Next Season’s Meager Harvest In Commercial Real Estate by Michael Aked, Jim Masturzo – Research Affiliates

I made hay while the sun shone.

My work sold.

Now, if the harvest is over

And the world cold,

Give me the bonus of laughter

As I lose hold.

— “The Last Laugh” by John Betjeman


Key Points

  • Investing when prices are low and reinvesting to maintain (and upgrade) value are both necessary requisites for successful property investment. Changing fundamentals, such as new construction spend and the vacancy rate, also impact commercial property investments’ real return.
  • Over the last 5 years, US commercial property investors have earned a real return of nearly 10% a year, surpassing the returns of the previous three decades. We estimate a much lower real return for the next 10 years, similar to the returns earned in the 1990s.
  • We analyze two scenarios over the next decade—one with property prices sticky at current high levels and one with prices that revert to lower norms. Under both, the annualized expected real return is far lower than property investors earned over the last 35 years: 1.4% and 2.6%, respectively.

The dog days of summer are here. The garden is ripe with the tomatoes, cucumbers, and peppers we have dutifully tended. The summer season is truly a time of gastronomical delight, tempting us to try to extend the period of harvest. Should we leave the fruits longer on the vine? Should we plant more seeds? No. The time of planting and toiling is past. Now is the time to enjoy the fruit of our labor, just as the owners of direct property in the United States, who braved the winter winds of 2008–09, are enjoying today. Their efforts are being handsomely rewarded with a real return of nearly 10% a year since 2010, surpassing any of the three decades following the late 1970s when good recordkeeping began. Unfortunately, we do not expect the strong harvest from commercial property to continue in the decade ahead.

The Past Harvest

Capitalization rates (income per unit of price) of commer­cial properties have declined over the last 35 years. The average capitalization rate in the 1980s was 7.0%, in the 1990s 7.8%, in the 2000s 6.8%, but in the 5 years ending 2015 only 5.5%. High prices and high capital returns— although great for owners who wish to sell—when unsup­ported by income lead to low current yields and inevitably to lower long-term returns as capital price gains outstrip the necessary support of cash flows.

We define cash flow as net operating income following the definition used by the National Council of Real Estate Investment Fiduciaries (NCREIF),1 which is the gross income earned from rent and amenities (e.g., parking, laun­dry facilities, and vending machines) reduced by operating expenses (e.g., repairs and maintenance, insurance, and property taxes). We define price return as the real capital return, or the real appreciation in average market value per square foot.

These income and price change series are probably the easiest and most accessible judgments of the health and return of direct investment in commercial property. Unfor­tunately, the gross real return of investing in direct property has fallen far short of the promises of income and price. From 2010 to 2015, the investor real return experience in US commercial property has been 9.8% a year, a lofty number and substantially higher than in the preceding decades, but nonetheless 5.3% a year short of that implied by the income and price appreciation of the properties. The average short­fall for the 35-year period beginning in 1980 is 4.1%.

Commercial Real Estate, Harvest

Like a garden, commercial property is expensive and time consuming to maintain, resulting in a real return shortfall. The constant toil of maintaining a property, not only to the expectations of the current pool of renters but also to compete with newer and upper-scale properties being built, can be a daunting task. We explain how the less obvious costs of being a landlord are important in generating robust forward return expectations. First, we consider the direct costs of property ownership, or the toil of constant property maintenance. Second, we turn our attention to the climate, or the impact of unpredictable property price fluctuations.

The Necessary Toil

The largest and most obvious advantage of property investing is the tangible income, or rent, an owner receives. Gross rents, usually a surprisingly large number relative to a property’s value, can be a deceptive indicator of a prop­erty’s income generation. Landlords face numerous calls on cash for capital expenditures (budgeted as reserves for replacement) to repair a building as well as to maintain its competitiveness with newer, cleaner, and better-built structures constantly entering the market. Vacancy, the loss of income from empty offices and apartments, can also be extremely costly.

The amount of reinvestment the owners/investors in a property are willing to make in that property determines the longevity of its income-generating potential. Essentially, three options are available to owners/investors:

  1. Maintain minimum quality (i.e., little to no reserves for replacement = maximum aging). The owner undertakes the minimum amount of capital investment in the property to maximize the income yield. The property will, however, suffer the maximum amount of degradation, known as aging, pushing the quality of the building over time into a cohort of lower-quality buildings, and in turn lowering its cash flow potential. Although the investor initially receives the maximum amount of income per year, the value of the building quickly declines over time.
  2. Maintain constant quality (i.e., average reserves for replacement = average aging). The owner undertakes enough capital investment to keep the building at a constant-quality level defined as the level of quality on the day the property was completed. By doing so, the investor receives less income because of the reinvestment, but the building suffers less aging. Nevertheless, the property effectively depreciates relative to newer buildings being constructed with fancier bells and whistles, and is therefore no longer considered as desirable as it once was.
  3. Maintain current quality (i.e., maximum reserves for replacement = little to no aging). The investor undertakes the level of investment necessary to keep the property at the most current level of quality, including integrating new technology and building standards as they are developed. In this case, an A-grade building can maintain its rating, and thus stem the tide of aging, by constantly upgrading to match the current definition of an A-grade building. This level of investment, however, is usually much greater than the benefits available from rent increases over the building’s lifetime.

For our analysis, we consider the constant-quality scenario in estimating reserves for replacement and aging because it is the most common of the three scenarios. In prop­erty investment, capital expenditures are lumpy over time because upgrades—a new HVAC system or new roof, for example—may require a large capital outlay one year, followed by much lower expenditures in subsequent years. Over the last 35 years, the average capital invest­ment required to maintain buildings in a state of constant quality was roughly 2% of market value.

Commercial Real Estate, Harvest

The Unpredictable Climate

Properties maintained at the quality of their construc­tion cohort (constant quality) are less desirable to rent­ers as time goes on. The difference in the

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