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.