07 Oct 2014

Real Estate is a Network Asset 

Adam Geha

07 Oct 2014

positioner

Recently, I was quoted in The Australian (weekend edition) making reference to EG’s investment philosophy which views real estate as a “network asset”.

I have since received emails from property investors asking me what I meant by this statement and why I believe EG’s Network Investment Model is so integral to long term out-performance.

A “network asset” is one whose value is not entirely intrinsic but rather interdependent on the network of assets surrounding it. This is particularly true of real estate: the value of any given real estate asset is to a large extent determined by the cluster of assets of which it forms a part.

This is the reason why, for example, business parks exist: it is the cluster of office buildings that gives each individual office building much of its value. Place an individual office building just 1km outside the cluster and it would most likely halve in value.

The same is true of residential assets. The value of all houses in a street will tend to rise as each individual house is renovated or redeveloped. Put another way, if you have rich enterprising neighbours, your property will tend to become more valuable over time (even if you yourself are neither rich nor enterprising).

Of course, this principle applies also in reverse. For example, the value of residential assets is adversely affected if they are in close proximity to a noisy airport or an industrial asset with frequent truck movements.

In other words, real estate values are interdependent – and this is what we mean when we say that real estate is a “network asset”.

The same principle applies to human beings. Businessman, Jim Rohn, famously quipped: “You are the average of the five people you spend the most time with”. A recent study suggests that your knowledge, your fitness level and your net wealth are correlated with the knowledge, fitness level and net wealth of the seven people you spend most time with outside of your work/family network.

Along similar lines, research also shows that the value of an individual (their remuneration) can be dramatically impacted depending on the network (team) in which they are placed. A great team is nothing more than a functional cluster of individuals with complimentary skill sets.

This is why novice recruiters focus heavily on the skills and experience of the individual whereas expert recruiters focus instead on how well the individual and team fit together. In other words, networks matter.

These are all fairly obvious observations. So how does any of this assist the expert real estate investor to achieve long term out performance?

In my experience, a good property investor spends almost all of their time analysing the merits of the individual asset: the size and aspect of the land, the quality of the improvements, the layout of the floor plates, the quality of the tenants etc. By contrast, the expert investor dedicates at least as much time to analysing the network (both present and future) as they do to analysing the merits of the individual asset.

At EG, about half of our due diligence on real estate investments is spent mapping out the “network”, which means we spend time researching the following key questions:

  • does the individual asset form part of a functioning cluster of similar assets ?
  • if it forms part of a functioning cluster, who owns the neighbouring properties? what are their plans and ambitions for these properties ? (remember: we are hoping for smart, enterprising neighbours who have viable commercial ambitions for their properties)
  • if it doesn’t form part of a functioning cluster, then is the asset a good candidate for land use change? how does the asset’s zoning relate to neighbouring zones and how might rezoning assist in creating value?
  • what infrastructure assets exist in close proximity to the asset? will this infrastructure be upgraded and when? what implications does any such upgrade have for the asset’s tenants and the asset’s highest and best use?
  • what is the quantum and profile of total public and private investment that is likely to occur within a 1km radius of the asset over the term of your investment period (typically, 5-10 years).

At EG we call this the Network Investment Model, or more colloquially, the “piggy back” model. In other words, when EG invests in an asset, we are looking to benefit from a “free ride” from the network.

So while EG only invests in assets where we can add value through active asset management, we do not invest in assets where the sole source of value-add derives from our own strategy. We are looking to leverage the collective power of the cluster rather than just our own smarts.

Swimming is far more rewarding when you develop a habit of catching waves. And the waves in real estate investment are generated by the network. Study and map the network and you will achieve consistent long term out performance.