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September 1, 2000
The Impact of the Internet on
Commercial Real Estate Sales

By Howard Hobbs, Ph.D., Real Estate Economist

    Economist at work!
    FRESNO -- Technology in an economic context can be anything that changes the production for economic goods, including real estate, so that the goods are improved, or produced more efficiently at lower cost.
    The production function relates the inputs to the production of real estate stock and services to the output. The inputs include the factors of production of land, and capital, as well as quality and a number of other types of amenities.
    Technology can affect the production of real estate through any of three points of entry.It may act "upstream" to affect the efficiency of production or quality levels of the inputs to the production process. Examples include the improved insulating properties of glass curtain walls and the spread of the secondary market and securitization in the commercial mortgage market.
    It may affect the construction and operation of the real estate structure itself. For example, the development of critical path method (CPM) construction management techniques in the 1960's enhanced the efficiency of production of commercial real estate, just as the invention of the modern elevator in the nineteenth century made high-rise development feasible.
    Finally, it may influence the "downstream" tenants of the property or other unrelated forms by increasing their efficiency of production or actually serving as their product.
     A current example is the dramatic impact the surge of demand by dot.com firms is having on the rent levels for office space in San Francisco.
     Firms being impacted by technology can have an effect on the local real estate market even if they do not themselves demand space there, to the extent that they are wealth generators in the economy in general.
    Technology can operate at any of these three points of entry at one of three levels: It may act incrementally to simply produce the same product more cheaply.
     For example, the development of PVC pipe substantially reduced plumbing costs. It may result in the production of an improved product. An example is the better insulating qualities of glass curtain walls discussed above.
   It may mean the development of an entirely new product such as the elevator. We must remember two important facts about technology in the context of real estate: First, technology is inclusive not only of "high-tech" intervention into the production process for physical goods. It is a part of all production processes for all goods.
  Improvements in the financial efficiency of the market for "intangible" commercial mortgages and the "low-tech" development of messenger and delivery services by office management companies involve the application of technology, just as does the spread of information technology and the Internet. Second,
     It must remember that just because technology increases the productivity of the economy overall, an increase inthe demand for real estate stock and services, does not necessarily do so for each sector of the real estate market.
     The blacksmith shops and train stations were rendered obsolete by advances in transportation technology, just as some assert space based retailing could be adversely impacted by the introduction of e-commerce.
   Several major events that are products of recent applications of technology in their anticipated effects upon the real estate market. Improved quality and cheaper consumer goods, especially electronic devices, new drugs and health therapies, and bio-engineered products, are proliferating.
     These influence the downstream users of the real estate by creating demand to house the production, distribution, and marketing of these goods and by creating additional wealth in the economy that generates demands for additional consumer good production.
     Those areas will thrive that host various elements of the market for such goods.
    Transportation development and the development of cities will continue current trends of decentralization and growth of the largest metropolitan areas.
     Forecasts of dramatic increases in the spread of the city because of increased telecommuting will not be realized because of evidenced continuing need for face-to-face and a desire for spatial proximity for purposes other than work, such as entertainment and socializing.
    However, ultimately the size of the city must have its limits, imposed by the time that those who still physically commute are willing to use for that purpose.
     The ultimate consequence of this for urban growth is "conurbation", a number of proximate clusters of specialized economic activity in a broader metropolitan region.
    Construction technology has affected the real estate market historically most directly through three new innovations: the development of steel frame construction, the invention of the elevator, and the introduction of mass manufacturing methods in building constructions.
    The first two made possible the development of high-rise office and residential structures and larger employment and residential districts within the feasible range of commuting.
     Mass manufacturing techniques, include standardization, prefabricated materials, and critical path method (CPM) construction management techniques, which have considerably lowered the cost of production of real estate structures.
     Innovations will continue to be introduced in the area of construction technology. Most notably, the "smart building", with high?tech control systems and "wired" for broadband technology, is coming into its own.
     More efficient procurement systems are also increasingly available through B-to-B e-commerce. Also,
financial engineering has definitely come into its own in the provision of debt and equity capital to real estate. On the equity side, the development of the REIT and RIOC markets over the last decade have provided an efficient means of delivering equity capital to commercial real estate.
     Although only making up a small fraction of total equity ownership, public market securitization of the real estate market is more important for investment-grade product and in certain sectors, such as regional malls and hotels.
     It now is sufficiently large that it provides a public-market reference point with respect to the evaluation of risk and the health of the market that is increasing the efficiency of the market overall and reducing the magnitude of real estate cycles.
    The same is true of the debt side of the market, where the development of the commercial mortgage-backed securities (CMBS) market has enhanced liquidity and reduced the swings in credit availability and cost. Both the securitized debt and equity components of the market are expected to be helped greatly by the continuing development of e-commerce, which will facilitate their growth.
    Manufacturing systems have had substantial impact on industrial real estate through improved supplier-producer relationships and just-in-time inventory methods.     Manufacturing facilities are becoming more specialized and centralized as product mix becomes more complex and "lean manufacturing" techniques proliferate.
    As greater efficiencies are sought in distribution management, just-in-time inventory management has reduced overall inventories. This reduced the need for smaller localized storage facilities. Industrial building investment as a share of GDP will continue to decline, as these trends continue.
    The Internet revolution is perhaps the most important technological innovation to impact real estate since the invention of the automobile and the elevator. It provides four different levels of product to the real estate market, each of which can have different degrees of influence.     The first level is the provision of information. This is the most basic level of production for the Internet.
    It makes up virtually all the substance of individual company Web sites, and market data provision over the Web has become a core product line for a whole host of online data providers, including consulting firms, trade associations, and government agencies. In spite of its basic nature, such data provision is highly important.
     A high degree of competition exists among data providers that is resulting in consolidation of the industry and survival only of those with the best (most reliable and frequently updated) product, the easiest access, the most capital for expansion and acquisition of competitors, and a broad infrastructure of relationships within the industry.
     The second level of product provision by the Web is the provision of analysis, including everything from appraisal methods to property management support, accounting, tax planning, construction management tools, and specialized software for statistical analysis.
    Surprisingly enough, the firms that may profit most from availability of this product may not be existing large mufti-faceted players, but rather the up-and-coming technology oriented "niche" players, which heretofore have not had sufficient infrastructure or resources to support such an extensive analytic function.
    Consolidation will also come Web-based purveyors of analytical tools as applied to real estate, although this component of the industry is still in the start-up phase, with many products being offered by the information providers.
     The survivors ultimately will be those that provide the most value-added to the most users, are adequately capitalized, and have the best infrastructure to support their product, including a capable user-support network.
   The third and fourth levels of product provision to real estate by the Web are the facilitation of real estate transactions online and, ultimately, the development of online real-time auctions of real estate interests, which eliminate the "middlemen" who are necessary for traditional real estate transactions.
     Facilitation of transactions online does not actually transform the marketplace, but only the location at which the transaction takes place, it becomes virtual as opposed to physical.
     It could involve anything from online completion of application forms and offering contracts to actual acceptance and transfer of ownership online.
The development of a real-time online auction transaction mechanism would be a fundamental transformation of the marketplace, dramatically changing existing market roles.
     Progress toward putting real estate transactions online, however, has been uneven, with the residential primary and secondary mortgage market being the furthest along, and the secondary market for commercial mortgage debt being not very far behind.
The Web also threatens residential sales, as many components of the transaction can increasingly be provided remotely.
     The segment of the market least likely to be impacted by Web-based innovations is the sales process for large commercial properties, which are a relatively thin market and highly heterogeneous, requiring high levels of personalized due diligence.
     The market for securitized REIT and REOC shares on Wall Street is a different animal, as it already is an online real-time auction as part of the stock exchange, but that should be distinguished from the sale of whole fee interests in individual assets through the private markets, which will continue to have a place in the real estate market.
    A series of questions have been frequently raised with respect to the anticipated impact of technology on real estate, which our analysis now permits us to answer:
(1) Will new technology, and especially the Internet revolution, make real estate redundant in the "New Economy"? No. Commercial real estate values will continue to decline as a share of GDP but will increase in real terms as the economy continues to grow as the result of the application of new technologies.
(2) Will brokers, loan underwriters, appraisers, and other agents in the transaction process be intermediated into oblivion as their functions become irrelevant in the new economy of the Internet? Those in traditional agency positions in the residential primary and secondary mortgage market will be most affected by the wholesale movement of a large share of that industry online.
    The commercial secondary mortgage market will be not far behind. The market for residential sales and "bulk" sales of commercial property portfolios will experience movement online with a commensurate reduction in the roles of traditional intermediaries.
     As REITs and REOCs become a larger share of commercial market ownership, the online electronic marketplace of the stock exchange will penetrate further into the real estate market.
    However, this level of activity is separable from the transfer of whole-property fee interests in commercial property in the private markets, which will continue to require a high level of personalized due diligence owing to the thinness of the market and the heterogeneity of the product.
    The agency position associated with larger commercial property transactions will prove the most immune from Web obsolescence. Second-tier regional malls, power centers, and big boxes may be at risk to the extent that they do not provide subsidiary benefits to consumers such as food and entertainment.
     The highest rates of penetration by e-commerce are predicted to be for computer hardware and software, accessories, music, consumer electronics, and flowers.
    However, the overall level of penetration into the space-based retail market by 2010 is predicted to be only 5.4%, significantly lower than many optimistic estimates. Census Bureau surveys of Internet usage found only an estimated 2% of U.S. households were using the Internet to shop online, significantly lower than other estimates such as Forrester's 9% figure for 1998.
    The recent decline in the share prices of many e-commerce dot.coms may portend the fact that neither the economies, nor the broad base of demand exists for e-shopping and that it may well exist more as a niche in the market, as do the catalog and the shopping television network, than as a supplanter of traditional shopping.     Even if e-commerce does take off in popularity, however, the resulting higher rate of economic growth overall may more than make up for the loss.
    Many inner-cities will continue to experience soft office markets as decentralization continues. "Landmark" high-end skyscrapers have rarely worked out well financially and have not been visions of economic sense. However, clusters of office space, lower density, and more functional will continue to be in demand.
     The CBD will continue as a viable office cluster but a smaller one, relatively if not in absolute terms, and only one of many others spread throughout the metropolitan region. The amount of office space per worker will continue to decline.
    As cities become increasingly disperse when the economic mandates for physical proximity and agglomeration become less decentralization will continue.
     Cities will be driven more by non-technological factors than technology, including low density zoning requirements, increasing affluence, a flight to high-quality schools and government services, and U.S. tax policy encouraging the purchase of larger homes.
     Four things could cause a reverse migration to the central city: increased transportation costs, an aging. Internet technology and improvements in transportation systems will reinforce of these trends.

[References:   Howard Hobbs, Ph.D. University of Southern. Cal. (1980) Web Portal  Inc.,
Real   Estate  Research Division (1999-2000) ;  Donald  T. Campbell  and  Julian C. Stanley, Eperitmental and Quasi-Experimental Designs for Rersearch (1966) University of Michigan, John's Hopkins University
(1963); Carey Vandell and Richard Green, Center for Urban Land Economics Reseaerch (1983); T.B. Veblin, Theory of the Business Enterprise, Scribner, N.Y.(1934). ]

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