CRE Investors: Still Crazy After All These Years

By Andrew McCulloch, Managing Director, Real Estate Analytics, Green Street Advisors

The commercial real estate industry has long been in denial about the true long-term costs of owning real estate.  Despite the accumulation of overwhelming evidence that cap-ex reserves in the low- to mid-double digits as a percentage of NOI are appropriate across most property types, we have never come across a property-market practitioner that employs a cap-ex reserve as large as what we use.  Green Street first labeled cap-ex as the industry’s “crazy aunt in the basement” nearly 20 years ago, a label that remains as appropriate as ever.

The ubiquity of 7- or 10-year IRR analyses effectively causes buyers and sellers to treat cap ex as a minor issue; the rehab done on acquisition is an “acquisition cost,” and the next rehab is a problem for a future owner.  Short-term thinking allows everyone to pretend that the aunt isn’t there.

If the industry is indeed guilty of systematically undercounting cap-ex, then opportunities for investors to exploit this mispricing are plentiful.  Cap-ex is a relatively minor issue in some property types (e.g., net lease and self storage), but it is a major cost in others (e.g., hotels and low-barrier office).  Cap rates across property sectors don’t accurately reflect these differences in ongoing maintenance costs.  This is readily apparent in REIT returns.  REITs in the lowest cap-ex sectors have delivered far better returns than REITs in the sectors at the high end of the cap-ex spectrum. Cap-ex differences exist even within certain property types, as a commodity-like an office building in a suburban market with no barriers-to-entry requires at least twice as big a reserve as a prime office building in a gateway market.

As a result of our 29 year history, Green Street has accumulated a vast store of proprietary data relating to the drivers of sector, market, and individual asset performance.  Cap-ex is an example of how information from the public markets can be enormously valuable to the private market.  The decades of information and insights from public REIT disclosure provides a treasure-trove of information that makes its way not only into Green Street’s REIT research, but also into our private market research product – Real Estate Analytics.  This intelligence is essential to forming reliable conclusions about real estate values and when assessing investment opportunities.