Where Are the Moats?
November 13, 2019 | James Sprow | Blue Vault
As we hear about the failures of certain IPOs and the failures of those amazing start-ups to generate profits after a few years of fantastic growth in revenues and customer counts, we must wonder if their business models might lack an important ingredient or reveal a hole in their economic logic.
When it comes to real estate, we’ve all heard the cliché phrases. Do “Location, location, location.”, “Barriers to entry”, “Buy land, they aren’t making any more of it.” “Gateway cities” sound familiar? What do they really mean? Even though real estate investment isn’t just a game of Monopoly, it does have some of the same basic parameters. There are properties, locations and sub-markets that are more valuable than others, and their values owe much to their location and the limited number of sites that can share those locations’ characteristics. Perhaps it is proximity to a major public asset or quasi-public asset (think of properties near Grand Central Station, Central Park, Wrigley Field, Silicon Valley or Wall Street, for example). Perhaps its due to the high growth in population in certain localities, or a major employer announcing plans to locate there. We know sites near major highway interchanges are more usually more valuable than the land in between because a) there are a limited number of acres easily accessible to a highway interchange and, b) easy access to a property is a valuable quality. Unique or scarce locations provide “moats” because competitors can’t easily duplicate them. Economists refer to this added value as “economic rent.” This means simply that they can earn higher rates of return because they have qualities that, due to their uniqueness, cannot be easily duplicated and therefore generate above-market returns.
What differentiates more valuable locations from less valuable locations when it comes to commercial real estate investments? One way to phrase it is “Does it have a moat?”* In other words, is it protected from competition by having some irreplaceable quality? Does it have a unique attribute that cannot be duplicated by the competition? In real estate, at least one answer is easy: location. Does the logic of real estate investing shed light on the failure of WeWork and Uber and some other high-flying companies to live up to the hype? We could say “maybe they didn’t have a moat.” There was no economic rent to be captured in their businesses. They are businesses that are based upon the changing desires of their customers for flexibility in where they work and how they travel. But, they are not protected from competition by their irreplaceable uniqueness or their irreplaceable assets.
WeWork became a billion-dollar company by leasing office space around the U.S. and turning it into flexible, short-term workspaces with amenities like shared spaces, coffee bars, and other trendy features. Uber became a billion-dollar company by enlisting free-agent drivers and providing them with the software that connects them to people who need a ride, allows them to drive when and where they want to in their own vehicles, and get paid quickly. But neither company has a moat. Neither company was so unique or had such unique and irreplaceable assets that competitors were effectively shut out of their respective markets. Other companies can lease office space and turn it into flexible workspace with amenities and short-term tenant rental commitments (e.g. Regus and at least 22 others). Other companies can link free-agent drivers with people who need a ride or want something delivered (e.g. Lyft, Curb, Grab, Ola, GrubHub, DoorDash, etc.). Neither the flexible office space concept nor the free-agent driver concept is patentable or otherwise protected from competition.
Another key to protecting a company’s market is the cost of switching. Cell phone service providers and cable television companies are discovering, to their chagrin, that consumers can switch providers at relatively low cost and are doing so at an accelerating pace. When the cost of switching is relatively low (like the short-term leases at WeWork, for example, or another ride app on your phone competing with Uber), a market niche is not protected. There is no moat.
When we look at commercial real estate and REITs, one of the features that makes one company more successful at producing shareholder returns is their irreplaceable or difficult-to-duplicate competencies or portfolios. They may have unique competencies, it may be their team of real estate experts, their pipelines of deals or potential deals, or their leadership, usually built upon long-term relationships and experience. Looking at their real estate portfolios, it may be as simple as owning or controlling the best locations, economies of scale that come with larger homogeneous portfolios, better property management, or other unique qualities. There may not be competitive advantages available to some REITs that are too small, competing with more experienced or qualified teams to find attractive properties, or who lack superior management. Paying market prices for properties doesn’t lock in higher rates of return. Higher returns depend more on the REIT’s unique attributes, including management talent and experience. Those attributes aren’t available to just anyone or any group that wants to assemble a property portfolio.
For one example, there are currently well over 150 Qualified Opportunity Funds competing for the investors who wish to take advantage of capital gains tax deferrals for up to 10 years provided in legislation passed by Congress in late 2017. These firms are competing to raise capital and find investments in the over 8,700 census tracts designated as Opportunity Zones in the U.S. Not all these funds will succeed, and the amount of capital raised for Opportunity Zone investments so far, since the legislation was passed and regulations clarified in 2018, is not encouraging. Those developers that do succeed will probably be those that controlled sites in Opportunity Zones prior to the legislation being enacted or those that have the difficult-to-replicate competencies, teams, and experience mentioned above. Those qualities act as “moats” that make superior returns possible, but not guaranteed.
Leitbox Portfolio Partners Self Storage Fund Reduces Risks by Finding “Moats”
At least one real estate investment manager that we are familiar with uses an approach that attempts to capitalize on the concept of moats. Bill Leitner at Leitbox Portfolio Partners Self Storage Fund, a Reg. D offering, utilizes a site selection process that targets locations to build self storage properties with retail tenants on the ground floor. His site selection algorithm is designed to find opportunities that would be ideal for this type of investment, and importantly, would not face competition within their service area. This “sharpshooter” approach eliminates some risks that larger REITs may not be able to avoid. Leitbox reduces risk by finding sites with “moats,” building quickly, stabilizing quickly, and exiting within a shorter length of time than the large self storage REITs are able to. Sometimes being smaller and more nimble is valuable in finding investments with moats.
A professor of finance that I studied with years ago went to work in the private sector running pension fund investments. He had found a niche in researching smaller companies that were not widely covered by Wall Street analysts. As long as there was poor analytical coverage of those smaller companies, he could be a “sharpshooter” and turn up opportunities for his investments that were undervalued and offered potential for above-market returns. Ironically, the more money he had under management, the less his strategy could succeed. In many cases, assembling a position in a small company’s equity was difficult due to the low volume of trade and relatively low float. He found he was often “bidding against himself” and paying too much to try to capture the economic rents available to his analytical expertise. In his environment, he couldn’t create a “moat.” This lesson can be applied to commercial real estate and other business endeavors. Look for the moat, and if it isn’t there, don’t expect above-market returns.
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*What is an Economic Moat?
Conceptualized and named by Warren Buffett, an economic moat is a distinct advantage a company has over its competitors which allows it to protect its market share and profitability. It is often an advantage that is difficult to mimic or duplicate (brand identity, patents) and thus creates an effective barrier against competition from other firms.
