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Article Excerpt
We propose a theory of urban decay. Following a negative real estate demand shock, property managers optimally suspend maintenance and the probability that they ever restart can be modest. Because maintenance expenditures are proportionately less risky than are the incremental building profits they generate, managers impose a more demanding profit standard on maintenance than on the initial investment. This differential in profit standards means that rather than maintain existing investments, property managers favor new investments, which, if marginally acceptable, they also leave unmaintained. Contractually required maintenance (e.g., for publicly subsidized real estate investments), increases the minimum profit for the initial investment acceptance and discourages subsidized real estate investments in favor of unsubsidized investments. However, the required profit for acceptance of a permanently maintained investment is below the profit boundary for maintenance if maintenance is not contractually required. Consequently, the subsidy that induces the investment is least expensive if maintenance is not required, more expensive if maintenance is permanently required and most expensive if maintenance is induced immediately after initial construction but thereafter is at the discretion of the manager. All of our findings are strongest for poorer quality properties.
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In its 1999 study "Places Left Behind in the New Economy," the U.S. Department of Housing and Urban Development (HUD) notes that even at the peak of the last economic expansion, many urban areas saw no substantial revitalization or economic growth. (1) In this paper, we propose a theory of maintenance for real estate investments that explains this disturbing finding. For a significant fall in operating profit that leads to maintenance suspension, there is a large probability that maintenance is never resumed even as new construction takes place elsewhere. If normal maintenance expenditures are largely determined by the physical attributes of a building and are unrelated to its profitability, then they are less risky than the incremental building profits they generate. Maintenance adds proportionately more to the value of investment expenditures than to the value of operating profits, and, therefore, maintenance adds to a property's value only if a manager imposes a more demanding profit standard on maintenance than on the initial investment. This more demanding standard for maintenance means that managers optimally neglect maintenance in favor of new investment. This result holds even if managers can suspend and recommence maintenance at no cost. We interpret our findings to mean that urban areas that see decay during an economic downturn may never recover even when economic conditions improve elsewhere. HUD's finding is therefore not surprising, although still disturbing.
We find that managers' inclination to neglect maintenance is most pronounced for poorer quality real estate properties. To the extent that initial quality is related to the economic means of an area, our model implies that properties are more likely unmaintained in lower income neighborhoods and have less likelihood of maintenance resumption. The most vulnerable segments of the population are the first to experience urban decay and the last to benefit from general economic expansion.
Our research has important implications for various assisted-housing programs of HUD and other government agencies around the world. (2) The goal of these programs is to provide a subsidy, usually in the form of a loan guarantee, for financially marginal projects that achieve important social goals such as affordable housing to low-income families, minorities or seniors. These subsidies can improve cash flows for an investment above the profit boundary for investment acceptance, but they may be insufficient to meet the maintenance boundary. Our model suggests that if these real estate properties are to be maintained, the subsidy must be large enough to induce not only the initial investment, but also subsequent maintenance.
Alternatively, the government agency providing the subsidy may contractually force the investor to permanently maintain the property. Our analysis of permanent maintenance indicates that such a requirement increases the minimum profit required for the initial investment. However, for reasonable parameter values, the profit rate boundary for accepting a permanently maintained investment is below the profit rate boundary for maintenance when maintenance is not contractually required. Consequently, the subsidy that induces the investment is least expensive if maintenance is not required, more expensive if maintenance is permanently required and most expensive if maintenance is induced immediately after initial construction but thereafter is at the discretion of the manager. The least expensive subsidy, however, virtually guarantees that the manager leaves the investment unmaintained, which, in turn, leaves the subsidy's original purpose unfulfilled.
In the next section, we characterize economic depreciation and maintenance for our analysis. We also review the relevant existing literature. In the third section, we describe the economic environment and the real estate investment. In the fourth section, we compare the real estate investment when the manager chooses to either permanently maintain it or leave it permanently unmaintained. In the fifth section, we consider a manager who has a dynamic option to suspend and recommence maintenance depending upon profitability. We investigate the minimum profit rate for investment acceptance and the probability that the manager recommences maintenance after suspension. Finally, the sixth section summarizes the empirical and policy implications of our model. The seventh section concludes. See the appendix for all technical details.
Depreciation and Maintenance
Economic depreciation is the reduced ability of an asset to generate future cash flows. For real estate investments, if property managers do not maintain their properties, operating profits and/or lease rates fall. Recognizing this possibility, if they anticipate adequate rates of return, managers make maintenance investments that offset this depreciation. For example, the manager of an apartment building replaces a fraction of carpets and appliances every year. More long-term building components like roofs and heating systems require both annual maintenance and periodic replacement within a building's life span. Maintenance is a service that tenants pay for in their rents. If a building is not maintained, the quality of services consumed by tenants declines and a manager reduces rent to retain occupancy. One can think of redevelopment, where a building is either replaced or substantially replaced, as an extreme form of maintenance.
Management science and operations research contain the bulk of the academic business literature on maintenance. This literature focuses on preventing cost increases for industrial, manufacturing, production and processing firms through repair and replacement. Repair and replacement is a significant issue for industrial firms because their equipment has rapid depreciation and relatively short useful life. Industrial firms maintain equipment to forestall replacement. (3) There are several differences between real estate and industrial firms in controlling economic depreciation.
First, the bulk of the capital expenditures made by real estate firms, buildings, have long rather than short useful lives. While replacement, which is redevelopment for a real estate firm, is an important issue when it occurs, it occurs rarely for individual properties. Managers construct buildings to last decades into the future. Because of the long time between redevelopment, research in real estate economics studies maintenance and redevelopment separately. For example, Williams (1997) and Childs, Riddiough and Triantis (1996) investigate redevelopment without maintenance, while Vorst (1986) investigates maintenance without redevelopment. For real estate firms, the association between maintenance (including component replacement, renovations and repairs) and redevelopment is not nearly as immediate as the association between repair and replacement for industrial firms.
Second, a manager in real estate maintains a property not principally to forestall redevelopment, which might occur decades in the future even without maintenance, but to forestall revenue contraction, which is immediate. (4) Of course, revenue contraction over the long term leads to redevelopment, but in real estate, the relation between maintenance and redevelopment is distant. Rents depend on building quality, which depends on a manager's maintenance and renovation program. For real estate firms, maintenance has a stronger marketing orientation than for industrial firms, and revenue preservation is relatively more important than is cost control. Further, because real estate investments have large EBITDA margins (5) (EBITDA is often more than 60% of revenue), maintaining revenue is essentially the same as maintaining profit. Because of this large margin, once a manager constructs a building, the principal element of investment return is revenue. The importance of revenues to return, in the near term and the long term, makes maintenance an important real estate decision.
Vorst (1986) investigates a real estate manager's maintenance decision, but his focus is on the optimal stochastic control problem. While mathematically elegant, Vorsts's model exogenously specifies the functional form of the building's selling price and assumes that this selling price is constant through time and independent of rent. He does not consider a utility maximizing agent and assumes unrealistic stochastic processes for the evolution of state variables. Most importantly, Vorst does not, nor does any other paper in the existing literature, compare the maintenance decision with the initial purchase (or, equivalently, construction) decision.
In the current paper, we investigate the minimum profit rate required for acceptance of a real estate investment depending upon whether or not a manager prevents economic depreciation by maintaining the investment, and also depending upon whether or not the manager dynamically suspends maintenance due to inadequate profit. In either case, for realistic parameter values that we use for our model, the manager imposes a more demanding profit standard on maintenance than on the initial investment. This difference means that a manager leaves a marginally acceptable investment...
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