Net Present Value is Ruining Real Estate

Value =

Though I don’t write about it often, I’m a total nerd for analyzing all types of cash flows from all types of income producing assets. In fact, I’d wager the only real quantifiable skill I retained from my four years at the University of Colorado (#skobuffs) was a strong ability to discount cash flows using the HP 12c or (in my later classes) Excel. Over time I’ve garnered a stronger understanding of the DCF model which remains a cornerstone to how I view the world of business and broadly speaking, investment decisions. For those of you reading this who aren’t from the world of finance, the DCF model is a very clean way to analyze a series of cash flow over time. Time is the big differentiator between this method of valuation and other methods. Though the DCF model is used in all types of businesses, it remains the gold standard when it comes to evaluating real estate.

This summer I had the opportunity to go to Europe. It was a wonderful trip with most of my time spent in Italy. Its impossible to go to a place like Italy and not marvel at buildings like the Duomo, art that has transcended time or the random estates that predate the formation of the United States. If there is an optimization function in Italy (or Europe broadly), it seems to be one for beauty first, profit second. Returning home, I’ve since had the opportunity to travel extensively. Chicago, New York, San Diego, Denver, Austin, San Antonio etc. While all of these places have their charm, culture and are worth the visit in their own right, the contrast to Italy (and Europe as a whole) is quiet stark. I can’t help but wonder what these cities will look and feel like after the abrasion of time takes its toll.

What will downtown Denver look like in 300 years compared to Florence? How will a nicer house in the suburbs of Austin compare to a chateau on a vineyard in France in 100 years?

The optimization function in the United States is clearly driven by the market first and foremost, which is to say its driven by extracting the highest return with the least amount of risk. IRR (a measure of return via the DCF model) trumps all. Seems reasonable right? It makes a lot of sense to my finance brain where my job is to maximize profits to myself and my partners but like most things in life, complex systems are impossible to boil down to one or two outputs.

This optimization function, one where we aim at IRR at all costs, is creating an underlying tide of anti-beauty, lack of long term durability and frankly – waste.

Capitalism has long had the problem of over valuing the short term at the expense of the long term consequences. Unfortunately, this is very much how the discounting of cash flows in and of itself works. Near term cash flows are more valuable to the model than cash flows further in the future. Unfortunately, beautiful things often take time pitting the DCF model directly against the underlying idea of beauty and quality. The long standing aim in real estate is to maximize cash flows in the immediate future, reduce costs and not get caught holding the bag. Divest in a property before it begins to show its age, lack of beauty or similar. After all, even build to hold developers seldom hold longer than a few presidential elections which is hardly long enough for the incentive of build quality to really come into the purview.

I’ve thought about this mismatch of profit and beauty (or quality) a lot. While I have no direct solution, I can point to a handful of things worth talking about.

1. Culture: Whether it was holding space for Central Park in NYC or the fact we used to wear suits on airplanes, there has been a marked shift in culture over the last 50-100 years where it appears to be a race to the bottom. Lazy. Less pride. More selfishness. Less accountability. C.R.E.A.M. “Who cares if I build something that people hate looking at and falls down in 20 years? I don’t even like looking at myself and will probably die soon enough anyway.” Legacy seems to matter less and less, and “Bowling Alone” seems to ring more and more true.
2. Improper Valuation of the Asset: One thing I’m perpetually struck with is how we are actually valuing some of these assets at exit. We need to be more realistic as analysts. The actual time until salvage of many of these buildings (or any business) is not infinite perpetuity like we’re pretending. If we could more appropriately weigh this into the valuation as a market of buyers, this problem would begin to self-correct. I won’t hold my breath on this one because its tricky to actually do this and would create a situation where lots of asset holders are “holding the bag”. (and you can’t realistically short an asset over the length of time that’d be required to actually realize a return on what I’m suggesting)
3. Slave Labor & Dictatorships Aren’t Good (but can create some great looking buildings…): I want to be clear here, you often need huge power imbalances that are very negative to society at large if you want buildings like Palazzo Medici Riccardi. Slave labor and huge concentrations of wealth obviously allow those at the top to worry less about IRR and more about opulence. I do not think this is good and am not calling for this sort of outcome.
4. I’m trying to be realistic: As much as I love Europe/Italy/beautiful stuff, I also know a lot of what we are building today will never be like that. Frankly, I’m looking at a lot of Europe through rose colored glasses, ignoring all the survivorship bias and shoddiness to much of the building that has in fact perpetuated. Maybe we will in fact have more of a feel like Florence in 500 years after the crappy buildings fall and the cool things stay standing. I could be completely wrong.
5. Technology always has limits: I love technology, but have respect for the ever present element of time. For instance, though I appreciate the idea that there are companies aiming at aging booze decades in days ( 18 year old scotch immediately – IRRs going through the roof!), there is something about doing things the “old fashioned” way that I tend to gravitate toward, especially when it comes to quality of experience. Old buildings, old school cooking, old school conversations (but on the backbone of modern society). Beneath all this is the question – How do we balance speed, technology, quality and beauty for the best outcome, now and into the future. We can’t give up new building materials, technology and HVAC systems but can we bring an underlying element of quality from yesteryear that seems to often be missing.
6. Government, Zoning & Codes are a Double Edged Sword: Even the most well intentioned HOA or zoning/planning committee can end up being more a headwind than a tailwind for what I’m writing about here, but these are often the more qualitative checks the market needs to keep from perpetually racing to the bottom and putting up basic boxes.

This is a very long winded way for me to say I desperately want to find a way to bring pride and Robert Pirsig’s version of quality back into the culture and broader ether. I don’t have all the answers, I’m not ditching my DCF models anytime soon and I certainly don’t know how you shift culture to aim at things that require more time, slowing down and creating less “value” in the short term for something more meaningful in the long run. Ultimately, the idea of injecting quality & beauty alongside profitability sure seems worthwhile, and by no means is a theme focused solely on real estate in America.

Editor’s Note (yes, that means Jeff): The idea for this post was spurred by a conversation outside Florence with Marco Barbier – Thx Marco!