About Real Estate: A Free CBRE-EA Weekly Publication Serguei Chervachidze, Capital Markets Economist Serguei.Chervachidze@cbre.com
As every landlord knows, operating expenses (OPEX) are an important element of commercial real estate investment performance. Operating expenses—a category that includes items ranging from utility bills and janitorial and cleaning expenses to taxation, insurance, and management fees—represent the costs of running a commercial real estate property. As such, they have a direct effect on the investment performance of the building (or a portfolio of properties), since they are subtracted from the revenue the property generates (generally termed gross income) to define the Net Operating Income (NOI)—a key metric in investment performance. NOIs, in turn, affect such investment performance measures as income return and—indirectly—property values and appreciation returns; it becomes obvious that the level of OPEX has a strong bearing on a building’s investment performance.
In spite of the important role OPEX plays in investment performance, there is very little research that analyzes the structure of these costs or identifies what drives the differences in these costs across markets. This article aims to share the latest findings on the drivers and structure of OPEX, identified at CBRE EA as part of our recent research on this subject. To tackle this issue, we use the National Property Index (NPI) from the National Council of Real Estate Investment Fiduciaries (NCREIF)—a database of institutionally-owned commercial real estate with history extending back to the early 1980s.
Our research identifies that operating expenses generally have two parts: a variable cost component, which changes with the gross income generated by the property, and a fixed cost component, which stays the same in a given property regardless of income. The interaction between these two elements implies that while OPEX varies with the gross income cycle—increasing or dropping with changes in vacancies and rents—there is a fixed cost floor, determined by the fixed cost element, below which costs never fall.
The graph below depicts the OPEX per square foot for the NCREIF National NPI office portfolio. The pro-cyclical pattern can be clearly seen here, with OPEX dropping between 2003 and 2005 due to a drop in Gross Income, and increasing between 2006 and 2009 along with increases in gross income.
Real Gross Income and OPEX, NCREIF National Office
Sources: CBRE Econometric Advisors , NCREIF NPI.
But how exactly does OPEX vary in response to changes in Gross income? In other words, what exactly is the variable cost component? The table below answers this question by providing estimates of the cost component for the four major property sectors. These coefficients (known to economists as elasticities) show how much operating costs per square foot (in constant 2011Q1 dollars) increase in response to a $1 increase (again in constant 2011Q1 dollar terms) in Gross Income.
These are average elasticities for each sector, and individual market and building elasticities are bound to vary. That said, these sector-specific coefficients provide a good idea of how much operating costs vary with income in each property type. For example, a $1 increase in Gross Income will increase OPEX per square foot by an average of 33 cents in office buildings, but only by an average of 24 cents in warehouse properties (all numbers are in real 2011Q1 terms).
That industrial variable costs have a lower elasticity than those of the other property types accords with what investors in this asset class generally experience: that these properties are usually cheaper to operate. A perhaps more surprising finding is that the elasticity coefficients for office, multifamily, and retail—property types with significantly different operating structures—are fairly similar to one another. We are conducting further research to better understand this finding.
Variable Operating Costs, NCREIF NPI Office
Sources: CBRE Econometric Advisors , NCREIF NPI.
After looking at the variable costs in the OPEX numbers, the next natural question is: what can be said about the fixed operating costs? Our research shows that fixed operating costs vary significantly among geographical markets, even within the same property type. The table below illustrates this phenomenon using office markets in the NCREIF NPI index. The costs depicted here are operating costs per square foot (in constant 2011Q1 dollars) that a property in a given market would continue to incur even if it generated no income.
Since this never happens on a market-level basis (these numbers are based on NCREIF portfolios of buildings held by NCREIF members in these markets, and portfolios of buildings always generate some revenue at market level), these numbers are theoretical in the sense that one will never observe them. That said, they still provide insight into the kind of fixed costs faced by office property owners in these various MSAs.
As can be seen from the table, fixed operating expenses vary widely across markets: fixed costs vary from 29 cents per square foot per quarter in Bethesda to as much as $1.61 in Nassau, NY (again, all numbers are per quarter and expressed in constant 2011Q1 dollars). A similar degree of variability holds for other property sectors (which are omitted for brevity). So what drives these differences in operating costs among markets? Can this be analyzed further?
Fixed Operating Costs, NCREIF NPI Office
Sources: CBRE Econometric Advisors , NCREIF NPI.
Our research shows that the cost drivers that are responsible for the differences between fixed operating costs across markets fall under three major categories: climate conditions (which in turn affect utility expenses), taxation and regulatory environment, and labor market costs (which affect management and property maintenance). To put these factors in perspective, the table below indicates the estimated impact a cost from each of these categories will have on the average fixed costs in NCREIF office buildings.
What Drives the Fixed Cost of Quarterly OPEX?
Sources: CBRE Econometric Advisors , NCREIF NPI, Wage Data—BLS, Effective Tax Rates—Economy.com, Climate Data—NOAA.
Specifically, for NCREIF office buildings, a 1% increase in the average state property tax rate on real estate increases the fixed cost per square foot by 23 cents. Similarly, a $1 increase in a given market’s average janitorial hourly wage increases the fixed cost by 14 cents. In a similar fashion, the Table demonstrates the effects of climate (expressed in the average annual number of heating and cooling months) on fixed operating expenses, per square foot.
While these numbers seem small in absolute terms, their significance becomes apparent when compared to the small values of fixed costs per square foot (for example, the average fixed cost per square foot in office buildings in the NPI sample is in the vicinity of 70 cents). These small per-square-foot expenses become quite large when they are multiplied by building size, which frequently reaches into millions of square feet. The bottom line is that the effects of these various variables are significant and go a long way towards explaining the differences in fixed costs among markets.
It is important to note that the costs we used in the table above are not the only ones that matter in each category of expenses. There is certainly more to labor costs than just the janitorial wage, and more to utilities expenses than heating and cooling. Rather, these effects illustrate in a statistical sense how important these various categories are in affecting the fixed operating costs for commercial office buildings.
In summary, we find that there are two elements to operating expenses in real estate: a variable cost, which changes with gross income, and a fixed cost, which remains constant. The fixed cost varies significantly across markets and within each property sector, with climate conditions, taxation, and labor costs driving these differences. It is important to understand these differences in operating costs across markets and property sectors when managing or building a portfolio of CRE assets. Our hope is that this article will help investors gain a better understanding of these costs and, as a result, enhance the investment performance of their CRE portfolios.
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