Depreciation of Office and Industrial Property - Dissertation Example

Depreciation of office and industrial property: A review of research and its practical implications Summary of the main findings, regarding property depreciation research, and the main trends which this research reveals A considerable amount of research has been carried out on the subject of property depreciation, both on a very localised level, such as Baum’s “Trophy or Tombstone? A decade of depreciation in the central London Office market” (Baum 1997), which analysed depreciation in London offices, and also on a nationwide level, as is the case with the IPF’s “Depreciation in Commercial Property Markets” (IPF 2005) for example. While the findings vary considerably, from one report to another to another, due to the wide ranging scope and variable measurement and calculation techniques deployed, there are several noticeable trends, which can be observed, across the variety of studies, which have been carried out since the period beginning in the 1980’s and continuing on into the present. Noticeable depreciation trends in the UK property marketplace since the 1980’s  The biggest single change, in the UK property market, has been the very rapid depreciation, and even obsolescence, of a great many offices in the 1980’s, which came about as a result of the IT revolution. Whereby, suddenly there was a need for far greater floor space, so as to accommodate IT equipment (Henneberry 1984). This combined with a requirement for more extensive cabling, within office buildings, meant that many buildings which had been set out as offices were now practically defunct.  Also with the rise of technology, in the 1980’s, the traditional rental dichotomy of office versus industrial rental, took a new twist, as many companies would require a mix of needs, which included office and technology, which would have an impact upon the sort of office/ industrial units, which would be on offer to potential customers.  Dynamic trends, in the commercial property market, would result in some investors building commercial space which would have early obsolescence trust upon it, as a result of rapid market changes. An example of this, was the rapid growth in retail warehouses in the 1980’s. While they made good rental returns, due to a sudden change in the marketplace, with the introduction of new and improved retail warehouse designs, coming into effect in the 1990’s, those which were built prior to this time, saw a rapid depreciation, once the new retail warehouses began to be rolled out (N Crosby 2006).  While the City of London Office space provides the highest level of rental turnover, surprisingly it has also been the one which has been more prone to depreciation than any other market in the Country (Baum 1997). This can be accounted for by the tendency to over rent in times of boom and the requirement for seriously high levels of capital investment in order to keep depreciation at bay.  Surprisingly, industrial property fares better than office property, in terms of depreciation. In particular shopping centres, possess the lowest level of depreciation, which is probably down to their high capital expenditure and their dominant position in a particular town or City centre (N Crosby 2006).  Lease structures, and the general commercial rental culture in the UK, have had a detrimental effect upon depreciation, in the UK. In particular, there is a tendency towards long leases and upward only rent reviews. This tends to result in an inflexible approach to property maintenance. Maintenance can cost as much as 19% of the gross profit per year (IPF 2005), and a study of commercial property rental in Sweden ( Baum and Turner 2004) , where the landlord is expected to carry out much more maintenance work on the property, revealed a much lower depreciation rate, when compared with the UK. The introduction of REITS, to the UK in 2007, and the new legislation in 2012 which is aimed at making REITS even more flexible, as an investment vehicle, could go a long way towards enhancing depreciation rates, which have tended to be hampered in the past by a distant management approach towards portfolio properties. An evaluation of the strength and weaknesses of research in property depreciation Since the 1980’s there has been a considerable amount of research carried out into the area of depreciation in the UK property market. On the face of it, the results appear to be fairly consistent regarding depreciation levels, as has been noted by Turner (2001). However in a study by Law (2004), she notes that this seeming parity, in rental depreciation, is actual an illusion. She carried out research on seven studies, which had been carried out up to the period of 1999, and discovered that the seeming similarity in results fell apart, once the same criteria were applied to each study. Basically, the various studies deployed a wide variety of measurement, data handling methods, and differing concepts about depreciation. A good example, of these discrepancies, is noted by Dixon (Dixon ET al 1999), when he compares two studies, on property depreciation, in the City of London office. For example, (Callus 1986) observes that the office properties revealed the greatest level of depreciation between years 5-10. However, (Baum 1991) observed that offices undergo the greatest level of depreciation between years 17-20! So how can two studies, which are carried out in the same region (City of London offices) at the same time period (1986), produce should radically different results? Obviously, the answer lies in basing different studies upon different criteria, as to what exactly depreciation is, and then endeavouring to study the subject by deploying measurements and calculation methodologies which vary to some degree! So how is it possible to overcome these discrepancies in depreciation research? Attempts at error correction in property depreciation research Various researchers have attempted to make progress in this area. The most widely quoted, and most often referred to study, is by Law (Law 2004), and is generally accepted as the referential work on this topic. In this study Law endeavoured to create a standard definition for rental depreciation, which is as follows: “The rate of decline in rental/capital value of an asset (or group of assets) over Time relative to the asset (or group of assets) valued as new with contemporary Specification” (Law, 2004). She also came up with a list of six findings, regarding the challenges which are faced in depreciation research, and they can be paraphrased as the following: i) There are two major challenges which are encountered by property depreciation research and they are measurement and data control. In particular, an accurate overview of depreciation is heavily dependent upon the measurement methodology. ii) The differences which are found, in measurement and calculation protocols, implicitly reflect the attitudes of the researchers towards timing as well as the concept of depreciation. While this is recognized by some researchers, these factors are more often than not ignored. iii) In general, the longitudinal approach is more accurate than the cross sectional one, when it comes to evaluating depreciation, because the cross sectional approach only evaluates according to age, whereas the longitudinal approach evaluates according to time and age. The rate of change in depreciation can be assessed either on a decline or growth basis. However, only a decline basis will be accurate. iv) The calculation function, as well as been consistent with a decline basis, should calculate the relative change between the sample and the benchmark. In order to produce an accurate weighting for a specific portfolio or market segment, it is essential to measure the change in values. Challenges in the application of Law’s findings The points raised by Law’s work sound simple, however they are far more difficult to apply in real-time. In particular there are several aspects in depreciation studies which need to be addressed: Depreciation and Obsolescence: Law takes a solid step forward, by creating a clear and popular definition of depreciation. However, obsolescence also has to be considered, and there is a tendency for research studies to confuse these two concepts. An example of this can be seen in Dixon (Dixon ET al), in his criticism of Barras and Clarke study “Obsolescence and Performance in the Central London Office Market” (Barras and Clarke 1996), that they continually interchanged the term ‘obsolescence’ with ‘depreciation’, with obviously confusing results. Even when obsolescence, is firmly delineated from depreciation, as in the case of Baum (Baum 1991), where he states that obsolescence’s is ‘a decline in utility not directly related to physical usage or the passage of time’, it is still not a cure-all, because there are so many sub categories to obsolescence. Indeed both depreciation and obsolescence can be further categorized into various sub headings, the most popular of which are: Depreciation Obsolescence • Economic • Functional • Physical • Technological Depreciation, can readily be subdivided into economic and physical (Hulten and Wykoff 1981a:85), whereby economic depreciation is seen as age related depreciation, as in a building which is twenty years old, will tend to have lower rents than one which is brand new. Whereas, physical depreciation exists, when the building physical undergoes a loss of productive capacity, due to either in use inefficiency or retirement (Hulten and Wykoff, 1981b). Regarding obsolescence, it can be readily subdivided into functional and technological (Khalid 1992). During the 1980’s, for instance, a great many office buildings became obsolete because of the rise in space requirements required to cater for the introduction of information technology, with the average office space required rising from 14% to 51% (Henneberry 1984) . Whereas technological obsolescence is seen, as in the case of a building whose aging reduces the utility of the building. A building with old fittings, such as elevators could be placed in this category, as to could be a building which was too old to facilitate hi-tech infrastructural change such as fiber optic cabling. While good research requires a clear understanding as to the variations between depreciation and obsolescence, it must also be recognized that it is all too easy to blur the line between them and as such this sets up a challenge for the research team, who would be well advised to take into account these variables, and to take note of them in the course of their study. Benchmarking and Calculation of Depreciation: Law notes the importance of good calculation, which is consistent with the decline basis. However, this is another area of concern. For a start providing a good benchmark, is itself a challenge. A benchmark (Law 2004) needs to have the following three qualities:  The specification should be equivalent to a new design.  In absence of site specific data, the benchmark should possess enough coverage and separation of property units, so as to match the location of the parities in the study.  The benchmark should be free of depreciation. In actual practice, setting up a good benchmark is a difficult thing to achieve, and all studies will have some variation in approach. For example, in the Callus report (Callus 1986), they used hypothetical benchmarks, whereby valuers were asked to create hypothetical valuations for a variety of buildings, provided a good representation of the relationship between age and performance. However, Dixon (Dixon et al 1999) compared the CALUS report with Barras and Clarke’s “Obsolescence and Performance in the Central London Office Market” (Barras and Clarke 1996), and found that their work, which deployed value based ERV data from the IPD (Investment Property Databank), provides a closer approximation to the actual marketplace. So here we see two reports which produce radically different results, because of the differing benchmarks which they deployed. Calculation is another difficult area. Of all the various calculation methodologies, the two most prominent are:  Average depreciation rate (ADR)  Ordinary Least Squares (OLS) Average depreciation rate (ADR), is based upon a geometric mean and it produces an average deprecation rate, however, ADR ignores fluctuations in the dataset in the intervening years between assessments. Whereas while OLS, is not good for working out averages, however, it is very good at fine tuning how the data is calculated, which helps to produce a regressive analysis, which can compensate for the generalizations which come about with ADR. In and off themselves, ADR and OLS, and other such calculation tools are useful, but it must always be remembered that each tool has its limitations. Calculation tools, then are an extension of the research methodologies, which are analyzing the data which they make calculations upon. Such models as the ‘cash discount’ model (Baum 91) are an attempt to take into account the wide range of variables which are required so as to produce good statistical analysis. Cross sectional versus Longitudinal Analysis: This is perhaps the most contentious area of property depreciation research, because each analysis tool carries with it a limitation, which results in a bias which will drive the study in a particular direction. According to Law, the best overall approach is longitudinal analysis, and this is simply because it observers a building’s depreciation rates, at a series of points over a spaced time period. So in a 10 year study for example, there will be several reference points, whereby each building has been measured. This clashes considerably with the cross sectional methodology, where a building is simply measured at a specify point in time. Cross sectional analysis, produces results which indicate the effect of age on buildings depreciation. However, the results are heterogeneous in character, there is no way for a cross sectional study to outline the changes in a building over a specific time period. Property depreciation rates will tend to be lower, during a property boom period, and greater during a down turn. Depending upon when the cross sectional analysis has been made, the results will tend to be skewed that particular way. So at first glance, the longitudinal approach appear to be superior, because it allows for good observations to be taken of ‘cohort’ (sub divisions within the sample group), which can provide for an in-depth depth analysis. However, longitudinal analysis requires a lot of data, and data handling issues can come into play. So the variables which have been chosen for the study become really important, otherwise the longitudinal analysis also becomes a generalization, rather than an accurate study of deprecation. Practical Considerations Property depreciation research is a challenge, because the property market place is always in a state of flux. It is extremely difficult at the beginning of a study to know in advance what changes are going to take place and to accommodate the study ahead of time to dwell with them. For example in the IPF 2005 study (IPF 2005), some shopping centres had to be delineated out of the sample, because of the frequent change in center ownership, which resulted in inaccuracies in the observations. Another issue for the same study, in relation to shopping centres, arose because they did not have an actual benchmark, in place for the shopping centres, so instead they decided to base the rental benchmark on the average rental rates in the town centres. However, this also failed to work, because the cash-flow figures of the actual shops in the shopping centres varied considerably from those of shops in the town centres, which were in the same geographical areas as the shopping centres, so the apparent benchmark, was not really a benchmark figure at all! Ultimately the researchers have to choose a model, to follow and measurement and calculation techniques, which can be rated as best practice. Once engaged upon the study, all that they can do is to endeavor, as best they can, to adapt to the organic results which will come in before them. Finally, it is equally important to avoid any pedantic attitude, at the end of the studies. The process of creating good property depreciation research, is an ongoing one, and the best strides forward are a result of researchers who are willing to point out possible inaccuracies in their reports, which in turn become fuel for further studies by the next generation of researchers. Practical considerations for different end users Regarding the practical implications, for such diverse end users as an appraiser and an asset manager, the same studies can be read but the inference will be completely different. From the point of view of an appraiser, the depreciation rates are only one aspect of a rental canvas, whereby various factors such as the overall marketability of a geographical location, combined with the utility of the buildings, which are been rented , will all have a bearing upon their handling of the properties which are under consideration. For example, shopping centres tend to have the lowest levels of deprecation; however they do require massive capital injection, just to get off the ground. However, an area like City of London, although it will procure good rental returns, reveals a requirement for substantial reinvestment in order to keep their buildings let. So for an appraiser, it is these variables which will all come into play in making a decision regarding buying, selling or refurbishing a property. Whereas for an asset manager, it is the medium to long-term cash flow of the various buildings in their clients’ portfolios, which becomes more import. Also with such new vehicles as REIT’s in play, office buildings in the UK are becoming a fairly flexible investment vehicle. Indeed the recent changes in legislation are making REITs an even more flexible and attractive investment vehicle option. While on one side the asset manager is as interested in such areas as the taxonomy of the portfolio, it is equally important that each building cash flow itself, in order to keep the investors happy. In this regard one good aspect of the REIT investment vehicle lies in the focus on reinvesting the vast majority of profitability back into the upkeep of the asset, which in turn results in better longevity of income and reduced depreciation rates. In general, the UK has fared quite badly in this regard. For example (Finn 1986) stated that a property which does not receive regular refits, will have great difficulty in warding off depreciation. This appears to be a bigger issue in the UK than in some other regions, such as Sweden for instance, whereby the leases tend to be of a shorter duration and the landlord is expected to improve the property on a regular basis. However, with asset vehicles such as REITS in place, and a movement towards shorter leases, there is a move towards greater flexibility in the marketplace. And this is the final consideration for the asset manager. Ultimately the asset manager is looking for a good return, across a wide portfolio of buildings in the medium to long-term, and any improvement in flexibility of property management will make their jobs easier. As a final note, we can see that the appraiser’s job is essentially an abstract one of valuations and suggestions to their clients, whereas the asset manager has to take more managerial hands on approach, in order to reduce depreciation rates over the medium to long-term. In this regard both of these professions require depreciation data, but will have a very different take upon it. References Baum, A. (1991) Property Investment Depreciation and Obsolescence, Routledge, London. Baum, A. (1997) Trophy or Tombstone? A decade of Depreciation in the Central London Office Market. Lambert Smith Hampton and HRES.London. Barras, R. and Clark, P. (1996) Obsolescence and Performance in the Central London Office Market. Journal of Property Valuation and Investment. 14 (4): 63-78 Baum, A. and Turner, N. (2004) Retention Rates, Reinvestment and Depreciation in European Office Markets, Journal Property Investment and Finance, 22(3), 214—35.Turner (2001). Dixon, J., Crosby, N. and Law, V. A Critical Review of Methodologies for Measuring Rental Depreciation applied to UK Commercial Real Estate. Journal of Property Research, 1999, 16(2) 153-180. CALUS (1986) Depreciation of Commercial Property, College of Estate Management, Reading. Finn, M (1986): address to the 1986 Building Industry Convention, unpublished. Referred to in RICS Press Release, April 22. John Henneberry, (1984) Aspects of technological change and its impact on demand for industrial accommodation, Property Management, Vol. 2 Iss: 2, pp.117 – 128. Hulten, C.R. and Wykoff, F.C. (1981a) The Measurement of Economic Depreciation, in Depreciation, Inflation and Taxation of Income from Capital (edited by C.R. Hulten), Urban Institute Press, Washington D.C. Hulten, C.R. and Wykoff, F.C. (1981b) The Estimation of Economic Depreciation using Vintage Price Assets, Journal of Econometrics 15, 367-96. IPF. (2005). Depreciation in Commerical Property Markets. Investment Property Forum/IPF Educational Trust.London. Khalid, Abd Ghani (1992) Hedonic Price Estimation of The Financial Impact of Obsolescence on Commercial Office Buildings, PhD thesis. University of Reading, Construction Management. Law, V. (2004). The Definition and Measurement of Rental Depreciation in Investment Property. Reading: University of Reading. Read More