For an owner/investor, the level of expenditure required to keep a property at current quality is financially inefficient; however, investors do have other options. The ability to turn over properties in a portfolio, by adding higher-grade properties and selling lower-grade properties, keeps the overall quality of the portfolio from slipping. Of course, such portfolio upgrades come at a cost because buyers of older buildings demand a price discount to compensate for aging. Therefore, from an investor’s standpoint, assessing the return prospects of the real constant-quality series is of greatest practical interest because it is actually owned, rather than aspired to.
Property investors can relatively easily invest in both new construction and existing properties, making the buy-versus-build decision a plausible tradeoff. Although new property development opportunities are plentiful around the world, the market is not without barriers to entry. Location, zoning laws, taxes, higher building standards and new regulations, among other considerations, are all tangible factors in the buy/build decision. Over a full cycle, property values are thus rooted to replacement costs, but at different times in the cycle more or less strongly.
Real constant-quality prices for commercial property have moved cyclically around a stable level for close to 40 years. Using long-term average valuation, we determine that current constant-quality property prices are now 20% above trend. This is decidedly a rough method to determine an equilibrium price, and more complex methods are available. One such method would be to utilize Tobin’s Q. As measured by Nordby and Taylor (2013), average Tobin’s Q ratios across major US markets were in the range of 0.85–1.36 (1.0 = indifference) over the period 2000–2012, with cities such as New York and San Francisco at the upper end of the range. Evaluating ongoing changes in Q ratios could provide a better metric to evaluate current valuation levels; however, we believe our trend method, although a rough approximation, leads to a similar conclusion as more complex methods.