GLOBAL GUEST COMMENTARY: Scratching the surface

Investors and fund managers clearly place a huge amount of importance on continued investment in their existing portfolios.

Globally, the real estate sector commits an estimated €75 billion a year to capital expenditure (cap-ex), representing as much as 2.5 percent of total capital value. The gathering pace of technological and social change is only putting more pressure on asset owners to upgrade, renovate and modernize.

What is most surprising is that, despite the large sums involved, relatively little work has been done to understand the relationship between cap-ex and future investment performance.

INREV’s recent study looking at trends in the UK, USA, Germany and the Netherlands, has revealed some surprising results.

The headline is that there is no magic, ‘one size fits all’, formula for cap-ex spending. Both the level of expenditure and its impact on performance varied widely at both a country and asset level. Generally, cap-ex levels were highest in the US, averaging around 2 percent of capital value, and lowest in Germany, at less than 0.5 percent.

In all four markets, returns were negatively impacted in the year the money was spent, but, in subsequent years, the outcomes were all very different.

Counterintuitively, additional cap-ex appears to destroy value in the Netherlands, where the assets that receive the investment tend to underperform. The reasons for this are unclear, but experts in the Dutch market suggest that it may relate to a combination of oversupply and domestic economic conditions at the time.

On the other hand, Germany, the UK and the US all see the expected boost in performance. Improved performance lasts the longest in the US, followed by the UK, and the effect tails off quickest in Germany. German assets also require a larger amount of cap-ex (more than 5 percent of total capital value) than in the other two markets to sustain the positive relationship over five years. Although depreciation is a particular feature of the German market, this alone is not enough to explain this trend, suggesting that there are other institutional factors at play, such as the valuation methodologies used.

Performance also varied significantly across property types in these markets. This was best demonstrated by the office sector, where cap-ex tended to boost performance in Germany and the Netherlands while destroying it in the UK and the US. Overall, cap-ex had the weakest impact on the performance of retail properties and delivered the most benefit in the industrial sector.

Where’s the sense?

What does all this mean for the industry? The uniqueness of the assets involved means there is no simple model that can be applied to predict how cap-ex will affect performance.

Additionally, it is difficult to completely isolate the impact of cap-ex from the myriad of other factors that affect performance. This has two key implications:
The first is to recognize that access to local knowledge is still of primary importance. With a limited cap-ex budget, investment must be focused on the right assets, in the right places at the right times. Finding the right level of investment (too little and there isn’t a performance benefit, too much and it might not be reflected in the valuations) still requires expert judgment by those who know the market best. Similarly, investment strategies have to be tailored to specific market characteristics and cannot be based on an assumption that relationships are constant across countries. That is particularly so in Europe.

The second is that there is a lot more work that can be done to further our understanding of how cap-ex can be deployed most effectively. While we may still need to rely on judgment and gut feeling for now, the quality and availability of both data and the resulting analysis will continue to improve, paving the way for broader and deeper studies and perhaps even reliable predictive models further down the line.

However, until that time, the best answer to the cap-ex conundrum is simply this – there is little substitute for spending it wisely.