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By AL BERRIOS
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Eenee-meenee-minee-mo.
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1) Economies evolve.
What drives it changes over time as different commodities are given different
values. Today's Western economies, for example, value service and knowledge,
and that's highlighted by service industries' increasing contribution to
national GDPs (in the U.S., it's the largest contributor at over 40%, [
1]
single-handedly generating 70% of all economic activity). There is no reason
to believe that this will revert back to industry or agriculture;
2) Because service and knowledge are not tied to location, it has "unchained" workers from desks and it has aggressively spread urbanization further and further away from the historic center of activity (to the point where many cities border each other so closely, "metropolitan area" is the only way to classify them);
3) As metropolitan areas sprawl and grow, advances in public transportation (including planes, trains, and automobiles), freight transportation ("FedEx it!"), and communication (post, electronic, or voice) makes moving away from the center of a metropolitan area a less burdensome prospect to the person or firm who does move. This subsequently empowers the transient firm or person, in perpetual pursuit of better costs, better value, or just a change of pace. In other words, locality of industry or agglomeration, a once potent business rationale for paying high rates (to be at a location where the "information about the industry is virtually up in the air"), ceases to be a source of lower costs for the firm or person;
4) Consider outsourcing's
and offshoring's impact on labor. It no longer matters where you or your
labor resides or what workers know because you can have anything made or
addressed anywhere after the right standards and training are put in place.
(Check out our HR study that keeps labor from offshoring with a lower cost
and higher output and quality [2]);
5) With 70% of all economic activity busily not-manufacturing things that require facilities and able to utilize labor anywhere it feels like (and, in theory, in any working environment), the cost of energy to a firm is a non-issue; but if it were, many of the things required to deliver a service can utilize energy increasingly more efficiently;
6) And if cost is not an issue, and the need for space is really pressing, a firm or government can do what Japan and Dubai did - build new land from garbage and dirt in the open sea, using cheap labor, sophisticated air, water, and waste filtration technologies, and more efficient forms of energy production and consumption. (Taller buildings are also another source of new "land").
Comparing Real Estate to Train Cars
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Elbow
room.
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In New York City, the
Metropolitan Transit Authority hauls nearly 5 million passengers daily to
their destinations and back (3).
During rush hour peaks, it's impossible to find an empty seat on a train.
But during off-peak hours, seats aplenty. Using peak as an example of high-demand
for space and off-peak as low-demand, we can examine how we as people make
decisions on space (as a commodity), when all things are constant.
There really is no ideal seat on a New York City subway train. Every seat is the same hideous color and uncomfortable plastic; every view is oppressive or offensive; and no seat provides relief from any number of unpredictable odors and sounds. Every seat is 2 to 3 steps away from an exit. And despite some seats being wet, dirty, or neighboring an occupant that absolutely requires a radius of 1 or 2 additional seats in every direction around him or her, every seat is still usable with a little attitude and a good napkin.
In every single occasion
one is fortunate to catch an empty train car, the same phenomenon will play
out as the train gets full: if there are 5 people in the car, with a median
of 59 seats per train car (4),
each passenger will choose a seat so there are almost exactly the same number
of seats between him and the next passenger (about 12 seats apart). Every
additional person that enters the train will place themselves exactly between
two others, so that there will be about 5 seats of distance between each
of 10 people on the train. And so on.
The question you should ask yourself is why this phenomenon occurs. Of course, the most obvious answer, with all things being constant, including cost of the space ($2 bucks), is the need for personal boundaries. But every single passenger knows that at some eventual point in the commute, he will lose his personal space. So, social etiquette notwithstanding, why not select a seat (immediately next to another passenger) based on what the train car (or market) will eventually be like? Particularly since the choice isn't based on any advantages they'll have in the train and there's no rational cost of doing so? (Living far enough away from your destination to have a choice where to sit on the train isn't exactly considered an advantage.)
Real estate is essentially like a train car. Every seat is virtually the same (perhaps more folks from your building are riding the first cart, so there's a familiar clustering, or a few extra amenities make the experience a little more pleasant). But there are no longer any advantages worth paying a premium for, not even clustering or amenities, since the train will get you to your destination wherever you sit. In other words, getting the "great" seat on train isn't the goal, just the means to the goal (and certainly not the only means, either).
Thus, the only apparent logic to the way people select a seat on the train seems to be irrationality. The same holds true for real estate.
So Why Is Real Estate
So Expensive, Again?
Ask any landlord or real estate broker and the market will always be "hot"
in any location you'd like to be in. The reason being because the location
has "it" all. "It", supposedly, is "culture",
entertainment, work, food, friends, and all sorts of uniquely urban wonders
and pleasures commonly referred to as "24-hour features" or location
amenities. "It" also serves surprisingly as a kind of obstacle
to choosing an alternative, since "it" is an addictive, convenient
leisure.
And herein lies the most striking example of the irrationality the drives the selection of space: a tenant's inability to define for him or herself culture, entertainment, work, food, friends, and pleasure, relegating that most important process to "the Joneses", or worse, the media or some broker.
In a consumer society, the irrational logic is made more complicated by a) consumers' ownership of so many things they simply do not need and are seemingly unable to live without, creating a perpetual sense of never having enough space; b) human's natural tendency to become addicted (or entitled) to easily-gained things; and c) convenience's insipid ability to destroy initiative, creating complacency, unwillingness, and laziness.
The Vanity Office Space
| Figure 1 |
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| Source: Census Bureau, Construction Spending January 2007, http://www.census.gov/const/www/c30index.html; al berrios & co. analysis |
To illustrate the truth of our irrationality proclamation, let's discuss the state of commercial real estate, specifically office space. It's a well-known fact that when times are good, office space vacancy goes down (or in the parlance, absorption goes up). The inverse is true when times are not-so-good. This pattern is cyclical and nearly predictable because it is based on predictable variables such as the prevalence of a particular industry in a metropolitan area, the state of monetary and fiscal policy, and the type of government or politicians in office.
But despite these things,
the value - and by inference, what people pay for it - continues to go up
(See Figure 1). In defense of the developers, landlords, and brokers, the
increasing cost of construction materials, land, and construction labor
are genuine factors in higher prices (5).
However, the most glaring contributions to this irrationality are: tenants'
vanity (because an inability to exploit an evolving economy, service industry,
and technology is a legally liable breach of fiduciary responsibility or
an admittance of utter incompetence) and an obsolete model of conducting
business, whereby owners struggle to realize better returns by any mechanism
other than higher rents; and tenants, in a quirky encouragement of this
failure to innovate, negotiate long-term deals to lock in rates, a variation
on volume buying for discounts, and regrettably, a lost opportunity to innovate
on the transaction process itself. (Incredibly, an executive can actually
defend his irrational vanity in paying through the nose for real estate
by claiming that it would be a breach of his fiduciary responsibility for
he would be risking his organization's falling off of the radars of customers,
employees, and investors by not being in the most expensive markets.)
The irrationality of
this obsolete model continues to boggle the mind, demonstrated in yet another
irksome problem: the lack of flexibility in agreements, which ironically,
tenants, out of sheer inertia, pay a premium to get. The flexibility is
preferred due to a tenant's own poor planning of space and worker churn,
acquisition, and utility (planning often off by as much as 100%). And this
poor planning is further due to a disconnect between business managers and
those executives responsible for corporate real estate (6).
And to add another layer of complexity to the business model, the more diverse a business base a municipality has, the lower the vacancy and hotter the market at any given time, creating an unusual lack of opportunities for the opportunistic tenant; and a symbiotic relationship between politicians who'd prefer no fluctuation in jobs or income taxes during their terms and the real estate and construction industries.
Clearly, introducing innovation to real estate transactions is comparable only to moving a planet so we can get a little more sun light. But, moving a planet is possible with the right incentive, so rationalizing real estate transactions is, too.
Moving Planets
Let's start by addressing vanity. Having finally been recognized as a breach of fiduciary responsibility, vanity is now punishable by lower stock prices or when the vanity borders on arrogance, termination of employment. An executive hoping to keep his job has thus sought to do the right thing by locating himself in the most cost-effective or opportunistic place, an action recently taken by Halliburton in their moving their CEO to Dubai. Even corporate HQs are no longer sacred, proved a few years ago by Boeing's move from Chicago. A March 10th (2007) article in "The Economist" pointed out that it's not just a fad, either, as a headquarter's location no longer correlates with successful management of operations.
Continuing with owners' inability to realize better returns from any other mechanism other than increases in rents, the problem exists in the commodity nature of the product. Space is space. Sure, an amenity improvement here and there will grant an owner the opportunity to charge an incremental premium, but no commodity is exempt from the laws of classic economics - only increased demand dictates prices. And in order to increase demand, there has to be a need. And as we logically proved with our train car analogy, tenants don't really derive different values from different spaces, since in a service-oriented economy, any space will help them reach their business objective.
Fully aware of these irrefutable facts, the real estate industry has actually learned to fabricate demand via their complex web of symbiotic relationships, leaving all but the biggest tenants utterly bewildered and without leverage. And it has been only through these artificial and cyclical increases in demand that additional supply is justified, at additional costs, which in turn, increases prices more.
A New Model
To the corporate tenant that values flexibility, but is constrained by the potential loss of tax incentives and/or legal establishment obligations (and not, as may have once been the case but no longer, any risk of being ignored by talent, clients, or shareholders or missing industry insights), we advise
a) redefining your job roles with the ultimate goal of outsourcing your work environment off to your workers' homes or their favorite public meeting areas, when applicable (a tactic that would ideally minimize your space costs to zero);
b) virtual leasing, whereby all your space needs are available on an on-demand needed basis with corporate landlords (a tactic proven to save between 5 to 10 times on monthly rental expenses); or
c) "worker cell" development, where highly trained teams of 5 to 10 are structured to manage most of the service delivery and are scattered in much smaller sites throughout a market, (a tactic that, contrary to the thinking that buying in bulk yields the best discounts, will actually yield between 2 and 3 times the savings by exploiting the various sub-lease and sub-sub-lease options available at below-market rates because of their relatively undesirable square footage, locations, and/or poor marketing).
Modifying corporate
real estate needs according to logic is one of the most strategically significant
decisions an organization can make. As services and knowledge continue to
contribute the bulk of the value to an organization, corporate real estate
can and must evolve from an unalterably fixed expense and into variable
expense.
Footnotes
(1) PRESS RELEASE AT 8:30 A.M. EST, WEDNESDAY, FEBRUARY 28, 2007, http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm; al berrios & co. analysis
(2) "Fixing HR: An Economic Analysis of 30 Thought Leaders' Best Practices + Detailed Blueprint for the New Economy", http://www.alberrios.com/c/1005research.html
(3) MTA website: http://www.mta.info/nyct/facts/ffsubway.htm
(4) New York City Subways Website: http://www.nycsubway.org/cars/currentfleet.html
(5) Urban Land Institute's Emerging Trends in Real Estate® 2007, http://www.uli.org/AM/Template.cfm?Section=Emerging_Trends&CONTENTID=72798&TEMPLATE=/CM/ContentDisplay.cfm
(6) BCG study, http://www.bcg.com/news_media/news_media_releases.jsp?id=1824
Al Berrios is Managing Director of al berrios & co., a pure strategy consulting firm, specializing in advising organizations + entrepreneurs on managing their enterprises in a service economy. Write or Subscribe to Consumer Strategies Report.
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