Published in the March/April 2017 issue of REIT magazine.
A revolution is coming in real estate investment, according to MIT professor David Geltner. “Rules of thumb” and “conventional wisdom” are out, he says. Empirical data and analytics are in.
“This is an industry that has always needed to use a lot of numbers, but it is an industry that never had real data,” Geltner says. In a wide-ranging interview with REIT magazine, Geltner discussed how the influx of data-driven millennials is changing the culture of the real estate business, what buildings and people have in common and more.
REIT: You’re a major proponent of transactions-based approaches to real estate valuations. Can you explain the advantages of this method?
David Geltner: Transaction prices are the fundamental datum for real asset valuation wherever there is a well-functioning market for the assets. Economists define values on the basis of “opportunity cost,” and opportunity cost is what you can sell for in the market.
There is also a venerable and abiding role for appraisals in various aspects of the real estate industry. We often need to value properties more frequently than they are transacted. And we often need an outside independent expert opinion about value, sometimes even when there is also an associated transaction price. Appraisals can also be quite useful for constructing real estate investment performance indices and benchmarks.
There is also an important role for stock market-based indications of property values at an aggregate level. REIT share prices reflect the way the stock market values commercial property assets. The stock market is the most efficient information aggregator about property values, and its valuations represent liquid opportunity costs available on a daily basis and based on a wealth of publicly-available information.
In general, empirically, we tend to find that stock market-based valuations of property assets move first in response to relevant news; followed by average private property market transaction prices, which on average reflect market values; and finally then appraisal-based indices tend to move last. But ultimately all these types and sources of property valuation information tend to end up in the same place.
REIT: Where do you think the real estate market is now in its typical cycle?
Geltner: Actually, I’m real good at telling you when the cycle has turned, after it has clearly turned. As of last year, I thought we had reached a plateau and that if the plateau held for a while, we might avoid a major downturn in commercial property pricing. But then the market turned up again.
I guess I wouldn’t want to bet against some sort of pretty broad and non-trivial downturn happening between now and 2020. Hopefully, just a correction, rather than a crash, but that may depend on how much higher commercial property prices rise before they fall.
REIT: Some of your more recent work has focused on real estate depreciation. Tell us a little bit about your findings.
Geltner: I think it’s pretty cool! We find that buildings are like people. Commercial structures in the U.S. seem to exhibit an average lifetime of about a century, maybe a bit less, especially in the case of multifamily apartment buildings.
The buildings live on average nearly a century before being demolished, but they pass through three rather distinct “stages of life.” Youth is from about zero to 30 years old and is characterized by a sharp drop in value as the structure loses its luster as a “new building.”
But once in middle age, roughly 30-65 years, there is relatively little differentiation of value by age. A 40-year-old building is not perceived much differently from a 60-year-old building as far as the age of the structure is concerned: Of course, middle-age buildings may absorb more capex in order to keep up their status.
Finally, in old age, over about 65 years, the building value begins to decline pretty rapidly again toward essentially zero, just the land value of the property remaining. As the building approaches its life expectancy, it may become less worthwhile to spend money to try to keep it up.
Our study is also the first academic study to combine estimates of routine capital improvement expenditures with the above-described estimates of “net depreciation,” which is the decline in value associated with age. We find that capex is approximately equal to net depreciation. In other words, for example, typically routine capex averages around 3.5 percent of the remaining structure value per year, and net depreciation is also about that much. Thus, “gross depreciation” or “capital consumption” is around 7 percent per year of the remaining structure value.
This is substantially more depreciation than is typically assumed in the real estate investment industry, in U.S. income tax policy, and in the official U.S. economic statistics.
REIT: Real estate derivatives seemed promising before the 2008-09 downturn, but then never seemed to get off the ground. Why?
Geltner: The tough nut to crack for commercial property derivatives has always been the short positions, at least regarding price index-based derivatives that would enable synthetic investment. There are probably plenty of investors who would like to invest synthetically in the long side of real estate indices. But the demand for the short side is more narrowly based on entities with exposure to particular property markets that they want to hedge specifically.
One strength of REIT-based products such as ETFs is that they are based on funded, liquidly traded shares, which therefore do not require matching long and short positions.
REIT: As an academic, what are some of the subjects in real estate that are lacking in rigorous analysis or in need of more attention?
Geltner: There is relatively little rigorous, economics-based focus on commercial real estate development: the actual process of capital formation, where and how financial capital is converted into the physical capital that greatly impacts cities, society, the environment and the economy.
A very exciting frontier is to link the economic and financial perspective of real estate development to the physical perspective of the architects and urban designers. We could use development of both theory and empirics.
This is an industry that has always needed to use a lot of numbers. But it is an industry that never had real data. This could change now because we do now have much more and better data, and getting more and better all the time. And we now have computational power that can make use of this data.
There is the potential for a major cultural shift in how the real estate investment industry does business. It may not happen, but real estate programs in higher education have an opportunity and an important responsibility to try to help it to happen.
REIT: What about improving real estate as a field of study in higher education?
Geltner: Honestly, there has been over the past few decades quite a blossoming of academic real estate centers and programs. I think the field has grown and matured and improved considerably, certainly over the 30 or so years I’ve been in it. And I would say this growth is accelerating.
When I started out there were just faculty members and Ph.D. students. Today post-docs and research scientists have added major new human capital to the equation, making the academic real estate research scene much more exciting. =
About David Geltner
David Geltner is a professor of real estate finance in the MIT Department of Urban Studies & Planning and associate research director of the MIT Center for Real Estate. He is the lead author of the widely cited textbook “Commercial Real Estate Analysis & Investments.” He received the Graaskamp Award in 2011 for excellence and influence in real estate investment research from the U.S. Pension Real Estate Association.