What’s Behind The Archaic Nature of the Real Estate Industry?
“Conservative” is the number one definition when it comes to describing the real estate industry. Property gurus do not mind, in fact, they almost perceive it as a compliment. However, the negative side of such a reputation is a lack of flexibility and resistance to innovations.
Real estate owners … preferred to insulate themselves from any kind of change and keep things intact.
Continuous efforts to “disrupt” the multi-trillion real estate industry have been consistently failing. Simply reiterating the fact that there are tons of inefficiencies to be addressed is not sufficient. Instead, diving deeper into the reasons behind the current state of property market might be a useful mental exercise for real estate innovators, as it might help to find the right approach to the right stakeholders.
There are three groups of factors, which defined the current state of the industry: place in the economic cycle, nature of the asset class and ownership structure.
A Decade of Bull Market
The real estate market was at its all-time high when the Corona crisis hit. The previous low interest-risk environment created abundance of capital – equity investors and lenders were queuing for investment opportunities. A growing economy, healthy inflation rates, high consumer confidence and low unemployment – all of that converted into high occupancy rates across all asset classes.
In such a booming market, real estate owners naturally did not have any incentive to seeknew competitive edges. In fact, it was the other way around: they preferred to insulate themselves from any kind of change and keep things intact. The closed relationship-based nature of the real estate business is another outcome of this status quo preservation strategy.
Safe Asset Class
The closed relationship-based nature of the real estate business is another outcome of status quo preservation strategy.
Historically, real estate has been perceived as an attractive asset class across wide variety of investor types, from huge institutions to non-accredited individuals, due to a few key features:
1. It is an asset class of a very stable and resilient nature, relying on predictable cash flow from rent;
2. When benchmarked against asset classes with same level of risk, real estate generates higher yields.
Real estate, especially office and multifamily sectors, have developed a reputation of being almost as safe as government bonds. The whole investment life cycle was crystal clear and did not require any active involvement from investors. All those factors, obviously, did not create a conducive environment for innovating.
Ownership Structure
The third group of reasons is related to widely adopted investment models, which, in turn, resulted in current ownership landscape. This topic has been so well summarized by Dror Poleg in his work “Rethinking real estate”:
The biggest chunk of real estate assets is owned by REITs, which gained popularity due to their unique tax status. In return, they’ve had strict regulations imposed on capital allocation. At least 75% of capital, invested in a REIT, must be allocated to real estate assets. They must regularly distribute 90% of profits in form of shareholders payouts. As a result, there are no cash reserves to be allocated to tech, which, in most cases, require massive upfront investments and a long time-span before starting to generate profit.
Another big category of property owners are private equity firms. Not being bound so much by regulations, they have their own issues, preventing them from investing in proptech .
Firstly, they often acquire buildings one by one, each of them being operated by a separate management company according to their own specific standards. Adopting technology for just one building does not make any financial sense, but scaling a certain technology across the whole portfolio could be challenging, if property management standards are not consolidated.
When embarking upon a new business idea, it would be wise to look at the industry from its stakeholders’ perspective.
Secondly, PE firm would typically raise a separate fund for a certain portfolio. Fund managers have different mandates from LPs. As a result, a cumulative portfolio of a PE firm might be very fragmented in terms of management strategy and stakeholders’ interests.
Finally, from a fund managers’ perspective, there is no incentive to allocate capital to anything that is not going to generate immediate return. Managers’ personal remuneration is defined by short term performance of their portfolio. Hence, investing in tech would result in lower salary.
When embarking upon a new business idea, it would be wise to look at the industry from its stakeholders’ perspective. Such an approach would help to avoid wasting time on projects, which are inherently misaligned with the industry’s internal logic, and instead concentrate on opportunities, which would be an organic fit for the current real estate market.