A 35-year-old man with 10 years of commercial real estate experience was sitting in an advanced financial modeling class while working on his Master of Real Estate degree at Johns Hopkins University. He had just listened to the professor explain how real estate models and valuations worked, what assumptions needed to be identified, how they would impact the outcome, and what are the strengths and weaknesses of the model itself. The student confidently raised his hand to ask the following question, “Can’t we just develop a model that produces a straightforward ‘Yes or No’ result that tells me if I should proceed with a real estate investment opportunity?”
This question really focuses on a bigger concept about how well the commercial real estate industry has adopted technology not only to evaluate investment opportunities but also to analyze the performance of existing properties and to make them operate as efficiently as possible. Currently, real estate professionals have many systems available in their “technology tool bag.”
Costar is the commercial equivalent of a residential multiple listing service, providing brokers with information on both suites available for lease as well as properties for sale. More importantly, it provides analysis which can assist real estate investors by illustrating competitive properties, what is the vacancy rate in those properties, when did these properties last sell, and for what prices. Costar can also provide information on leasing activity (net absorption) and can filter all its data into hundreds of different reports.
Argus is commercial real estate investment modeling software. All lease information for a property is input, including lease expiration dates, current rent, and all future increases along with certain future assumptions, and Argus generates a projected cash flow. Among the model assumptions that need to be considered are current market rent (from Costar), future rent growth, renewal probability (how likely will a tenant renew), operating expense growth (based on inflation forecasts), general vacancy (adjusting a property’s actual vacancy to market), and downtime (number of months to lease a space after it becomes vacant). Argus then will discount the projected cash flow to determine the investment’s Internal Rate of Return (IRR). One downside to Argus is that it only projects future cash flows. It doesn’t consider historical performance.
Processing, approving, filing, and retrieving invoices used to require significant file space and staff resources. Invoices were paper documents, were manually approved, and retrieving old invoices meant physically flipping through files. Avid software creates a digital scan of all invoices and provides an electronic method to review, comment on, approve and process them. It then retains a digital copy for easy retrieval of historical billings, and since the information is retained in the cloud, the data can be accessed from anywhere. For property management companies who process hundreds or thousands of invoices each month, this is a significant time-saver.
Over the past decade, software companies have developed programs to assist tenants with initiating service requests and automating a process so building engineers can receive and respond to those requests directly on their phones via an app. Equipment preventive maintenance records and reporting can also be generated which helps property management companies be more proactive in keeping tenants satisfied and minimizing equipment outages.
By installing exterior, internet-accessible cameras on a property, building owners can provide tenants with a higher level of security without incurring ongoing security guard costs. Images can be retained for future use, and tenants appreciate being able to see who accesses their space during non-business hours.
By creating a portal, real estate operators can provide convenient access to pertinent information for both tenants and investors. A secure portal can enable tenants to access a copy of their lease, upload their certificate of insurance, see their rental payment history, and make electronic rental payments. Similarly, a secure portal can assist investors with access to their real estate investments, including the investment amount and distribution history, and the ability to download their annual K-1s. Portals eliminate the need for staff to perform routine activities and provide tenants and investors access to their information at any time.
These various systems provide incredibly beneficial resources to help make better investment decisions and allow more efficient property operations. However, two major issues exist today. First, these systems generally operate independently from each other. Artificial intelligence (AI) to connect these diverse technology advances isn’t available yet. It still takes human analysis to connect the dots to an overall conclusion or decision. Second, they don’t account for human emotions in their analyses.
In an article entitled “Why AI can’t work in real estate management (yet),” the author states that real estate decisions are “driven mainly by growing human needs and unpredictable market shifts [and] … sometimes it’s very hard to predict and depends on many unrelated economical factors.”
Leasing and investment decisions are also influenced by and based on personal relationships, closely-held information, individual perceptions, egos, and human emotion.
As noted above, Argus modeling utilizes assumptions, such as future rent growth and inflation. One investor might feel more optimistic about the economy than another, which results in more aggressive assumptions and a higher valuation or IRR. This is where AI has difficulties and instead where human experience and judgment factor better into the overall analysis.
In his 2011 book “Thinking Fast and Slow,” Daniel Kahneman recalls, “A chief investment officer of a large financial firm said he invested tens of millions of dollars in Ford stock because he had recently been to an auto show and had been impressed. In that case, the investor’s heuristic question, ‘What do I think of Ford cars?’ overrode the more salient question, ‘What do I think of Ford’s stock?’”
So, while machines can make faster decisions and prevent common investor mistakes, such as herd mentality and confirmation bias, they can’t understand or simulate human emotions. AI can’t evaluate why a tenant will pay more for space because of its address or level of finishes and how that appeals to their ego.
In an article entitled “Do robots make better investment decisions than humans?” the author states that artificial intelligence also can’t effectively evaluate “investment decisions [that] have a longer time horizon and may have different objectives, such as [a 1031 exchange], liquidity needs, [estate planning] … and regulatory matters. In other words, investment decisions are typically based on qualitative factors while trading decisions rely more on quantitative analysis.”
Now, let’s get back to our Johns Hopkins student. After asking that question, an extended pause followed, and the professor said to the confident student, “You’ve completely missed the point.” Models, he said, “provide guidance and are only one tool to evaluate a real estate opportunity. But that’s all they are. You can’t model human emotions.” Why someone can envision their business in one space versus another, or how a real estate investor will respond in the moment of a blind auction, is impossible to predict and develop a program for analysis.
That confident student, who was sitting next to me in that class, just learned an important lesson when it comes to real estate investing. Analytics and artificial intelligence have improved the information and data that we have available. They can assist investors in understanding the sensitivities related to certain assumptions and help make better decisions. They can help existing properties operate more efficiently, provide more expeditious information and maximize personnel resources; however, they don’t replace experience, discipline, and understanding how to correlate information from various sources that are needed to complete the full picture and ultimately make the final yes or no decision.
Kenwood Management is always looking for new investors to join the Kenwood Community. Learn more about our investment services and how you can generate steady and secure commercial real estate gains with our team of experts.
In celebration of our 25th anniversary, we will be holding an investor event on September 8 at The Marriott Convention Center in North Bethesda. Our guest speaker will be well-known economist Anirban Basu. Please hold the date. Invitations will be issued soon. Also, spouses/significant others are welcome as are any of your friends who would be interested in learning more about our investment opportunities.