Real Estate: Rent-Seeking to Value-Added
Indranil Ghosh and Matthias Lomas
Martin Sorrell, the former CEO of advertising giant WPP who now runs S4 Capital, says remote working is “energizing,” and is now keener to spend on his staff rather than “expensive offices.” It’s a theme echoed by titans of industry from banking, to tech, to consumer goods. In fact, flagging demand, remote working, and concerns about public health could jolt the entire real estate sector from an over-reliance on inflated valuations to a focus on adding value through increased safety, flexibility, and cost efficiency.
Real estate values have soared this century, especially in cities and their commuter towns. Since the height of the real estate bubble in 2007, house prices are up 15% in the US, 21% in the UK and 40% in Australia, Canada, and New Zealand; while in India, Brazil, and China they have increased by over 200%, 150%, and 50% respectively since 2009. Also, US and European commercial property prices increased by 35% and 20% between 2007 and the beginning of 2020. The winners have been property owners who have enjoyed steep price increases relative to the amount they’ve spent on improving their assets.
The losers have been residents, businesses, and society. Most citizens’ disposable income has been significantly eaten into by housing costs (see the chart), depriving other sectors of consumer spending. Corporate resources have also been diverted away from innovation and growth. And in many developed countries, soaring urban housing costs have contributed to declining birth rates due to lack of space and disposable income to support a family.
However, the pandemic will slow or reverse the gains from property assets. Aside from the logistics sector which is booming due because of increased e-commerce, the pandemic is decimating real estate values due to plunging occupancy and delinquent rent payments. With 30 million Americans out of work, 1 in 4 were unable to pay their full April housing bill. The US’s National Association of Realtors’ chief economist Lawrence Yun thinks house sales could decline 30% to 40% in the coming months as prices slow or turn negative. Office-focused real estate investment trusts have plunged 23% lower than the S&P 500 this year, which itself has dropped 10%. Furthermore, US and China hospitality occupancy rates are between only 30% and 40%.
The downward pressure on valuations will continue. Millions more jobs are at risk as the prospect of a wave of corporate bankruptcies looms large. This does not bode well for commercial real estate, with PwC reporting than more than a fifth of US CFOs are considering cutting back on real estate as they transition back to on-site work.
This pressure and persistent behavioral change caused by Covid-19 will force property owners to add more value to their assets in order to hold on to occupants. A survey by Ipsos MORI found that over 60% of Brits would feel uncomfortable going to bars and restaurants or using public transport once the lockdown has ended, and almost 70% would feel uncomfortable going to large events.
Adding Value Through Safety, Flexibility, and Cost-Efficiency
To ‘reoccupy’ workplaces, employers must provide greater reassurances that employees will be safe. Urgency is greatest in manufacturing facilities where tasks cannot yet be automated and whose production entire supply chains hinge upon. Thermal sensors checking the temperature of workers entering buildings may become commonplace. Also, as smartphones are less prevalent in factories, contact tracing infrastructure utilizing tools like Bluetooth beacons and long-range scanners rather than mobile apps will be installed. Offices, malls, hotels, and schools will soon also have to make provisions.
According to Ron Rock, CEO of IoT and contact tracing company Microshare, organizations want “living and breathing assets” which provide the data and real-time feedback to demonstrate that workspaces are clean and safe. Technology which measures air and water quality, energy usage, and worker proximity and contact will be in high demand.
‘Contactless’ technology like automatic doors and voice-activated appliances will also be more prevalent. High-quality buildings could embed antimicrobial properties into fabrics and other materials.
It will particularly difficult to encourage people back into high-density settings like retail, restaurants, and gyms without higher hygiene standards and controls on traffic flow and social proximity. We could see real-time analytics on these customer priorities displayed on apps like Deliveroo, TripAdviser, and Foursquare.
Demand for flexible real estate molded around tenants’ needs will also increase. Global Workplace Analytics predicts 25%-30% of people will work from home on multiple days of the week within two years. This won’t lead to the end of the office, but it may change its role to focus on convening, innovation, and well-being. Big corporate offices could be re-imagined as spaces where we come together for strategic initiatives and to deepen relationships, while routine meetings are done virtually. Building design will also trend to offering more spaces for concentration, relaxation, socializing, and regeneration.
Furthermore, more workplaces will adopt a seven-day working week with rotating shifts and will want the freedom to flex up and down space. Also, many employees will want to work in less dense environments. Indeed, it was widely recognized before the crisis that lower density offices were better for productivity.
Residential property owners will also have cater more for homeworkers, for example by providing inbuilt office space and making space easily convertible to working conditions.
The challenge for property owners will be to provide safer and flexible real estate and cost efficiencies that tenants will inevitably demand as the economic crisis persists. Tenants may need less space overall, which will force real estate owners to reduce their own costs to hold on to revenues. One way to do this would be to implement smart energy management systems that cut energy costs and lower emissions, thereby adding further value.
It will take some time for the best approaches to emerge, but eventually a shake-up of real estate will allow us to live and work in safer, healthier, more comfortable environments. Moreover, if rural areas and towns can attract high-income workers wary of living in dense cities with good schools, healthcare, and leisure attractions, they may benefit from the pandemic. New workers could inject economic vitality in these areas which have struggled compared to cities by starting new businesses and creating jobs. It could also increase birth rates again as couples will likely be able to afford bigger properties.
Real estate owners will face a tough challenge to persuade clients like Martin Sorrell to keep paying for large property portfolios. However, perhaps the pandemic was the disruption that was needed to shake-up the sector for the benefit of society overall.