the convergence of real estate and technology

The convergence of real estateand technologyAmy YoungReceived (in revised form): 22nd December, 2000

AbstractTechnology is impacting on all companies at Internet speed, and ane-understanding of the future is required in order for real estatecompanies to determine their strategies and how they plan to fit intothe New Economy. Real estate companies present some of thegreatest challenges as well as the greatest opportunities, dependingon the vision of the CEOs. Considering the inefficiencies andfragmentation in the industry, significant wealth may be created inthose real estate companies willing to move to the edge of thefrontier and explore opportunities to converge real estate andtechnology. This is entering into uncharted territory, and theimportance of management and a clear strategy to steer throughthese changing times has never been greater. The author recentlypublished a report, ‘Wired Real Estate: The Ultimate Portal’, whichhighlights the potential that exists in the real estate industry as realestate and technology converge. Based upon this analysis, a wiredinfrastructure is seen not only as a competitive advantage, but anopportunity to expand beyond bricks and mortar to offer tenantsvalue-added services, or intangible assets, which should lead to highstock valuations. This paper gives a brief summary of the 164-pagereport.

WIRED REAL ESTATE: THE ULTIMATE PORTALIf warp speed and intangible assets are the defining characteristicsof the Knowledge Age and the Internet revolution, how does realestate fare as an industry and as an investment? On the surface, thereal estate industry may appear to be the very contradiction of thenew economy, as development projects and transactions areinherently slow and inefficient and buildings are tangible.

Is the new economy a challenge or an opportunity for real estatecompanies? It is certainly both, but an e-perspective is required.The challenge for the real estate industry is to re-tool businessmodels, to wire buildings for high-speed Internet access, to createand/or acquire new economy platforms, offering value-addedservices and technology solutions to tenants, and to marketbuildings as assets with both tangible and intangible value. Thischallenge requires a complete change in mindset as visions,executions and marketing of the e-enabled real estate industry areestablished. The potential is for wired real estate to become the

Amy Young

is a vice president at Deutsche

Banc Alex Brown in Global

Equities. She has focused on

the convergence of real estate

and technology/

telecommunications, co-

authoring the publication

‘Wired Real Estate: The

Ultimate Portal’ in May 2000.

Prior to joining Deutsche

Banc in 1998, Ms Young

worked at Lehman Brothers in

Global Equities, assisting in

the coverage of

Conglomerates. Ms Young is

involved in various professional

organisations, including the

Urban Land Institute,

Association of Foreign

Investors in Real Estate,

Building Owners and

Managers Association,

International Council of

Shopping Centers, and the

Association for Investment

Management and Research.

The recently published report,

‘Wired Real Estate: The

Ultimate Portal’, highlights

the potential that exists in the

real estate industry as real

estate and technology

converge. A copy can be

obtained from the New York

office at 212 469 6771.

Keywords:broadband infrastructureproviders, carrier hotels/colocationfacilities, convergence, e-marketplaces/e-applications, intangibles,Internet infrastructure

Amy YoungVice President, Deutsche BancSecurities, Inc., Global Equities31 West 52nd St, 11th Floor, MS1102, New York, NY 10019, USATel: +1 212 469 7305Fax: +1 212 469 7300E-mail: [email protected]

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ultimate portal, in the physical and virtual sense. Everyone needs aplace for shelter, to work, and to spend his/her leisure time, whichis the physical portal. In terms of the virtual portal, the newdemand for space, mission critical facilities that house thetelecommunications and IT equipment, are in essence where thevirtual portals reside. Thus, the convergence of real estate andtechnology is bringing together the physical and virtual worlds.Wired properties not only help customers move into the neweconomy and digital information flow, but this Internetinfrastructure enables many real estate companies and othercompanies to initiate B2B and B2C services, furthering theconvergence.

ENTERING THE KNOWLEDGE AGE AND THE IMPORTANCE OFINTANGIBLE VALUE‘Entering the Knowledge Age’ attempts to provide a briefretrospective of the past, providing a view on the future, anddescribing how a real estate company might survive and increase invalue in this period. The four major trends include the notion ofintangible assets — value-added services, brands, partnerships,leadership, technology systems, intellectual capital — which areexpected to be awarded higher valuations in the future, and manyreal estate management teams are tapping into this value. Secondly,collaborative thinking is the name of the game and the real estateindustry has joined in with the formation of Broadband Office,Constellation Real Technologies, Merchant Wired, BroadbandResidential, Office Technology Alliance and potentially others. Theindustry leaders have realised that there is too much fragmentationto create critical mass, so consortia have been formed to create thescale necessary to attempt to make a technology solution the defacto industry standard. Thirdly, a technology discipline is vital forthe future success of all companies in all industries, and this holdstrue for the real estate industry. Fourthly, business structures arebeing re-tooled and new ways of operating and serving customersare being adopted. The real estate industry is cognisant of thesechanges, launching e-business initiatives and services to betteraddress tenant needs. The knowledge age is also referred to ascustomer empowerment times. Armed with knowledge about thepeople who enter and exit a building, real estate may become theultimate portal. The wired real estate platform may then beleveraged to create intangible value, via new economy services forits tenants and customers, and thereby its shareholders. Boldstatements have recently come from Simon Property Group andEquity Office Properties as they set out to build new economyplatforms, spending R&D dollars to maximise the potential ofintangible assets and value creation.

LINKED INTERNET INFRASTRUCTURE AND REAL ESTATE‘Broadband Network Solutions’ represents the backbone from

Intangibles

Collaboration

Customerempowerment

Broadbandinfrastructureproviders

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Young

which the real estate industry and other industries may createnumerous B2B and B2C initiatives. Broadband refers to the speedof telecommunications transmissions and the type of connectivity tothe Internet; broadband is high speed and always on access, withno need to dial via a modem. As wiring buildings for high-speedaccess becomes more of an imperative, real estate owners arerealising the importance of offering open access and serving tenantswith the best broadband service providers, including DSL, coaxialcable, wireless and fibre optic cable providers. Each of thebroadband solutions offers connectivity at a different speed andcost, with DSL at the low speed and cost end of the spectrum, andfibre optic cables as the optimal solution with the highest speedsand the best quality, but the most expensive. Each tenant mayprefer a different cost and/or speed. Real estate owners aredeploying these technologies but the selection depends on theproperty type, the location and the cost/speed relationship that thetenant desires. In exchange for granting access to the buildings,some real estate owners have entered into revenue-sharingarrangements with broadband service providers. Wiring a buildingis not a simple process, with multiple complex issues concerning theconduit, or riser, where the pipes are located needing to beaddressed. Riser management, which is a burgeoning area, requiresnetwork wiring expertise and engineering knowledge. Real estateowners are becoming more involved in managing and protecting theriser, with an open architecture considered critical to optimising thecapacity and to provide for fair competition, as tenants should havemultiple options in selecting their broadband service provider. Asreal estate owners typically market location, location, location, inthe future, real estate will be defined by location, bandwidth,location. Tenants will determine where they want to locate basedupon the broadband offering and the value-added servicesprovided. Buildings are not only about bricks and mortar, oroffering tenants physical space, but in the new economy, real estateis changing, offering building owners the potential to help tenantsnot only in their space configuration needs but also in theircommunications infrastructure needs. The need for landlords toprovide an Internet infrastructure to tenants is becoming morewidespread, as companies move into the wired world. Manybuildings will be wired for Internet access over the next couple ofyears.

In conjunction with the move to wire buildings for high-speedaccess and connect the world to the Internet, a new demand forspace is rapidly emerging — carrier hotels. These ‘mission critical’buildings house telecommunications and IT equipment, offering thephysical infrastructure plus other value-added services such asinfrastructure services and managed network services. Real estateowners, telecommunications carriers and technology companieshave entered this market. There are three basic layers of serviceofferings: the raw space; infrastructure services, including redundant

Location

Carrier hotels/Co-location facilities


The convergence of real estate and technology

power supply, fire suppression systems, advanced air conditioningsystems and state-of-the-art security and monitoring systems; andmanaged network services including a network operating centrethat monitors the equipment, colocation services for web hostingcompanies and application service providers (ASPs) and bundledbandwidth services. Tenants typically include Internet backboneproviders, broadband service providers, Internet service providers,large corporates, and colocation tenants. This market is veryfragmented, with many local players, and no global leader hasemerged at present, although TrizecHahn, the first North Americanreal estate company, invested in Global Switch to build these highlyreliable and highly secure facilities on a global scale. In terms ofvaluing mission critical facilities, a discounted cash flow model isthe most appropriate for assessing the present value of future cashflows. Intelligent properties not only help move tenants into thenew economy and the digital information flow, but enable manyreal estate companies and other companies to initiate B2B and B2Cservices, furthering the convergence of real estate and technology.

REVOLUTIONISED REAL ESTATE TRANSACTIONS‘E-business initiatives’ seek to identify the exponential growthdriver for the real estate industry. As the new economy moves thereal estate industry into a more efficient, transparent andtechnologically advanced marketplace via e-processes and e-hubs, amultitude of B2B and B2C initiatives are being and could belaunched by public and private real estate companies, real estateservice companies and real estate technology start-ups. Revenue-enhancing and cost-reducing opportunities exist for all real estateowners to capitalise upon. The recent announcement fromConstellation Real Technologies was a defining moment in the realestate industry, as the leading real estate companies joined togetherto work collaboratively. The intent of Constellation RealTechnologies to create an e-business venture fund and operatingcompany represents a significant move to steer the real estateindustry into the new economy. Constellation has invested $35m inFacilitiesPro.com, which is building an online procurementplatform to provide maintenance and repair supplies via theInternet. Similarly, Project Octane has invested $30m inSiteStuff.com, which is a competing e-procurement start-up. Theseconsortia are working to establish a platform, or an e-marketplacefor all transactions to be seamlessly e-connected. From the B2Bperspective, real estate transaction structures are beingrevolutionised, with substantial opportunities for reducing cycletimes. Online leasing, e-appraisals, e-lending, e-procurement,building portals, property management optimisation software, e-productivity tools, and Web-enabled project management systemsare all emerging to exchange information pertinent to real estatetransactions both in real time and digitally. Cost savings andreduced cycle times are necessary in all real estate transaction

E-market places/E-applications

B2B


Young

processes, and the consortia, public and private real estatecompanies, real estate service companies and hundreds of start-upsare moving to capitalise on the potential of B2B e-applications. Thekey is developing measurement and reporting systems to quantifyimprovements being made and the relationships being formed withtenants and suppliers. From a B2C perspective, e-services are beinglaunched by real estate companies, and the number is expected tomultiply as properties become wired with high-speed broadbandaccess and information flow improves. Creativity and e-thinkingwill reign, with multimedia cybercasts changing retail centres intoclicks and mortar marketplaces; office buildings offer executiveoffice suites and virtual concierge services, thus becoming just-in-time workplace solution providers; smart apartments enableappliances to communicate with one another; and industrialfacilities become global supply chain management systems andfacilities and/or e-fulfilment centres. As buildings becomeintelligent, real estate owners may work to cement theirrelationships with tenants, creating a ‘stickiness’ or loyalty, toincrease tenant retention.

REAL ESTATE COMPANIES ARE LAUNCHING NEWECONOMY PLATFORMS‘The convergence of real estate and technology’ provides a morecomprehensive look at the four major property sectors —multifamily, office, retail and industrial — concluding with a briefanalysis on spinning off or retaining these initiatives. As initiativesare launched and become more established, management teams aredeciding whether to spin off the technology initiative to unlockvalue and reward shareholders or to retain the potential upside.Both approaches have their own merits, depending on the long-term strategy of the company. Spinning off the higher growinginitiative could translate into a higher stock valuation than within areal estate company, and capital needs may be funded via venturecapital firms and other financial sources. In the USA, the real estatecompany, structured as a REIT, then maintains its bond-like andlow-risk characteristics. Retaining the technology initiative enablesthe real estate company to be a provider of integrated solutions,offering not only bricks and mortar space but also value-addedservices. The ownership of the real estate is leveraged to extend thevalue proposition of a new economy platform to tenants. Thevalues of these new economy services are in the process of beingcreated within real estate companies. The early adopters who createefficiencies within their business model or who reward the customerwith value-added services will lead the way.

PRUDENCE — THE CRITICAL ASPECTAlthough real estate and the new economy offer opportunities andchallenges, it is important to consider the risks. The report touchesupon the risks relating to telecommunications’ regulatory and

B2C

Spinning offinitiatives

Risk



legislative issues. Although the Federal Communications Commission(FCC) does not regulate data communications, the FCC ismonitoring the evolution of wired real estate in order to preserve fairand just competition. In addition to regulatory risk there is executionrisk, and here management teams are carefully consideringtechnology opportunities and not boldly investing substantialamounts of capital into highly speculative and unproven technologies.As speed is important, prudence is also crucial to advance and survivein this knowledge age. The importance of revenue-sharingarrangements in offering value-added services to tenants thattranslate into a cash flow stream for the real estate company, asopposed to equity investments, is emphasised in the report.

OPPORTUNITIES AND CHALLENGESThe knowledge age is moving all industries into digital applications,e-marketplaces, and collaborative work environments, changing OldEconomy business models into value-creation models based upontangible and intangible assets. Wired industries are mixingtechnology and the new economy with traditional business lines.The mindset of the real estate industry is changing and moving intothe new economy, using technology to enhance the underlying valueof real estate. The conclusion must be that the real estate industry,which is fragmented in nature, is the ultimate portal. The inherentvalue in real estate may be capitalised upon to create materialefficiencies and revenue-generating opportunities, creating intangiblevalue as real estate and technology converge. Stock prices couldclimb for the companies that embrace the new economy and firmlyposition themselves on the Internet speedway.

As a consequence of these trends, the real estate industry,traditionally valued on its tangible assets, needs to be redefined inthe new economy. A value needs to be ascribed to the intangibleassets in addition to the net asset value (NAV) which reflects theunderlying value of the bricks and mortar. The value of thephysical infrastructure, or the bricks and mortar platform, iscalculated via the traditional net asset value model. Based on theauthor’s view of the changes unfolding in the new economy, workhas been carried out to enhance the NAV analysis with a valuationfor intangibles, as many real estate companies are launching e-business initiatives, recording service income, building brands andforming strategic alliances. This value should be added to theunderlying value of the real estate. Thus, in September 2000, theWired Real Estate Blended Valuation Model was introduced, whichredefines the way real estate companies are valued. It wasintroduced following Simon Property Group’s analyst/investor dayin early September, which provided details on its new economyplatform, in addition to showcasing Merchant Wired. MerchantWired is an Internet infrastructure start-up that was formed bySimon Property Group and five other mall companies. MerchantWired’s CEO Jim Guiliano provided the vision and strategy for the

Valuation


Young

company to be a provider of Internet infrastructure solutions forretailers, addressing both the high-speed connectivity demands tothe Internet and security and reliability needs. Merchant Wired isanticipated to record operating losses in the early years, with a pathto profitability expected to occur by 2002. A discounted cash flowmodel was used to arrive at the present value of Merchant Wired.This analysis is the core of the Wired Real Estate BlendedValuation Model. Since Simon Property Group has multipleinitiatives in developing its new economy platform, those valueswere also incorporated. The price to earnings ratio compared to thegrowth rate (PEG) as the methodology in valuing the B2B and B2Cplatforms was used. Combining the calculated values, the totalvalue for Simon Property Group shares equated to 80 per cent forthe bricks and mortar platform and 20 per cent for the value of thenew economy platform, the intangibles. The challenge for analystsis to measure what creates value within a company, and the totalvalue of a company includes both tangible and intangible value.The value of real estate companies should incorporate the value ofthe bricks and mortar platform in addition to the value ofintangibles. In stock analysis, the more accurate value on stocksshould lead to more accurate investment recommendations. Stocksand their potential need to be more accurately valued as risk andreturn profiles are changing. Wall Street underestimates the changesthat are happening in the real estate industry.

Significant wealth may be created for shareholders in thosecompanies that are willing to move to the edge of the frontier andexplore opportunities to converge real estate and technology. In the1990s, the transformation of US real estate from private ownership topublic shareholders was pioneered via REITs. The 2000s will be abouttransforming real estate companies into Real Estate Technologycompanies. Management teams are re-thinking their business modelsand are gradually realising that their models must change in theknowledge age. although the adoption rate is slow, some real estatecompanies are developing technology platforms and, if investedprudently, wisely and with a well-executed plan, these technologyplatforms could produce significant share price appreciation in thefuture. Analysts must understand thoroughly the strategies and goalsof each CEO and company, in order to distinguish between the realestate companies moving more to real estate technology companies,with the potential for capital appreciation, and those companies thatwill remain focused on collecting a stable cash flow stream from theirbricks and mortar platform. From the author’s perspective, the realestate industry is in a state of flux and investors need to be attuned tothe transition in order to adhere to or adjust their investment risk andreturn objectives and to own the appropriate stocks. Based uponevidence from research and analysis, there is a revolution in terms ofinvesting in the real estate industry. This convergence will change theindustry and investing in stocks of real estate companies in a verydramatic way.

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