Germany: Smart Buildings: A Permanent Revenue Stream For Real Estate Developers?

Last Updated: 31 July 2019
Article by Lukas Weidner and Fabian Hafenbrädl

As all real estate professionals know, commercial buildings are evolving - triggered by rapid technology changes as well as changes in workplace patterns. Buzzwords like efficiency and productivity are omnipresent and buildings are being seen more and more as virtual gateways to connect people with each other and the outside world. Brick and mortar of the future integrates people, technology and communication.

At the same time, many real estate developers are exploring new ways to keep their business model profitable and - despite this ever-changing real estate world - sustainable. Even (or indeed especially) very successful players in this field are mindful of the general threats to their business model such as shrinking margins due to higher construction costs and land prices, higher execution risks, and increased pressure/scrutiny of society toward the project details. Several progressive developers do not see their future necessarily in scaling up their construction activity or the individual features of the property. From their perspective, the key is to diversify into actually operating smart buildings.

Vertical diversification

Selling properties that are packed with cutting-edge technology is nothing new for most real estate developers today. However, many seem to leave the operating part to third parties and therefore miss out on turnover in a growing field. Beyond that, they ignore the opportunity to potentially generate long-term gains by owning the data despite having disposed of the property at the beginning of its life cycle. It is the same business model that many industries, like machinery and plant construction, apply or at least are currently trying to establish. Last but not least, developers stay "connected" with the buildings and their current owners. Why deal with a third party for an update of the navigation system of your car if this can be purchased as part of the annual services? And what of the situation where a developer repurchases at a later stage a property it had earlier disposed of?

This approach of using opportunities can be called vertical diversification. It is vertical because designing and setting up the property is the developer's core business. Staying involved with the building post completion - even if only through sister companies for tax or other reasons - makes the developer a player in the downstream market too. The individual value chain extends, but the trade remains the same. As with virtually all kinds of diversification (and played out in many other branches of the economy), the underlying rationale is a mixture of growth strategy and risk mitigation. Operating smart buildings goes far beyond providing a simple service to the purchaser of the property besides facility and property managers.

Prospects of success

Vertical diversification strategies are generally most effective in mature areas. While this cannot be said about the proptech aspect to this business model, there is certainly no doubt about the maturity of the core business at hand. Therefore, the relevant players seem well positioned, notably:

Market access

The developer will in many instances be in a position to dictate the operator's identity for the building or at least steer the tender process as part of the combined acquisition negotiations. There may even be some level of control on prices. This constitutes a significant competitive advantage compared to third-party operators - be they competitors for individual smart building services, existing facility management services or for the whole package for a project.

Market knowledge and experience

The wealth of knowledge that real estate developers have gathered over the years should not be underestimated. So, while numerous third-party operators for smart building technologies exist, this does not necessarily mean that these services work to the satisfaction of all involved stakeholders, first and foremost the daily users of the building. Given the complexity of current building technologies, it can regularly be observed that data is misinterpreted and that the smart building does not live up to its full potential. This is particularly true for building control systems. There is an opportunity for developers to forge ahead in this field and offer one-stop solutions from the source.

Maintenance as a building - related service

Operating a smart building directly leads to a new business. Maintenance of a smart building can be seen as a new building-related service that has to be carried out either by the owner of the building or by a third-party provider. While it is market standard in Germany that a tenant (even outside triple net leases) is responsible for certain maintenance works, a landlord will in most cases still be obligated to carry out a vast array of such works (particularly if the work affects a system that serves all premises in a multi-tenant building). Last but not least, it will in many instances simply be more convenient and efficient for the tenant - against an additional fee - to instruct the landlord with specific maintenance works. Institutional investors typically lack the required know-how or such services do not fit into their business strategy. Consequently, they are already using third parties for these services and so the floor may as well be open for the developer to generate new turnover using the aforementioned competitive advantages.

Such maintenance includes on the one hand, hardware upgrades as well as software updates and repair of items like sensitive sensor nodes, but on the other hand, also service levels including an emergency repair service for the smart building. The liability coverage of the service provider is of great importance, since a smart building with, for example, closed doors or no heating can lead to extensive damages. If the developer and the operator of the building are associated with one another or are the same entity, there is also obviously a fine line between generating additional ongoing pieces of work and potentially triggering the liability regime under the purchase agreement with the investor/new owner. This is not to be treated lightly from a sales perspective and needs to be carefully considered when drafting the relevant purchase agreements.

Data access and data ownership

Smart buildings produce huge quantities of data that have to be collected, analyzed, prepared and finally provided to the key players. It is not sufficient to install server rooms in the building; a complex cloud infrastructure is required. "Data is the new oil" is an often-cited saying. In fact, one of the key issues for smart buildings is the question of who has access to and controls the data that is generated by the building itself and by the people that are using the building on a daily basis. Data ownership has to be discussed between all relevant stakeholders. Due to a lack of statutory legal protection, the focus is on the contractual clauses to be agreed between the involved parties.

As described above regarding maintenance, the purchaser of a property might be interested in a high-end smart building, though running an IT platform does not always fit into its portfolio. However, having direct access to the building data can be the decisive competitive edge in a more and more difficult real estate market. This allows the developer to sell a smart building with access to the developer's own smart platform. Furthermore, the developer is probably the player who can profit the most from the analytics of building data. Such data may provide new insights regarding trends in the usage of buildings and thereby enables the developer to build today the buildings investors will ask for tomorrow.

Data analytics and smart phone applications

Analyzing building data and preparing it for individual user groups presents challenges for the operator. Furthermore, they must provide a user-friendly front-end that facilitates the usage of the building. Every party is a potential customer of the operator of the smart platform. By facilitating third-party services, for instance on a commission basis, nearly all consumables can ultimately (and more or less exclusively) be integrated into the smart building concept.

Relevant stakeholders

While the general upside of these products seems obvious, it is important to bear in mind the different roles and primary smart goals of the different stakeholders.

A developer intends to build the best possible buildings in order to attract new investors. They require usage data to enable them to identify new trends and developments in the usage of buildings. The investor's aim is to obtain the greatest possible long-term rental income, which is ensured by efficient use of space and this is where smart building data can, for instance, help to identify and avoid inefficiencies. Today's tenant is looking for comfort and easy digital access to the outside world. Comfort indicators like the ability to properly and easily control the room temperature along with convenient ways to operate a business from within the premises are very attractive features to potential tenants. The individuals actually using the building are typically employees/customers of the tenant or people living in the building. This group operates the smart technology on a daily basis to open doors, turn on lights, or control the AC by using hardware as well as smart phone applications, etc.

This ultimate focus on individuals means that data protection law comes into play as well. Both in residential and office buildings, the data obtained from sensors and the user patterns might regularly qualify as personal data under the applicable data protection laws.

Summary

Some developers are wondering how to amortize the higher costs of smart buildings if the investors are not willing to factor the existing opportunities into higher purchase prices. One answer might be: operate such smart buildings yourselves.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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