More tech means risk is up for property investors
PropTech means more customer power, more operational leverage and more risk for investors.
Before the tech wave of the 1990s that gave us the internet and email, the desire of human beings to find rooms or space to use and inhabit was facilitated by a very clunky process. Yellow pages plus newspaper and magazine advertisements supported by brokers and agents were the standard route to finding a house or apartment to buy or rent, to book a hotel room, to find an office or a parking space or to find a gym. Tech-enabled platformisation has changed all that.
In 2008 Apple launched the AppStore and the iPhone 3. Suddenly it became possible to connect people with rooms via a smartphone. Airbnb quickly followed, and by 2011 it was a unicorn. WeWork was valued at $45bn in 2018. The formula is now ubiquitous, and used by Hubble, HQO, OfficeApp for offices; SpareRoom for apartments; Booking.com for hotels; and and hundreds of others for parking spaces, storage space, shopping centres, and so on.
This simple idea has transferred power from property owners to property users. Apps and platforms now mean that the customer has choice and an efficient way to compare offers. Customer power is bundled through rating mechanisms, just like ownership power had been supported by tech such as that used by credit rating agencies to score customers. This power transfer has been exacerbated by the discovery of cyberspace and the many metaverses we are about to be sold (see our recent paper on the metaverse here), meaning that Mark Twain’s adage (‘buy land; they’re not making it any more’) lacks its former force. So we now talk about the hotelisation of the office market, meaning the growth of customer choice through platforms, and the shortening of lease or licence agreements. We also talk about real estate becoming more operational, as owners of space are encouraged to offer more services — like hotels do — in order to attract occupiers.
Hotels had not been considered as core real estate investments up until the mid-2000s, and thus attracted relatively low capital flows. Depending on the operational model used, real estate-backed hotels might not earn stable lease rents and did not as a result have the ‘fixed-income’ aspect of other real estate investments. The freehold owner of a hotel might operate the asset personally, employ a manager or lease the asset to a hotel group. Similarly, a hotel group could procure its real estate in a number of ways: it could buy a freehold, it could sign a lease for the asset or it could enter into a management contract.
Where the hotel operator signs a lease, this arrangement can produce a traditional, low-risk real estate investment, especially when the operator is a well-known and financially secure company. Where the operator signs a management contract, the property owner’s revenue will be the revenue of the operation, determined by the room rate, the occupancy rate and any additional revenue streams, less the manager’s fees and costs (which may include a share of revenues or profits). In this case the property owner’s revenue will not be a stable lease rent but will be exposed to the risk of the underlying business. Platformisation means that customers will increasingly express their opinions, driving operators to provide more services or to cut rents. Hence the demand for shorter leases, smaller spaces and enhanced collaboration has driven the occupier markets closer towards the operational customer-centric model found in hospitality, where a positive or negative user experience is capable of being publicised by platforms such as Trip Advisor.
With shorter contractual obligations comes increasing choice. The end user of the space is now able to leave without penalty if that space does not meet their expectations or requirements. Accordingly, managers of flexible space have begun to compete by offering more amenities, often including a host of unnecessary luxuries as a part of their service offering (free beer at WeWork, for example). Operational property returns are more directly dependent on the operation of the business carried out within the building. The heightened operational risk means that specialist skills are required to manage these real estate assets.
In accounting, the higher the degree of operating leverage in a business, the greater the potential danger that a relatively small error in forecasting sales can be magnified into large errors in cash flow projections. This concept has not been used in real estate, but recent market developments mean that it needs to be.
Core real estate is a low risk asset because there is no operational leverage, especially if the lease is triple net/FRI (full repairing and insuring, meaning that the tenant is responsible for these costs). There is operational leverage if the landlord has external repair, management or common parts expenses. Some shopping centres have a lot of operational leverage where low occupancy and falling rents leave the landlord with a heavy and irrecoverable cost burden. Net operating income (NOI) is then much more volatile. Where the landlord is responsible for all operating costs, including staff, raw materials and so on, operational leverage levels (and risk) go shooting up. This applies particularly to managed hotels, senior housing, and student accommodation. In such cases it should be possible to measure operational leverage and quantify risk.
Operators will develop a deep understanding of building and customer requirements in a specific property type and the best will operates at scale. They will develop modern buildings with the latest building technology, creating high quality, energy efficient environments for living, working and/or playing. They will use platforms — customer-centric systems for operating buildings with a high service/amenity component, and a centralised customer relationship management (CRM) and in-house leasing team with deep relationships with major customers. They will develop cost-efficient supply chains. The best operators will be highly sought after by investors as managers of risk and deliverers of return; for those who miss this trend, higher risk will not be compensated by higher returns. The PropTech wave means more customer power, more operational leverage and more risk for investors.
