US Videos

Putting a Value on Commercial Real Estate

Todd Lukasik, CFA

Todd Lukasik: Hi, I'm Todd Lukasik, equity research analyst at Morningstar, covering commercial real estate services firms and real estate investment trusts. And today I'm very lucky to have with me the CEO and founder of CoStar Group, Andy Florance.

Andrew Florance: Thank you for having me, Todd, it's a pleaure.

Lukasik: I thought we'd start off today and I guess have you talk about your vision for CoStar 22 years ago when you founded the company and what's happened since, what the company looks like today.

Florance: You know, a lot has happened in 22 years, but I think what's more amazing is some of the things that haven't changed. When we first got into the business, our interest was coming up with a better way to value commercial properties and transact business.

I actually got in the business writing financial models for buildings. The problem with modeling the value of buildings--and understand what's happening in the markets--was that there was no data. There was no data on rental rates or vacancy rates or what buildings sold for. So we have spent 20-some years going on there and visiting 3 million buildings around the United States, making 10 million phone calls, putting 10,000 man-years of labor into collecting the most robust quantification of commercial real estate that's ever been built.

Twentysome years later we're actually taking all that back to building very sophisticated, automated valuation tools and financial models for properties, to advise people with large portfolios or to help people with large portfolios value those portfolios and understand their debt exposure and risk exposure and the like.

Read Full Transcript

Lukasik: And you alluded a little bit to what you're doing now, or where the company is going, but are there other things that you'd like to discuss with regards to the acquisition strategy to further the value of the data you are providing to your existing customers as you tie in additional functionality?

Florance: We have a lot of great opportunities out there. We built this amazing database, 70 billion feet of constantly updated information about commercial real estate in the United States and the United Kingdom.

Once you've got that kind of a data asset and a distributing network out to 84,000 industry practitioners, there's an awesome opportunity to continue to lay on modules onto that that add value.

As an example, we recently acquired a company called Resolve Technologies. And what they do is they'll take all the information an institution has on their commercial properties. They're usually in different accounting systems, budgeting systems, and they roll it up into one data warehouse so that the institution gets a clear, one-source view of their properties.

In a deal like that, we can add a lot of value because we can actually begin flowing our data in next to those, next to their internal systems and give them a market context to the portfolio properties that they've got. And that's something that only CoStar could do that. We're the only ones with that sort of software capability or data asset to add that value to Resolve.

So we can take a good company like Resolve and hopefully over time make it 10 times more valuable by connecting our data assets.

There's a lot of opportunities like that where there are companies out there that may have a set of information or software around commercial real estate that we can almost at no cost quadruple the information they have for their customers and make their products much more valuable, and do it at a high margin.

Lukasik: One of the things we like to think about at Morningstar and the companies that we follow is the concept of an economic moat, a sustainable, competitive economic advantage that's going to protect cash flows and the business going into future periods.

I think it seems like you alluded to part of that in the last response in terms of the size of the database, and just the challenge that any potential competitor would face to try to replicate that--to even be in a position to try to compete with you all. How do you think about competitive advantages, or economic moats, in your business?

Florance: Well, I think at the core you've got to have this information and you've got to have the participation of the commercial real estate industry to make a system like ours work.

When I look back on the amount of labor--not just with our company, but with the 25 companies we acquired to integrate into our company--when I look back at how much effort that went into building the largest-ever collection of information on commercial real estate, it's daunting. It literally was more than 10,000 man years of labor. We spent more than a billion dollars over twentysome years collecting this database, with thousands and thousands of people working on it.

We did that when generally we were the clear leading player in any given market. So we were able to do it at a lower cost than a new entrant would have to do it, if they were a second competitor without the revenue to support the effort.

I think it's possible to replicate what we've got, but I think it might take 20 years and a billion dollars. And realistically, the value of the data we offered to a given city or marketplace, the data really comes into its own and becomes valuable about five years after we've been in a city. That's when all the leases in our system have been rolled once, and we've been able to watch all the buildings cycle their tenants once. That's when the information gets really valuable. That means you have to have very patient competitors to come to this space.

I think the economic moat is fairly wide, and we always have new competitors coming in. But we have a tremendous advantage when you look at the business. It's not something I would ever want to replicate.

Lukasik: Right. And I guess in thinking about the market today, if it is 20 years and a billion dollars, you then have that. But you also have a competitor that's already sold into a majority of the market as well.

Florance: Right. You get an existing market share. Increasingly, our customers are looking for us to more tightly integrate our data flows, so that we aren't just providing them terminals or a Web site where they can come in and look up information to run analysis. They want us to write software routines to integrate our data directly into their routines.

So we've got customers who are spending a million dollars in internal software efforts to integrate our data in. And that's the type of thing that people just don't throw those out the door.

Lukasik:: There's a big switching cost as well.

Florance: Huge switch cost.

Lukasik: Right. OK. Now commercial real estate has been a scary word, or a scary place to be recently. Some of the commercial real estate services firms we follow, customers of yours, have seen revenue declines very sharp in this market, whereas Costar's revenues have held up relatively well, and have only decreased single digits through this point.

Why is it that we can see your customers suffering much more than would be indicated by what we see when we look at your financials?

Florance: Well the secret is, CoStar's not in commercial real estate.

Lukasik: [laughs]

Florance: So that's the big difference. We don't own any buildings. We don't earn any commissions on transactions. We have no debt into commercial real estate. A number of companies that own properties lend into commercial real estate, or rely on transaction volumes to remain at a constant level to generate revenue, have had a challenging time. And we have seen a number of customers basically not make it through this cycle.

But the reality is, we provide information services. And the value of that information actually goes up when there's more risk and there's more danger. So we see a lot of new customers come in to the marketplace. People that had no interest when things are all good. People that didn't perceive there was any risk in investing in CMBS. People that didn't see any risk in lending. They are all of the sudden really struggling to value their portfolio, and they turn to us and they buy a lot of our products and services.

Also, we're seeing folks come to the market--hedge funds that I think probably accurately perceive this is a great time to be investing in commercial real estate at the bottom of the market. They're using our tools to try to understand where those opportunities are.

Certainly, we're not immune to the cycles. But if you look at our operating history, we show growth in the mid- to upper-teens year-over-year in revenue, and great margin growth when we're in normal times. And then we go flat or decline a little bit in the downturn, while you cycle out a lot of customers and bring a lot of new customers in.

The buildings don't go anywhere. An office building in New York City may go bankrupt, but someone is going to continue to operate it and leasing in it. They tend to be our customers.

Lukasik: Great. Well thanks a lot for joining us today. I appreciate it.

Florance: Thank you very much, Todd.

Lukasik: I'm Todd Lukasik with Morningstar, and thanks for watching.