In economics and game theory, there is a concept known as The Bertrand Trap, named after Joseph Bertrand, in which two economic competitors reach a state of equilibrium by charging the marginal cost of producing a product. In simplistic terms, this means that businesses that compete on price will continually lower prices until they reach an equilibrium where each earns a marginal profit. In many ways, capitalism, and the theory of competitive markets, depend on this basic theory to maximize efficiency of production.

What does this have to do with real estate? Well, I remember my economics professor presenting that apartments are essentially a commodity, in which producers build a common product and compete to offer it at the lowest price. In other words, apartment investors are susceptible to the Bertrand Trap.

I think my professor was correct with regards to certain types of apartment products, which may be comparable to a commodity. And yes, in the apartment building business, cost must be controlled produce a profit. But I do not believe that high quality, urban apartments—the type of apartments we build and manage at UDP—are a typical commodity. To explain why, let’s have a closer look at The Bertrand Trap.

Economists consider that there are 5 ways to avoid The Bertrand Trap, which, by the way, you do want to avoid if you plan to have a sustainable business that turns a profit.

1. Cost leadership: this means you consistently produce for less money and can therefore consistently out-price your competitors. Think Wal-Mart.
2. Limit capacity: work in an industry/sub-market where total capacity is restricted because of limited resources, so the intersection on your supply-versus-demand curve does not end up at your marginal cost (i.e. you can charge more than your cost because there is not enough product to go around).
3. Product differentiation: continually innovate, and “build a better mouse trap.” This is how Apple Computer makes its profits, as well as most tech firms, luxury retailers, and high-end service firms.
4. Collude: think OPEC. This is illegal in the United States.
5. Tacit collusion: think “mutually-assured-self-destruction”: firms cautiously avoid each other’s product space in order to avoid a mutually harmful price war.

Of these, method (4) is illegal, so we do not pursue that strategy. Method (5) really only works in an oligopoly, or market where there are only a few dominant competitors that can tacitly collude, and does not apply to the very fragmented real estate industry. Cost leadership (1) is a possibility, but that is more the business of the construction industry and their contractors, who compete for investors’ business through cost leadership. This leaves us with (2) limit capacity and (3) product differentiation.

As real estate developers and re-developers, we can absolutely work in a market of limited capacity. We do this by developing in urban locations where the supply of build-able land is limited. Permitting in these locations is a long process, and unlike suburban development, land is hard to come by and requires a lot of local knowledge.

We can also practice product differentiation. One of the easiest ways to differentiate your apartment building is through location. We choose our locations carefully, and because we are working in an urban environment with limited land supply, our locations are unique. In suburban markets, if you build a successful garden-style apartment, there is typically plenty more land available right next door for your competitors to acquire and entitle. In contrast, by producing our locations carefully, we can offer our tenants a plethora of urban amenities, within walkable distance, in an urban streetscape that took years to mature and cannot be reproduced overnight.

Suburban apartment developers can differentiate their product by providing built amenities, or access to natural features such as views or water. However, because of the abundance of suburban land and the relatively low hurdle to construct these amenities, these differentiations tend to be short-lived. That is why suburban assets tend to sell/trade at higher yields (i.e. lower prices), because they are considered riskier and often suffer more rent and occupancy volatility.  That said, some suburban developers are very good at managing product differentiation as a specialty, and are able to stay ‘ahead of the curve’ to succeed in suburban markets.

Focusing on quality helps us differentiate our product, and protect us from supply-bubbles. So while this concept does not necessarily help us answer the question of whether we are in a bubble, it does help protect us from danger should it turn out that we are.  When our capital partners ask the question: “What are we doing about all of the apartment supply scheduled to come online?”, my response is: “We are focusing on quality apartments in desirable, supply-constrained locations.”