Clients ask me how to position assets for the “new normal.” How do you prepare for the unexpected? Nobody knows how—or if—the new normal means that real estate markets will radically change, whether the pandemic will cause that change, or whether the pandemic will only accelerate trends that were in place well before Wuhan.
One thing is certain: Defining the new normal in terms of airborne pathogens misses the point entirely. More broadly, the new normal is defined in terms of change and uncertainty. Conceptually, change and uncertainty are the defining characteristics of our world. Positioning for the new normal requires an understanding that change is occurring at an accelerated pace.
What does this mean for real estate?
Much has been written about our aging infrastructure. Real estate is part of that aging infrastructure. Although we may think of real estate as a fixed asset, properties are becoming more of a hybrid asset. Commercial properties are a hybrid asset comprised of a relatively permanent shell filled with building elements that are subject to change. Some elements, a staircase for example, are more permanent. Other elements, like elevators, HVAC, and communications, change due to a combination of wear and innovation.
Wear and tear used to be the primary reason for changing out building elements. An owner’s great dilemma was deciding whether it was finally time to replace a system, or whether that system could undergo less expensive repair and last a few more years. Today, things are much different. Cold air, hot water, and a dry roof are not enough. Technology, comfort, and aesthetics—once luxuries reserved to Class A properties—are becoming less-negotiable requirements at Class B and C properties. Today’s tenants are after the “experience.” They want buildings to meet technological needs in a comfortable and attractive environment.
The pandemic may have added building hygiene to the list of tenant requirements, but if you think that the pandemic is the only source of change, you are missing the point. The list of tenant requirements is growing. These elements may require replacement and improvement well before they are worn out. And failure to keep pace may result in a loss of property value.
To position assets for the new normal, you must hedge against change and uncertainty. It will be better to own more flexible structures. Owners can hedge uncertainty risks by maintaining larger reserves to pay for more frequent building updates.
You want to be ready for the future? Invest in things that make your properties more valuable to tenants. Acquire properties that are more generic and more easily adapted to a larger number of alternative uses. Reduce your leverage. You will pay the price in lower returns on equity in the short term. But you’ll celebrate the stable and secure growth in your equity over time.