances that the unicorns could have powerful—potentially disruptive—impacts on real estate practices and opportunities.
 
• Pose risks of what happens if the unicorns’ valuations, after soaring, then plummet.
 

These tech effects are direct and indirect, subtle and powerful. With more companies being funded, commanding larger valuations, and representing a greater share of the capital markets and accounting for a greater share of economic activity, more and more, the prospects of GDP being static, declining or increasing, is tied to tech. Indeed, the recent surge in incomes and prosperity metrics is not unrelated to the continuing emphasis on tech.

Real estate, of course is directly linked to the economy, for when the economy is good, real estate is good; just as when the economy is bad, real estate is bad. So this truism may be supplement by a new maxim: when tech is good, real estate is good; when tech is bad, real estate is bad.

Some of the powerful implications for real estate investors and managers of these tech innovation developments are:

1. As the economy is increasingly dependent of venture-backed tech, more tech funding means more economic linkage to tech.
 
2. As tech is inherently characterized by the skewness of the power law, rather than the normalcy of the normal bell shaped curve distribution, society and the economy are inherently more risk than  would apply, if the economy were less dependent on tech and more 'normal', as it once used to be.
 
3. Real estate on a macroeconomy level is subjected to the very same risk forces as is the economy, so because the economy is exposed to more risk, so, too, is real estate exposed to more risk, more so than many real estate participants may realize.
 
4. Real estate has been the beneficiary of the 'gold mine store' consequence of tech innovation, setback, and breakout prosperity. In the mid-19th century contrary gold rush, only a few struck it rich—but everyone who sought to strike it rich had to shop at the gold mine store. Similar reasoning applies to real estate and tech.
 
5. With more funding of tech ventures, there is increased probability that extreme fat tail outlier outcomes may fundamentally change how we experience our places and the very roles of property in society and economy, which circumstance shall have profound consequences for real estate investing risks—and rewards.
 

The risk of risk management is that most risk management programs are innocent of what is discussed here, especially the five implications immediately above.

Exhibit A

Elements That Are Customary Focus of Investing

Decisions and Risk Management

• Economy
• Markets
• Tenants
• Customers
• Suppliers
• Capital costs
• Energy costs
• Insurance – costs coverage amounts, and uninsured losses
• Taxes – rates plus new taxes
• Engineering
• Environmental impacts
• Larger Environment – severe storms, natural disasters: earthquakes, climate shifts, pollution, draughts
• Government – service shortfalls, fiscal mismanagement, place protection shortfalls
• Terrorism
• Military conflict
• Construction quality
• Compliance
• Eminent domain
• Culture/demographic shifts
• Manager competence and performance
• Reputation, image, and brand
• Legislative action or inaction
• Regulations and rules
• Politics

Comments? You can contact me directly via my AdvisoryCloud profile.