“I had never seen such ugly cows in all the land of Egypt,” said the Pharaoh. “The lean, ugly cows ate up the seven fat cows that came up first. But even after they ate them … they looked just as ugly as before. Then I woke up.”
Joseph listened intently and interpreted the dream as follows: the kingdom’s farmland was about to experience seven years of unprecedented yields, followed by seven years of drought. He told the Pharaoh that “the abundance in the land will not be remembered, because the famine that follows it will be so severe”. In order to prepare, Joseph advised the Pharaoh to “collect all the food of these good years that are coming … to be kept in the cities for food”.i
As the biblical story shows, humanity has been preoccupied with real estate yields since time immemorial. Even in ancient Egypt 3500 years ago, young upstarts were trying to guide powerful rulers to adopt more sustainable policies, reinvest their proceeds in new systems, and think strategically. And even the Pharaoh, owner of all the land in Egypt, was subject to disruption by powers that he could not understand or control.
Farmland is the quintessential real estate asset. It is valued based on its inherent characteristics and bears relatively stable and predictable returns. Unlike other real estate assets, it does not require expensive maintenance or complex ventilation or electric systems, and its value cannot be depreciated—at least according to the IRS.ii Farmland is also a scarce commodity and its ownership involves little-to-no interaction with customers.
Many of the words we now use to describe all real estate assets—landlord, yield, tenant, improvements—originate in the agricultural world. Many of the attitudes and assumptions we have toward real estate are equally ancient.
An Asset Like No Other
What makes something valuable? The answer may be clear to any reasonable person, but economists have spent hundreds of years arguing about it. Adam Smith and Karl Marx didn’t agree on much, but they both thought that the value of a thing was a function of the amount of labor required to produce it.
But how much labor goes into producing land? Figuring out the value of property, including the improvements erected on it, is a challenge. Marx struggled with the idea that land “is essential to the production” of everything but “is not itself produced”.iii If land is not “produced”, then its value cannot be equal to the value of labor invested in its production. So why should anyone pay for it?
Smith saw rent as a consequence of landlords’ power and not a result of any unique effort, stating that “the price paid for the use of the land, is naturally a monopoly price. It is not at all proportioned to what the landlord may have laid out upon the improvement of the land, or to what he can afford to take; but to what the farmer can afford to give.”iv
Smith thought that being a landlord was an easy enough job. As he wrote in The Wealth of Nations, landlords’ “revenue costs them neither labour nor care, but comes to them, as it were, of its own accord, and independent of any plan or project”. This, in turn, led landlords to “indolence, which is the natural effect of the ease and security of their situation”. In 1844, Karl Marx quoted Smith’s view of landlords in his Economic and Philosophical Manuscripts.
A century after Smith, and not long after Marx’s death, economics went through a revolution that turned the idea of value on its head. A new group of thinkers arrived at the conclusion that things do not have a fixed, objective value based on the cost of labor that goes into them. Instead, the value of a thing is subjective—and it is the result of the utility it provides to an individual buyer. And because each buyer is different, things are worth more to some people than they are to others.
This means that simply owning something is not enough. To maximize the value of an asset, you have to market it to those who are willing to pay more for it than anyone else. This so-called revolutionary idea makes intuitive sense to any businessperson. Yet, in large part, many still assume that it does not apply to real estate assets, at least not completely.
As Professor Andrew Baum of Oxford University’s Saïd Business School pointed out, unlike other businesses, real assets are valuable even when they do not have customers or generate any income. Landlords are called landlords for a reason: they own land, and land is inherently scarce and is thus inherently valuable.v The assumption of inherent value still drives many real estate owners and operators to the “indolence” highlighted by Adam Smith and Karl Marx.
Real Estate Value 101
What determines the value of a real estate asset? Valuation professionals commonly refer to four characteristics:
- 1.Demand : The quantity of people or entities who have the desire and ability to pay for the property;
- 2.Utility : The ability of the property to meet the needs of prospective owners (and their tenants). The broader an asset’s ability to serve different needs, the higher its utility;
- 3.Scarcity : The available substitutes for the property compared to the intensity of demand for it; and
- 4.Transferability : The freedom to buy, lease, encumber, or sell the asset at will.
Based on the above, the ideal asset is one that meets the needs of the largest group of people, has limited substitutes, can be transacted freely by its owner, and exists within a reasonably liquid market. You may have noticed that there is a tension between “utility” and “scarcity”: if all landlords try to meet the needs of the largest possible group of people, the result will be an abundance of very similar assets—the opposite of scarcity.
How did real estate owners deal with this tension until now? The short answer is that they mostly didn’t. Real estate assets are special. They are built on land, which makes them inherently scarce and immovable. Land scarcity protects landlords from “substitutes” and frees them to develop assets that appeal to a broad range of end users. In other words, natural constraints allowed and encouraged them develop average assets for average tenants.
But scarcity is a double-edged sword. It makes it difficult for competitors to “move in” on your market (buildings can’t move). And it also makes it impossible for your own asset to move anywhere else. Other scarce resources such as oil and precious metals can be distributed to ideal customers who would pay the highest price. In contrast, real property is both a form of supply and a form of distribution; its ideal customer is whoever happens to need access to that location at that time. Once a real estate company makes a bet on a location, it is locked in.
Lock-in provides an extra incentive for landlords to develop assets that can suit the needs of different tenants in succession. If a building can’t move, it needs to be able to adapt. For example, a typical office space in Midtown Manhattan served a law firm during one decade, a media company during the next, and a financial services firm in the decade after that. In...