Why the next 24 months will matter more than the past 24 years.
The March 2008 collapse of Bear Stearns signaled the end of real estate’s extended bull run. The September 2008 trifecta of the Lehman bankruptcy coupled with the Washington Mutual and Wachovia bank weekend fire sales shook the real estate industry to its core. The still looming waterfall of maturing commercial mortgage–backed securities, the slowly thawing capital markets, and the ongoing uncertainty about where the next market will come from have left real estate professionals searching for solid ground. Entering the third year of the broad recession, the industry has retrenched, reorganized, and is struggling to recapitalize. But is the industry retooling?
For years the industry has accepted real estate as the all-encompassing term for both what it does and what it creates. By definition, real estate is “all land and improvements that are immovable.” But the increasing complexity of how the industry goes about its business and, more important, the positive impact it can have on the broader society, defies the static nature of this one-dimensional definition. Recently, industry leaders are shifting the discussion from the topic of real estate to the built environment. The latter term provides a more apt, multidimensional view of the industry’s scope, encompassing “the manmade surroundings that provide the setting for human activity.”
Changing how the industry thinks about what it does as less “immovable land and improvements” and more “providing the setting for human activity” is anything but subtle. It creates a very different call to action and, if the industry chooses, positions it to be one of the most positive forces of the coming decade for resolving the complex challenges associated with human settlement.
From Commodity to Responsible Real Estate
After World War II, real estate development changed from an industry of locally focused entrepreneurs who took great pride and responsibility in their communities, to one of a global nature that delivered a range of “products.” As companies sought to make these products conform to a formula or easily replicated template—be they garden apartments, grocery-anchored shopping centers, subdivisions, or suburban office parks—they provided diminishing returns in terms of their contribution to the natural environment and society.
The past 20 years were instructional because they made manifest, more than at any other time in history, the good, the bad, and the ugly of the real estate profession. The ongoing evolution of the industry, and a sampling of its products, is portrayed in the figure at left.
The four categories represented on this continuum define the choices the industry has made collectively, and the mileposts of its potential. Each category has varying degrees of complexity, contribution to society, and, many would argue, risk and reward.
Commodity real estate results when the industry focuses only on maximizing efficiency—creating, replicating, and rolling out product regardless of region or community setting. A one-size-fits-all solution, it is the widget end of the business. The entire national landscape is pockmarked with its legacy and the environmental and human impacts left in its wake. It could be said that it represents the worst the profession has to offer, and as such is the basis for so much derision toward what the industry does.
Trophy real estate is where some of the industry’s greatest innovation—and most photogenic projects—have evolved. But too often it is a “look at me” creation—dismissive of underlying social and environmental needs. Due to its showmanship rather than substance, much of this class of real estate lies in distress, overleveraged and underwater, because it was built up on promotion and fleeting status in lieu of a deeper sense of purpose.
Investment real estate is the more stable product class, emerging when real estate is viewed through the same lens as a stock or bond. A tangential interest in societal contribution may have been involved in its creation, but it is largely a product of financial engineering, efficiency of design, strong delivery, asset management, and branding. It may serve as a good neighbor or corporate citizen for communities, supporting employment or housing choice, but it is rarely a game changer in terms of the larger built environment.
Responsible real estate builds on the lessons of all previous categories while upping the ante. It is the best that the industry can be, representing the innovation and creativity often found in trophy real estate, coupled with the financial discipline and strong execution capacity associated with investment real estate. But it adds a third dimension—a true recognition of the real estate industry’s role and responsibility to positively shape the built environment. It is not a “look at me” outcome, but a conscious and deliberate response to the need for economic return and creation of social good. It works seamlessly with its existing context and respectfully with its community partners. It delivers long-term value—not just to its investors, but to its host community as well.
Will This Be the Decade of Real Change?
At the turn of the millennium, responsible real estate represented the fringe. It was often cloaked in the simplest of green trappings—resource-efficient technologies, a location awaiting transit, and entitlement-extracted impact fees that were spun as social equity. As the industry enters the next 24 months, this could be the moment when real change in the built environment is created. The industry has already developed the tools and skills to create complex capital stacks and technologically sophisticated buildings. It regularly wrestles with complex site planning challenges and even more complex operating agreements. But just as important as what the industry has learned to do is how markets are changing to leverage these increasingly sophisticated skills.
Demographic trends, not just government policies, are shifting the industry’s energy to transit-focused and walkable locations instead of the cheapest available sites at the edge of communities. Perceptions of status—both by consumers and tenants—are moving from trophy designs to smaller footprints, more environmentally responsible operations, and healthier indoor environments. Social equity, more broadly defined and measurable than ever before, is being thoughtfully incorporated and discussed as part of initial project programming and capitalization rather than being negotiated during the public entitlement process.
The next 24 months provide the industry with a strategic opportunity to build on what it does well, while adding the additional skills needed to emerge from the downturn as a powerful force for solving many of today’s most challenging problems. No other industry has the collective capacity, problem-solving skills, and ability to move others from pontification to execution. Industry professionals must be prepared to get the next generation of development done right when the market rebounds.
While similar predictions for change have been heard at the end of previous downturns, there are three reasons why this time can be different:
The changing calculus of value. Buyers and tenants in the next cycle will be calculating costs and value in a more multidimensional way than ever before. Quality of life, walkability, access to cultural facilities and events, a smaller environmental footprint, and even being part of the “urban vibe” are among a more complicated set of variables that will help users determine perceived value.
A leveling of the playing field. The cost differential for developing responsible real estate rather than commodity real estate is real. It is not only about first costs, but emotional and intellectual investment as well. To help move from policy to reality, a number of forward-thinking government agencies are bringing risk capital and know-how to the table to help level the playing field for developers who choose to focus on responsible rather than commodity real estate.
A movement from niche to portfolio. For years, green building and socially responsible development was the niche of a few forward-thinking individuals. Today, responsible real estate investment is rapidly moving into the mainstream, fueled by institutional investors who see green as a proxy for increased long-term value—an insurance policy against future obsolescence, a sign of higher-quality construction, and a more holistic definition of their fiduciary responsibility.
The destruction of real estate values increasingly correlates with geography. The axiom of “location, location, location” is taking on a new dimension because this past cycle demonstrated an increasing relationship between loss of market value and the least environmentally responsible locations. The calculus buyers once used to determine their housing choice—the farther I drive the more square feet I can purchase—has given way to a more complex analysis. The relationship between increased cost of place—housing cost plus transportation burden—has become more evident in an era pushing toward $4-a-gallon gasoline. More than just dollars and cents, people are rethinking the time spent in their cars as a virtual tax on their quality of life or family time.
In Foreclosing the Dream, William Lucy’s 2010 chronicle of trends, demographic changes, and forecasts that can be derived from the current housing crisis, he writes, “Household spending on transportation averages 18 percent, but varies by location. Outer suburban residents average 25 percent of household income for transportation, compared with only 9 percent for households in compact development settings.”
Concentric rings circling major urban centers can be used to illustrate measurable value losses based on distance from the core. Almost everyone has a friend or relative in the suburbs whose home value has been halved. As these homeowners consider future purchasing decisions, the safety or volatility of their investment is now another measure of value, perhaps more than granite countertops and that extra bedroom. Similarly, suburban office complexes, far from transit and centers of human activity, are some of the most distressed asset types, either because of increased vacancy rates or loss of asset value.
When the market recovers, it will be accompanied by a new paradigm of households and tenant values. While a core of starter and move-up families remains, it will be flanked by two ends of the demographic spectrum:
new generation-Y buyers and renters who want the vibe, hipness, and quality of life that accompanies urban center and first-ring suburb locations or new urbanist centers; and
empty nesters who now want to move back closer to the center of activity, culture, and education.
Value will not be measured in square feet, but in the number and range of activities accessible by foot within five minutes of one’s front door. The WalkScore phenomenon—with calculations available at www.walkscore.com—and its increasing role in real estate listings is evidence of this new calculus of value.
New programs such as the U.S. Department of Housing and Urban Development’s (HUD) tripartite Sustainable Communities Initiative are a radical approach by the federal government to promote collaboration among agencies and integrate into a holistic view formerly competing and destructive policies affecting transportation, land use, and the environment. The result will focus policy, intellectual power, and funds on making communities places where the whole is greater than the sum of its parts.
At the same time that policies are changing to support more responsible forms of development, government agencies are putting real money where their mouths are. In some progressive corners of the country, these agencies are going beyond just drafting policies in the hopes that the market will fall in line with their thinking. Instead they are bringing real, at-risk dollars to the table to help level the playing field between complex urban settings and path-of-least-resistance exurban sites.
California’s Strategic Growth plan dedicates over $1 billion of its $2.5 billion budget to infill infrastructure and transit-oriented development. These monies are available to both nonprofit and for-profit developers to help balance the costs of complicated core development versus greenfield sprawl. The Bay Area’s Metropolitan Transportation Commission is offering $31 million in climate innovation grants for planning scalable transportation projects that can reduce greenhouse gas emissions in the region. And at the Urban Land Institute’s annual Fall Meeting, the ULI Responsible Property Investing Council toured a number of innovative projects underway or completed in Washington, D.C.’s core. With the mayor’s office providing a range of tools—including creative capital structure and matching predevelopment funding—developers are able to offset the increased costs and risks associated with responsible urban development.
Green certifications under the Leadership in Energy and Environmental Design (LEED) program progressed at a rate of nearly 1 million square feet (93,000 sq m) per day last year—an indicator that green building is gaining increased traction in the market. New tools such as the LEED for Existing Buildings Volume Program—simplifying certification of multiple buildings by an organization—also are helping portfolio managers improve existing building stock in greater numbers than ever before.
TIAA-CREF, as the owner of 43 million square feet (4 million sq m) of office buildings, as well as a large portfolio of other commercial and multifamily real estate assets, is one of America’s largest institutional real estate investors. In 2007, the company’s Global Real Estate group created a dedicated unit called Strategic Initiatives charged with implementing green strategies across the company’s entire real estate portfolio. Since 2002, the firm has been an Environmental Protection Agency (EPA) Energy Star Partner, and was recognized by EPA in 2003 for mandating that its entire office portfolio be benchmarked through this program.
In conjunction with these efforts, and in response to growing demand among its clients for investments with environmental/social/governance initiatives, TIAA also formed a dedicated Socially Responsible Investment team in 2006, with separate corporate social real estate (CSRE) and new $50 million green building technology partnership (GBTP) venture capital investment programs, managed by Cherie Santos-Wuest, director of global social and community investments. The CSRE portfolio strategy can be characterized as a triple-bottom-line strategy, in which portfolio investments endeavor to produce risk-adjusted market-rate returns; measurable social impact, including jobs, income, and community revitalization for low-income residents; and environmentally sustainable construction and practices across portfolio investments.
The dedicated CSRE strategy now totals over $512 million in commitments. TIAA’s history of socially responsible real estate investment began in 1985 with a primary focus on affordable housing. “Back then, affordable housing was considered to be the sum total of socially responsible real estate investments,” says Santos-Wuest. “Today, the basic attributes that make for sound real estate investment have evolved and expanded to include investments in workforce housing, transit-oriented and urban development, and sustainable development initiatives.”
It is one thing to dedicate a portion of one’s portfolio, or entire portfolio, to responsible real estate. But does it add value, or at least match the returns of investment real estate?
In their study “Income, Value, and Returns in Socially Responsible Office Properties,” Gary Pivo and Jeffrey Fisher examined 1,200 office properties in the National Council of Real Estate Investment Fiduciaries (NCREIF) database—accounting for total market value of about $100 billion—to determine whether elements now considered cornerstones of responsible real estate development added asset value. The study, published in the July/September Journal of Real Estate Research, found that with some exceptions, over the past ten years, properties that were Energy Star labeled, close to transit, and located in redevelopment areas “had net operating incomes, market values, price appreciation, and total returns that were higher or the same as conventional properties, with lower cap rates.”
The real estate industry is at a powerful inflection point in this painful recession, but therein lies the opportunity. To harness the potential of this moment, the industry must be willing to work differently and fix the institutionalized impediments hampering broader adoption of responsible real estate as a core class. This moment presents a wonderful opportunity to retool the profession, reteach company teams, and expand the definition of value. If the industry more deeply embraces the potential of its collective skill set and its responsibility to society, it has the chance of a lifetime to become the profession that positively reshaped the built environment.
See Six Recommendations for Making the Most of the Recession for changes in practices, the author states, that will lay the foundation for a more successful outcome when the market returns.