Expense and rent strategies in real estate management

Journal of Real Estate Research, The, 1998 by Chinloy, Peter, Maribojoc, Eric

Peter Chinloy* Eric Maribojoc**

Abstract. A model of the real estate market is developed where the rent-vacancy tradeoff also embeds selections on expenses. High expenses and rents or low expenses and rents are explicit strategies, positioning properties along an efficient isoprofit frontier. Instead of a rent-vacancy trade-off, the operator can select either gross or net rent, or some combination as an offset for vacancy. This macrostructure is more in keeping with observed real estate markets, where some managers focus on net operating income, and others on effective gross income. Empirical results for apartments in Portland, Oregon supports the hypothesis that expenses and rents are positively correlated. An aggressive expense-increasing strategy pays off in higher rents, though in not all cases is net operating income positive. There are two implications. First, incentives in management create strategies to maximize gross as opposed to net income. Second, rent-vacancy tradeoffs that use gross income may misstate the adjustment toward equilibrium.

Introduction

Prices and rents in real estate markets are set by negotiation rather than in auction markets. Property managers have flexibility in offering amenities, negotiated with prices as part of a contract package. The effective price of services is therefore a hedonic rent that adjusts for amenities, defined to include frequency and quality of repairs and improvements, overhead associated with tenant services, discretionary capital improvements, degree of rent concessions and marketing effort, and maintained level of tenant improvements. While hedonic pricing has been applied widely in real estate markets, it usually does not embed the decision-making of agents, nor is it part of underlying structural behavior. There has been an extensive application of rentvacancy trade-offs in adjusting real estate markets toward equilibrium. If the rent in these trade-offs is gross, with no accounting for expenses, there is likely to be a misstatement.

This article develops a model of rent-setting where managers have control over rentsetting. Managers select a strategy with high or low rent-expense combinations along an efficient isoprofit frontier. The positively sloped frontier of rents and amenities yields an equilibrium hedonic rent that determines the short-run inventory of space.

Even though the hedonic rent maximizes profit, it usually is not set where tenant demand absorbs all the inventory, leading to positive vacancy. Lowering rents increases the risk of receiving lower quality tenants.' With locked-in leases to existing tenants, positive vacancy is a walk-up put option to sell or rent space to new tenants with high search costs and inelastic short-term demand.

On the demand side, tenants compare the hedonic rent with returns and affordability of ownership. The return to ownership or user cost depends on capital gains, imputed rental income and operating costs. Affordability is based on the rent-asset price ratio. Although the hedonic amenity-adjusted rent is the relevant price, tenants and other participants cannot observe it directly. They observe actual rent and form expectations about it.2 If the expectation of actual rent is exact, the market is in equilibrium at given amenities and management styles.3

An implication is that the trade-off between rent and vacancy using effective gross income is incomplete. If managers are able to select an expense strategy, rent collection depends on expenses. A manager may seek to recruit or retain tenants by increasing expenses and rents. Data on effective gross rents without either net operating income or a behavioral structure of managers do not provide complete information on the trade-off.

The focus of the model is on empirical implementation. To test whether managers have flexibility to select strategies on expense-rent combinations, the type of product and property, type of market and overall firm are held constant. The sample is a portfolio of apartment buildings in Portland, Oregon, of similar size and date of construction, and having the same ownership, but flexible on-site management. They are observed monthly over an identical reporting period from January 1987 to December 1994. Differences in product, property type, location, market segment, overall management and ownership, and date of construction are all controlled for, and smoothing biases and temporal aggregation are removed.

The results confirm a positive correlation between gross rents and expenses. However, there is not always a positive correlation between net rents and expenses. Net operating income is positive for certain expense additions, and negative for others, indicating that optimization at the margin is not always occurring. There is scope for increases at the margin in certain expense categories and reduction in others, though partly mitigated by the lumpiness of investments.

While all five broad expense categories show positive gross rents, marketing is the only category that consistently generates positive net rents, or net operating income. A dollar more in marketing produces more than a dollar in effective gross income, and positive net operating income. If the optimal management pursued each expense item until net operating income is nonincreasing, there is scope to increase marketing expense. At the other extreme is "noncontrollable" expense, not subject to the discretion of the manager, for property taxes and insurance. Only between 10 and 20 cents per dollar of noncontrollable expense passes through to effective gross income, and the incidence of property taxes is largely on the owner. Controllable general and administrative expenses similarly have low pass-through effects, implying net negative net operating income and incidence on the owner.