Vanishing value: the risk of ignored obsolescence
Welcome to this week’s blog. If you’d prefer access the audio version.
If you’re under 30, you’d be forgiven for wondering what the bright-red human-sized boxes are on the high street. For those of us that are a little older, these were once a lifeline. Permanently armed with a 20p piece or a scribbled note of the reverse charges number, these were how you called your parents when you got stuck in town. However, such was the speed of mobile phone adoption through the late 90s, that the UK’s one-time stock of 70,000 public phone boxes has now dwindled to under 10,000, and most of those that are left are used less than one a month, or never.
You probably get where this is going. The lesson is that technological shifts can very quickly render physical assets obsolete. This should be front of mind for property investors right now. Whilst the direction of structural change has for some time now been obvious for those interested in this subject, the past 12 months has put the vehicle into overdrive and brought the changes to mainstream attention. Five years ago, it was easy for pure-play office investors to take part in a little schadenfreude at the expense of retail investors. However, recent events have highlighted the fragility in all sectors for those assets that are misaligned to the changing world.
In today’s blog, I consider the issue of obsolescence in the face of massive change. I look at the sources of obsolescence, identify how these can bite real estate, and run through some perhaps unexpected consequences, before offering some thoughts about how to position for resilience.
Obsolescence is ‘the quality of no longer being in use, having been replaced by something newer and better or more fashionable’. I’m afraid that where there is change, obsolescence is always lurking around the corner. We’ll all feel its withering touch at some point in our lives. That might come in throwing away the TV that cost you thousands; it might be when your apprentice with fresh ideas gets promoted over you, or it might be when your ex introduces her new boyfriend. It might also be when the property asset you bought has its value marked down. The first examples are a forgivable part of life; the latter in my opinion less so. My sense is that real estate investors rarely give proper reflection to the prospect for change, and are rarely held accountable when it rears its head. ‘We couldn’t have known about the impact of e-commerce’. Really? The way that the market works is that the buyer of any openly marketed asset is, by definition, the one that takes least account of the prospect for negative change, and in this we have a systemic problem.
Different brackets of redundancy are more predictable than others. We are usually pretty good in the real estate world at provisioning for physical obsolescence. On purchase, buyers carry out surveys and create budgets to address issues, from lifecycle upgrades to remediation costs. Less explored is the rate of redundancy in new technological equipment as buildings start to integrate this more deeply. In the past month I’ve spent £3,000 repairing an electric fault in my otherwise mechanically perfect car; this is due to a system that didn’t even exist 20 years ago and isn’t essential to its basic function of getting you somewhere. How long before the same issue applies to buildings?
To the extent that we are sighted on such, we are also reasonably good at addressing legal obsolescence. This might for instance arise where a building no longer meets a code or, for instance, now has an unsatisfactory EPC rating. Legislation is usually well trailed and so gives us time to react. But I think we can do a lot better in this regard. We all know what the sources of legislation change are likely to be in the coming decade. Clue: sustainability. Answer: don’t buy unsustainable assets, at least not without a big discount to reflect future taxation and code alignment.
More difficult to predict is stylistic change. Admittedly, this might be superficial, or even the tenant’s responsibility in most office assets; however, if you’re designing high-end apartments you need to nail this. Shifts in the source of capital (Russian vs Middle Eastern vs Far Eastern) for instance can elicit big changes in the tone of the décor. The solution? Leave your fit-out choice until the last moment possible to limit the change risk.
The more challenging changes, however, come from functional and economic obsolescence. This is where for instance the form of the real estate is no longer matched to the function for which it was intended, and consequently, becomes beyond economic repair. A vanilla example comes in the form of some factories. If you built with 5m eaves, and the industrial process now operated ubiquitously needs a height of 10m, then you are facing demolition. But what about more nuanced changes? Suppose people used to sit at desks in an office 5 days a week, and now only need a collaboration space for 2 days per week? The building might still suit; but what if your competitors are delivering a perfectly matched product and commercial structure – what would that do to your lettability?
One of the biggest future sources of risk in my view comes from locational obsolescence, (i.e. the asset isn’t where it needs to be). This relates to the land rather than the improvements on it, but could critically devalue both. In the past, transport infrastructure has been a big determinant of this risk. When the railways bypassed settlements, they put trading posts out of business, and when mass car ownership allowed people to travel to out of town malls conveniently, the high street suffered. Some company and mining towns disappeared entirely when their geographic raison d’etre vanished, leading to total write-down in asset values. The challenge ahead comes through new commuter patterns, and the virtualisation of travel. Particularly in this there is a risk to city centres, where day-time footfall may be lower moving forwards.
What else should we be thinking about on this subject?
In a world becoming more focussed on sustainability, there is an issue brewing in the growing disconnect between physical and economic obsolescence. Through technical innovation, the physical (technical) life of buildings is increasing (250 years for the frame is not unusual). However, due to industrial change, the economic life is likely to reduce (perhaps less than 20 years in some cases). The difference between the two is unsustainable waste. A further nuance of this is that different parts of the building will age at different rates, and because say the lifespan of the M&E and the age of the cladding is not coterminous, investors will always end up in a position where either: (1) they need to renew a component beyond the economic life, or (b) they need to redevelop when there are perfectly good materials left in the building.
It’s actually worse than this, in that the economic life of each of the components ages in a different way relative to its technical life. I would stake a guess that modern digital components will become outdated much more quickly than structural ones. Further, in a mixed-use building, each sector element will suffer from different rates of economic obsolescence. For instance, demand for the shop at ground floor might disappear early, leaving it boarded up and damaging the brand of the rest of the building, whereas the long let flat on the top floor might last for a century, leaving it difficult to redevelop the offices in the middle.
This is a big problem for real estate. The product lifecycles in our industry are massive compared with other industries. Elsewhere, products become obsolete somewhere between every year (for a smart phone) to every 30 years (for a plane). Meanwhile in real estate, Cherry Tree Cottage, where I live, has stood for 400 years (with a little modernisation in the meantime). Commercial property recycles much more quickly than residential, but new business models could accelerate this further. Trends towards flexible occupation, modular development, renting fit-out elements as a service, and the circular reuse of materials, all provide positive news for the real estate industry, and will help to limit the damage associated with change going forwards. If only these represented more than a small fraction of the market that is.
I come back to the point, however: how do investors account for this now, and how should they in the future? A traditional term and reversion calculation assumes income in perpetuity, with obsolescence and other similar risks implicitly (mythically?) expressed in the yield. Meanwhile, a discounted cashflow approach will rarely carry for more than 5 years, and in my experience only includes items that will obviously need addressing in this period (typically physical ones). Finally, a depreciated replacement cost approach explicitly considers a broader range of deterioration factors, but is so infrequently used in valuing (and certainly in lending) as to be irrelevant.
Perhaps the elephant in the room is that given people’s own job lifespan is typically less than 5 years, it is not in the interests of those making the decisions to raise this debate, but rather to leave it as a problem for others in the future, who can readily disclaim accountability. However, for those who intend to be in the same job (perhaps even the same project) in 10 years’ time; my advice is to start putting greater focus on obsolescence now. Think about which areas carry higher risk, and think about how you can manage risk in your contracting structures.
If all else fails, think about how you can create a pivot, an option, a new function or a new purpose. The red phone-boxes with which I started this discussion still provide a lifeline to many; over 600 have found a new use as a home for defibrillators.