Microsoft PowerPoint - GeltnerSlidesDeprecForHoytMay14

LEVERAGING SCIENCE,DEVELOPING INNOVATION

CharacteristicsofDepreciation

inCommercialandMulti‐FamilyProperty:

AnInvestmentPerspective

By:

Sheharyar Bokhari &DavidGeltner

MITCenterforRealEstate

Thisversion:March,2014

PresentationPreparedforthe

PensionRealEstateAssociation

SpringMeeting,Boston,May14,2014

Depreciationfroman“InvestmentPerspective”…

“Depreciation”=“Long ‐termpermanentdeclineinpropertyvaluenetofgeneral

inflation,associatedwithbuildingage,causedbystructureobsolescenceevenafter

expenditureonroutinecapitalmaintenance.”

“Obsolescence”=“Physical”,“Functional”,or“Economic”…

“InvestorPerspective”=“Fundamentalimpactofdepreciationoninvestment

performance”

 Economic(notaccrualaccounting)perspective

 Focusedoncashflows&marketvalues(not“bookvalues”)

 CompatiblewithIRRorHPRmetricsofinvestmentperformance

 Declinerelativetopropertyvalue notjust

structurevalue

(though attributabletostructureobsolescence)

 Notsameastaxpolicyperspective(thoughrelated).

Studyfeatures:

 Largermorecomprehensivedatabase:73,229obs 2001‐13,

sales>$2.5M,fromRCAdatabaseof investmentproperties.

 Basedonactualtransactionpricesnotappraisalsorassessments.

 NOIeff ectvs“capratecreep”effect.

 Causeofdifferencesacross

metros.

Whydoesdepreciationmatter?...

• Affectsthecapitalreturn(hencetotalreturn)ofCREinvestment

• RealdepreciationisubiquitousinCREinvestmentproperty,anditisnon ‐

trivial(Wefindcloseto150bps/yr includingland value ≈25%assetval).

• Butitisoftenignoredinmicro‐levelDCFvaluationanalysisofinvestment

property:

• Typical

pro‐formaautomaticallyprojectsrentalgrowthof“3%”,

vaguelybasingthatoninflation(eventhoughactualinflationis

probablylessthan3%),notrecognizingthatrealdepreciationmeans

thatrentsarelikelytogrowlessthaninflation.(Theoffsetisthe

typicalproforma appliesadiscountratethatisunrealisticallyhigher

than

actualexpectedIRR.)

• Andrealdeprecationhas“characteristics.”Itvariesacross:

• Metromarkets(relatedtospacemkt supply elasticity)

• Typesofproperties

• Ageofthebuiltstructureontheproperty

• Propertymarketconditions

• So,depreciationisimportantforinvestorstounderstand…

Measuredepreciationby“usedassetvintageprice”method:

Usehedonicregressionmodel:

Ln(Price/SF)=f(PropertyAttributes,TransactionInfo,LocationControls,Time

Dummies)

• PropertyAttributes=PropertyType,LnSqft,Age,Age

,cbd_fg

• TransactionInfo=SellerType,resolveddistress_fg,cmbs_fg,leaseback_fg,

excess_land_potential_fg

• LocationControls=RCAMetroAreadummyvariables

InthisspecificationAge&Age^2coefficientscapture

essentiallycross‐sectional variationinpriceasafunctionof

buildingage,i.e.,ageasofagiventime(timeofsale).E.g.,How

muchless30‐yr‐oldBldg Asellsforcomparedtootherwise

identical20‐yr‐oldBldg Basofthesamepointintime.Hence:

“real”(netofinflation)depreciation.

Alsonote:thisisdepreciationnet ofroutinecapital

expendituresontheproperties(whicharenotcontrolledfor).

Similarhedonicmodelofcaprates:

StandardizedCapRate =f(HedonicVarbs,TimeDummies)

Hedonicvarbs:

Age,Age^2,

LnSqft,

cbd_fg,

resolveddistress_fg,

cmbs_fg ,

leaseback_fg,

excess_land_potential_fg,

SellerDummyVars

PropertyType,RCAMetroDummies

Where:StandardizedCapRate =CapRate – AvgCapRate(byMetro& Year)

InthisspecificationAge&Age^2coefficientscapture

essentiallycross‐sectional variationincapratesasafunctionof

buildingage.Systematicvariationincapratesacrossmarkets&

acrosstimearecontrolledforbythestandardization.

RealDepreciationinU.S.CommercialProperties

MostlyduetoNOIdecline(onlyslightlytocapratecreep)

Resultsforthenationalall‐propertysample,73,229transobs,Price&Caprate modelstogether…

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RatiotoZero‐AgePropertyValue

PropertyAge(yrs)

CumulativeEffectofRealDepreciatononPropertyValue(includingland):Dueto:

NOIEffect,CapRa te Effect,TotaloftheTwo

DuetoCapRateEffect TotalDepreciation DuetoNOIEffect

BasedondatafromRealCapitalAnalytics,Inc. forallU.S.commercialproperties>$2.5Mvalue

“NOI Effect” reflects some combination of lower rent, lower avg occupancy, or higher operating expenses.

Overallnatl average=1.3%oftotal

propertyvalueperyearduringfirst50years

sincebuildingconstruction.Younger

propertiesdepreciatefaster,probably

mostlybecausebuildingstructureissmaller

fractionofolderproperties’values.

1.62%

1.51%

0.11%

Magnitudeofrealdeprecation:

• Overallaveragerate:1.3%oftotalpropertyvalue(inclu land)peryear(basedon

medianpropertyage).

• E.g.,ifrealdeprec =1.3%andinflation=2.5%thenobservednominalincreasein

same‐propertypriceis2.5%‐ 1.3%=1.2%/yr onavg.

• Fasterdeprec rateinpropertieswithyoungerbuildings,mostlyduetodeclineof

structureproportionoftotalpropertyvalue(seenextslides).

• Equatestoapprox 6%/yr ofremainingstructurevalue(excludingland)for

median‐agebuilding(24yrs old).

• Thisisinspiteofcapex.E.g.,ifcapex averages2%ofpropertyvalue/yr,then

presumablywithoutthecapex therealdepreciationwouldbeatleast

1.3%+2%=3.3%ofpropval orabout16%ofremainingstructurevalue/yr.*

Atmedianbuildingagestructure

is20%oftotalpropertyvalue

depreciatingat6%/yr (ofstructure

value).Ifcapex is2%oftotal

propertyvalue,thenit10%of

structurevalue,hence,sumof

depreciation+capex asfractionof

remainingstructurevalueis:6%+

10%=16%.

Property

$ Value

Components

Time

RR R R

R = Construction / reconstruction points in time (typically 30-100 yrs between)

U = Usage value at highest and best use at time of reconstruction

P = Property value

S = Structure value

L = Land appraisal value (legal value)

C = Land redevelopment call option value (economic value)

K = Construction (redevelopment) cost exclu acquisition cost

Stylizeddepictionofpropertylifecycle,valuecomponentsovertime:

Valueonasinglelandparcelinaplacewithincreasingreallocation

(usage)value,historyspanningperhaps200years.

Realdepreciationdragspropertyrealvalue(P)downbetween

redevelopments…

Computingtheimpliedaver agestructurelifetime…

Empiricallyestimatedhedonicpricemodel(asfcn ofbldg age):

Ln(P/SF)=‐0.0219474(Age)+0.0001843(Age

)

Thisisaquadraticfunction ofage.Ithasaminimumpoint(overAge).Beyond

thatminimumpointthereisnofurtherpropertydepreciation.Therefore,atthat

minimumpoint,thebuildingstructureisfullydepreciated(assumingthatitis

onlythestructurethatdepreciates,nottheland).

Findthisminimumpoint

usingcalculus(setderivativewrt Ageequaltozero):

dLn(P/SF)/dAge = ‐0.0219474+2*0.0001843*Age=0,

Ageatwhichnofurtherdepreciation=0.0219474/0.0003686=60yrs.

MinPoint

60yrs age

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BuildingAge(yrs)

CumulativeEffectofRealDepreciatononRemainingStru ctu reValue(excludingland):

AssumingLandisInitially52%ofTotalPropertyValue&LandValueisConstantReal

Computingtheimpliedlandvaluefractionat(re)development…

Ageatwhichnofurtherdepreciation=0.0219474/0.0003686=60yrs.

Whenthebuildingisnolongerdepreciatingitisworthless,hence,timefor

redevelopment.Atthatpoint,entirepropertyvalueislandvalue.Asafractionof

valueofnewly‐builtpropertyvalue,thispurelandvaluecomponent

foundby

pluggingthebuildinglifetimeage(i.e.,agewhenstructurebecomesworthlessas

indicatedbynofurtherdepreciation)backintoourhedonicpriceequationasa

functionofbuildingage(exponentiate togetfromlogstolevels):

Exp(Ln(P/SF))=Exp(‐0.0219474(60)+0.0001843(60

))=0.52.

Landvaluefractionis52%ofnewly‐builtpropertyvalue(structureis48%).

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BuildingAge(yrs)

CumulativeEffectofRealDepreciatononRemainingPropertyValue:

Land&StructureComponents(60yearstructurelife)

RemainingPropertyValue(Land+Structure) LandValue

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RemainingStructureValue&StructureDepreciationRate:

AssumingLandisInitially52%ofTotalPropertyValue&LandValueisConstantReal

FractionofNewStructureValueRemaining DepreciationRate/YrFractionofRemainingValue

FractionofStructureValueRemaining

&

RateofStructureDepreciation/Yr…

6%/yr @

Median

Bldg Age

(24)

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PropertyAge(yrs)

CumulativeEffectofRealDepreciatononPropertyValue(includingland):

Non‐ParametricModel

Non‐parametricmodelalsosuggestsdepreciationpetersoutinthe

40to90yearagerange,withstillabouthalfoforiginalproperty

valueremaining…

However,thebuildingsalesdatabaseisinherently“rightcensored”:

Doesnotincludethepropertiesthatweredemolishedalready.

Furtherwork(notreportedhere)willexaminedata

ondemolitions.

Thefindingaboutthesmallroleofcapratecreepisalittlesurprising.Typicalindustry

expectationsarethat“non‐institutional”propertysellsatcapratesabout200bpsabove

“institutional”property.Supposingthisreflectsdepreciationofanew“institutional”

propertytoafully“non‐

institutional”propertyovera

50‐year

period,thenthis

impliesacapratecreepeff ect

ofabout50bps/year:

((1/.10)/(1/.08))^(1/50)‐1=‐.0045

Yetwefindanaveragecaprate

creepeff ectonvalueofonly11

bps/yr.Thisimpliesthatthe

NOIsourceofrealdepreciation

(rent– vacancy–oper

expenses)accountsabout93%

ofpropertyrealdepreciation,

implyingNOIofavg 50‐yr‐old

bldg is53%thatofnewbldg in

realterms.Ifsomeofthisis

duetoloweroccupancy&

higheroper exps,thenthisis

consistentwithnon‐instl rents

approx 2/3ofotherwise

equivalentinstl rent.

Source:©Exh.11‐8b(p.251)Geltner‐Miller“CommercialReal

EstateAnalysis&Investments”3e,OnCourse Learning(2014)

RCAdatabaseobs withpreviously‐notedhedonicvariablesandsalesbetween2001&

1Q2013:MoreComm thanApts,andApts avg almost10yrs olderthanComm…

Note:wehavefilteredoutthefewobs withpropertyage>100yrs,toavoid“historicalstructure”eff ects.

AGEMeans&Mediansin theSamples:

Sam pleNMean Median

Natl‐AllProp 73229 29 24

Natl‐Ap ts 17316 37 33

Natl‐Comm 55913 27 22

Capratesubs 21910 24 20

Bu bble 23885 30 24

Non‐Bu bble 49344 29 24

MaxisLA_Metro with10,246obs;Min isPittsburghwith208obs.

RCAdatabaseobs withpreviously‐notedhedonicvariablesANDlocatedintop‐25

RCAmetros(byobs),salesbetween2001&1Q2013:

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RatiotoNewlyBuiltPropertyValue

StructureAge(yrs)

CumulativeEffectofRealDepreciationonPropertyValue(includingland)

TotalDepreciation‐Apts TotalDepreciation‐Comm

Intheaggregate,apt &non‐resi commercial depreciationisverysimilar

(controllingforage,slightlymoreinapts,avg 1.7%/yr vs1.3%/yr)

BasedondatafromRealCapitalAnalytics,Inc. forallU.S.commercialproperties>$2.5Mvalue

Becauseinoursampletheavg apt is10yrs

olderthantheavg non‐resi comm property

(median33vs 22 yrs old),thedepreciation

rateofthemedianpropertyisactuallyslightly

lowerinapts:1.34%vs 1.45% /yr.

‐1.34%

‐1.45%

Untilbuildingsareveryold,apartmentpropertiesdepreciateslightlyfaster,

industrialslightlyslower,office&retailinbetween.Propertieswithyounger

buildingsalwaysdepreciatefaster(smallerlandvaluefraction).

BasedondatafromRealCapitalAnalytics,Inc. forallU.S.commercialproperties>$2.5Mvalue

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Ind Off Ret Apt

DepreciationRatesByBuildingType&Age

1yrold 10yrsold 30yrsold 50yrsold

Depreciationperyearasfractionoftotalpropertyvalue(includingland)

Estimateddepreciationratesasafunctionofbuildingage,byRCAMetroMkt,sortedfrom

highesttolowestdepreciationrates…

Real Depreciation Rates Per Annum:

Metro Market: 1 10 30 50 Average

Dallas 4.84% 3.94% 1.89% -0.20% 2.62%

Houston 3.38% 3.03% 2.25% 1.46% 2.53%

Austin 3.50% 3.01% 1.92% 0.81% 2.31%

Pittsburgh 3.37% 2.88% 1.79% 0.69% 2.18%

Charlotte 2.79% 2.42% 1.60% 0.77% 1.90%

Denver 2.96% 2.49% 1.45% 0.39% 1.82%

Atlanta 3.22% 2.65% 1.36% 0.05% 1.82%

Phoenix 3.23% 2.64% 1.31% -0.04% 1.79%

Tampa 2.78% 2.34% 1.36% 0.36% 1.71%

Baltimore 2.36% 2.05% 1.36% 0.67% 1.61%

Sacramento 2.35% 2.03% 1.30% 0.57% 1.56%

Philly_Metro 2.35% 2.02% 1.29% 0.56% 1.56%

Chicago 2.16% 1.89% 1.27% 0.64% 1.49%

Detroit 2.19% 1.85% 1.09% 0.33% 1.37%

St_Louis 1.96% 1.68% 1.05% 0.42% 1.28%

Minneapolis 1.66% 1.49% 1.12% 0.74% 1.25%

So_Fla 2.26% 1.76% 0.65% -0.47% 1.05%

DC_Metro 1.55% 1.33% 0.84% 0.34% 1.01%

Portland 1.39% 1.23% 0.89% 0.54% 1.01%

NYC_Metro 1.42% 1.20% 0.72% 0.23% 0.89%

Seattle 1.25% 1.07% 0.65% 0.24% 0.80%

SF_Metro 1.15% 0.99% 0.65% 0.30% 0.77%

SanDiego 1.30% 1.04% 0.46% -0.13% 0.67%

Boston 0.80% 0.72% 0.54% 0.37% 0.61%

LA_Metro 0.67% 0.55% 0.28% 0.01% 0.37%

Average 2.28% 1.93% 1.16% 0.39% 1.44%

All estimated rates are statistically significant

Building Age (Yrs):

Depreciationvariesstronglybymetroarea:

Biggermoreland‐constrainedcitiesshowlessdepreciation…

Thesearethe(absval ofthe)estimatedcoefficientsontheAgevariablebyMetro,

wherebldg ageismeasuredinyears,+/‐ 2Std.Errs:

(Note:TheAge^2coefficient,notshownhere,makesthedepreciationrate/yr afunctionofbldg age,notindicatedhere.)

AbsoluteValueofEstimatedCoefficientonBuildingAge(Yrs):

+/‐ 2Std.ErrRange

Insomemetros,oldbuildings(near50yrs)stopdepreciating, 

perhapsbecausethestructureisvirtuallyworthless(allland

value)…Here:Depreciation&bldg ageinSouthFloridaMetro:

So.Fla Metroisstrongestexample,butthereareothersamong

thetop25RCAmetros:Atlanta,Dallas,Phoenix,SanDiego.

LA_Metro alsostopsdepreciating, butitalmostnev erstarts

depreciating…

LosAngeleshasverylittledepreciation.

(Note:LA_Metro hasmostdata,hence,mostprecisedepr estimates.)

Otherswithverylowdep:Boston,SF,SD,Seattle.

(NYC_Metro &DC_Metro arelowbutnotaslowduetotheirapts depreciatemuchfasterthantheirnon‐resi comm,perhapsanon‐CBDeffect.)

Dallas hasthemostdepreciation(amongthelargest25)…

Otherswithveryhighdep:Houston,Austin,Pittsburgh,Charlotte

(andunlikeDallas,theseothersshownowsignofdepreciation

endingbyage50).

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0 1020304050

RatiotoZero‐AgePropertyValue

PropertyAge(yrs)

CumulativeEffectofRealDepreciationonPropertyValue(includingland):

ComparisonofSeveralMetroAreas

Bos NY DC Chi SoFL Dallas LA

Depreciationrates&age‐profilesdifferacrossmetros

Bos

Chi

SoFL

Dal

Transactionpricecapratesseemtoreflectinvestorawarenessof

differencesinrealdepreciationratesacrossmetros

Slopeofregressionlineis0.47(t‐stat=3.5,R

=35%).Realdepreciationaloneapparentlycan

explainanimportantamountofthedifferenceincapratesacrossmetros.

Atlanta

Austin

Baltimore

Boston

Charlotte

Chicago

DC_Metro

Dallas

Denver

Detroit

Houston

Minneapolis

NYC_Metro

Philly_Metro

Phoenix

Pittsburgh

Portland

SF_Metro

Sacramento

San_Diego

Seattle

So_Fla

St_Louis

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

0.5% 1.0% 1.5% 2.0% 2.5% 3.0%

AvgTransactionCapRate(2001‐13)

DepreciationRate/Yr%PropertyValue

CapRatesRelatedtoAvgDepreciationRateByMetro

Correlation=+59%

Andavg realdepreciationratesreflectthedifferencesinsupply

elasticityfordevelopment inspacemarketacrossmetros

DirectionofCausalityis:Supplyelasticity Depreciationrates CapRates

NYC_Metro

DC_Metro

LA_Metro

SF_Metro

Chicago

Boston

Houston

Seattle

Dallas

Atlanta

Miami

San_Diego

San_Jose

Denver

Phoenix

Philly_Metro

Austin

Minneapolis

Portland

Tampa

Orlando

Charlotte

Baltimore

St_Louis

Detroit

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

0.0 0.5 1.0 1.5 2.0 2.5 3.0

AvgDepreciationRate/Yr%PropertyValue

Metro(CBSA)DvlptSupplyElasticityIndex(SaizMeasure)

DepreciationRatesRelatedtoDevlptSupplyElasticityByMetro

Correlation=+75%

Regressionlinehasadj R

=56%,t‐stat5.4.

Regulatoryconstraintsreducedepreciationsomewhat,but…

Greaterregulation lowerdepreciation.

Physical landsupply constraintsreducedepreciationevenmore…

LandConstraint SupplyConstraint+Highlandvaluefraction Low erdepr 2ways

0.2

0.4

0.6

0.8

1.2

0 1020304050

RatiotoNewlyBuiltPropertyValue

StructureAge(yrs)

DepreciationinTypicalvsBubblePeriod(2005‐2007)

(CumulativeEffectofRealDepreciationonPropertyValueincludingland)

TotalDepreciation‐TypicalPeriod Total Depreciation‐BubblePeriod('05‐'07)

EffectofPropertyAssetMarketConditionsonDepreciation:

Duringthe“bubble”period(2005‐07)depreciationwasonlyslightly(though

statisticallysignificantly)lowerthanduringother years:1.2% vs 1.3%/yr.

Conclusions&FuturePlans…

• RealdepreciationinCRE averagesaround1.3%/yr,withinterestingdifferences

acrossmetroareas.

• Depreciationisfasterin“younger”properties(newerbuildings),largely(but 

notentirely)reflectingthelargershareofthestructurevalue(ofnewer

buildings)inthetotalpropertyvalue(smallerlandvaluefraction).

• Iflandvalueaverages20%

of(newly‐deve loped)propertyvaluethenreal

depreciationofthestructurealone averagesabout1.9%/yr,rangingfromover

2.7%fornewbuildingstounder0.6%for50‐yr‐oldbuildings.

• Apartmentpropertiesdepreciateonlyveryslightlymorethannon‐resi

commercialproperties(1.7%vs 1.3%/yr),notenoughtojustifytheIRSpolicy

differential(although,IRSdepreciationrulesalso ignoreinflationwhich

rendersdepreciationexpensededuction“recapture ”ubiquitousanyway).

• Metroswithlesssupplyelasticity(pertheSaizmeasure)showsignificantly

lowerdepreciationrates(probablyreflectinggreaterlandvaluecomponent).

• Physicallandconstr aintshavebiggerimpactondepreciationthanregulations

• Assettransactioncapratesare

positivelycorrelatedwith,andareimportantly

explainedbythedifferenceindepreciationratesacrossmetros.

• Depreciationcontinuedtoexistduringthe“bubble”years(2005‐07),butata

slightlyreducedrate(1.2%vs 1.3%/yr,statisticallysignificantdifference).