Determinants of Operating Costs of Multifamily Rental Housing

Operating costs are an important, but not much studied, component of apartment financial performance. This paper establishes an economic framework for interpreting operating costs and uses a unique data set to investigate the determinants of operating costs. Empirical results are consistent with theory and indicated that housing quality is a strong driver of operating costs; older properties must incur more expense to achieve a level of housing quality; economies of scale in property operations are significant but top out at around 200 apartments; and a property’s operating expense/rent ratio Is influenced by local area input costs and short run apartment market fluctuations. The paper concludes with a discussion of some implications for affordable housing policy. -----------------------prepared for presentation at the annual meeting of the American Real Estate and Urban Economics Association, San Diego, California, January 4, 2004. The author gratefully acknowledges the advice and other assistance of the National Apartment Association and of the following individuals: Eric Belsky, Roland Freeman, Lynda Ose, Robert Sheehan, Barbara Vassallo, and Charles Wilkins. Views expressed are those of the author. 12/18/03 Determinants of Operating Costs of Multifamily Rental Housing Real estate economists spend a lot of time analyzing rents, property values, mortgage flows and pricing, and construction costs. This is the case for all income property types, including apartments. But we researchers do not pay much attention to the operating costs of these properties. There seem to be at least two reasons. First, operating costs are not as exciting as some other financial variables in real estate. Operating costs generally are not highly volatile, and property owners and managers have limited control over some of these costs. Second, real estate operating costs are not as visible as some other financial variables in real estate. Although several surveys of apartment operating costs are available, they are annual compendia, in contrast to the quarterly, monthly, or even daily readings available on other real estate financial variables. Despite this lack of attention, the importance of operating costs for a property’s financial performance is unquestionable. Over a building’s life cycle operating costs can rival the capital costs of building it. This can be illustrated by a simple example using realistic values. An apartment property with a total development cost, and market value at time of construction, of $1 million would be expected, at an 8 percent capitalization rate and an operating expense ratio (operating expense/rental revenue) of 40 percent, to have rental annual revenue of roughly $140 thousand and operating expense or cost of roughly $60 thousand. Capitalizing the operating cost, again at an 8 percent rate, results in a present value of $750 thousand, or three-quarters of the original development cost. The softness of apartment rents since 2000 has put added pressure on operating cost reductions as a way of boosting, or at least maintaining, net operating income. Operating costs have also been spotlighted by recent hikes in utility costs, property tax bills, and insurance premia in some jurisdictions, and by mold eradication efforts nationwide. The purpose of this paper is to shed new light on operating costs of multifamily rental housing, also referred to here as apartments. The specific contributions are to establish an economic framework for interpreting operating costs and their 1 Total development cost includes all “hard” construction costs for labor and materials, “soft” costs of professional fees and development taxes, interest on construction loans, and the cost of purchasing and improving the land. The capitalization rate is defined as net operating income divided by property value, and net operating income is defined as rental revenue less operating expense. Operating Costs of Multifamily Rental Housing draft of December 18, 2003 1 determinants, and then to employ a unique data set to empirically estimate those determinants. Previous Research Most of the analysis of apartment operating costs has been applied. The nation’s largest apartment REITs, as publicly traded companies, release considerable information about operating costs at their properties. To cite just one recent example, Archstone-Smith in its 2003Q2 quarterly release, presents data on its operating costs by local market and property type and on cost changes from a year earlier. Another applied research use of operating cost information is by architects and engineers, who investigate operating costs in making their building design decisions. Life cycle cost analysis calibrates the tradeoffs between construction costs and maintenance costs, with the goal being the minimization of total costs over the expected life of the property. One of the most obvious tradeoffs requiring life cycle analysis is between insulation costs at time of construction and energy costs for heating and air conditioning over the life of the building. Real estate trade groups have long been active in collecting and disseminating data on operating income and expense at apartment properties. The National Apartment Association, Institute of Real Estate Management, and Urban Land Institute all conduct annual surveys. Results of these surveys are widely used by apartment owners and managers in benchmarking their own properties’ performance. The figures are reasonably current and the publications group results by local market and property type, facilitating peer group comparisons. While very useful for that purpose, these annual compendia have not typically been used for more analytic work, one reason being that the income and expense data for individual properties have not generally been released. Thanks to the National Apartment Association, this study is able to analyze property level information, enabling multivariate analysis not possible with the grouped data. In addition to these applications by industry, government also has interest in the operating costs of multifamily rental housing. In public housing and government assisted privately owned housing, tax revenues are used either directly or indirectly to defray operating deficits. Reductions in operating costs therefore can reduce the claims on public funds. Operating costs of public housing have been a focus of housing policy analysts for more than thirty years, with several efforts fielded over the years to devise better methods of compensating local public housing authorities for costs over which they have no control while not rewarding inefficient management. Most recently, a research team was charged by the U.S. Congress with answering the question: “What should it cost to 2 See http://www.archstonesmith.com/investors/pdf/ASN%202Q%2003%20Earnings.pdf Operating Costs of Multifamily Rental Housing draft of December 18, 2003 2 administer good quality public housing?” The Public Housing Operating Cost Study, or PHOCS, included an extensive econometric analysis of operating costs at multifamily properties with FHA-insured mortgages (Graduate School of Design, 2003). We will return to results of that study later. Policy interest in operating costs extends well beyond public housing, however. Operating costs are important for preservation of the affordable stock of rental housing – both government assisted and purely private unassisted “market rate” properties. Operating costs in excess of rental revenues can lead to property abandonment or to “repositioning” of the property through renovations or redevelopment that bring it into a higher rent bracket. This broad policy interest in operating costs was one motivation behind HUD’s support for the 1995-1996 Property Owners and Managers Survey (POMS), conducted under contract to HUD by the U.S. Census Bureau. Like the FHA data used for the PHOCS study, the POMS data are available at the property level, enabling multivariate analysis. Other strengths include the availability in POMS of a variety of variables describing property operations, residents, and financing. Among the drawbacks of POMS are its lack of geographic coding other than region, its moderate sample size (about 5700 units), which restricts subsampling and multivariate analysis, and its age (the financial data refer to 1994 or 1995). The biggest drawback of the POMS, however, is the uncertain accuracy of responses. In addition to high levels of non-response, it is unclear if the respondent was always informed on the questions being asked. The POMS questions on operating costs are particularly suspect on these grounds. Academic research on operating costs of apartment properties is practically nonexistent. When operating costs do appear in scholarly studies, it is usually as an independent variable in investigations of some other outcome. In particular, some studies of multifamily mortgage loan default use operating costs is as an input to net operating income which in turn is a trigger for mortgage default (e.g., Goldberg and Capone, 2002). An Economic Framework Operating costs first enter into apartment decision making as a developer is deciding what to build on a particular site. As illustrated below in Exhibit 1, the rent that can be commanded for apartments depends on their quality. Quality here is a single-dimensional summary measure of the physical and service 3 Technically, the unit of analysis in POMS is the housing unit, rather than the building or property. But many of the questions in the survey pertain to the property, and through use of appropriate weights, the survey results can be made representative of either all rental housing units or all rental properties. Operating Costs of Multifamily Rental Housing draft of December 18, 2003 3 attributes of an apartment and the property in which it is located. Market rent will go up with quality, but the level of rent and its sensitivity to quality depend both on the location and the time period. Rent is shown in the chart as the present value of the expected rental revenue over the life of the property, as forecasted at the time of the development decision. Also shown in the exhibit is the total cost of providing housing of different quality levels, again at that location and as of a specified time period. The total cost is the sum of the development cost (as defined earlier) and the present value of operating costs over the expected life of the property. Like rent, total cost depends on both location and time. Exhibit 1: New Construction: Developer’s Quality Decision