The Effect of Tax Laws and the Cost of Capital on the Size of Newly Constructed Strip Shopping Centers

Article excerpt

Abstract

While the impact of tax policy and other economic variables on the total amount of construction has been widely studied, this article proposes that these variables also affect the size distribution of the properties constructed. The basic intuition is that there is a lower bound to the economically feasible size of a project due to economies of scale in construction. Events favorable to construction, such as lower interest rates and more favorable tax treatment, relax this lower bound permitting the construction of smaller properties. This proposition is tested using data on newly constructed neighborhood shopping centers in Clark County, Nevada from 1971 to 1999.

Introduction

This study shows that several factors, including federal tax laws, have a significant impact on the size distribution of newly constructed retail shopping centers. For example, because there are economies of scale in construction, smaller properties may be economically feasible only when tax laws are favorable to real estate investment.1 The impact of tax laws on average property size after controlling for the real cost of construction, the required rate of return and per capita sales is demonstrated. Similarly, these same factors may have an impact on the standard deviation and skewness of the size distribution. In the following section, a brief review of the literature is presented. In the following section, the theoretical model is presented. This is followed by a discussion of the data and empirical results. The last section is the conclusion.

Review of the Literature

Optimal Size

Much of the research surrounding retail shopping centers has focused on the effect of tenant mix and anchor tenants on rental revenues, and, therefore profit maximization.2

Little research has been done pertaining to the optimal size of commercial real estate properties. The exceptions are two studies by Gat (1995) and Colwell and Ebrahim (1997) that look at the optimal size of office buildings. In these studies, rent is assumed to be invariant to the size of the structure and, because office buildings tend to have multiple stories, an optimal size results from the fact that the construction cost per square foot increases with each additional story. Shopping centers, on the other hand, are nearly all one-story structures and, as a result, the construction cost per square foot decreases with size. The optimal size of shopping centers results from the assumption that at some point rental revenue per square foot must fall with additional size. The concavity of the rent function is explained below.

The result of the mainstream research has a common, well accepted theme: shopping center owners seek to achieve a tenant mix that is relatively heterogeneous and include an anchor tenant for overall drawing power. The heterogeneous mix attracts shoppers that have a desire for one-stop shopping and reduces cutthroat price competition. The anchor tenant draws customers from greater distances and provides the smaller tenants with additional customers. In turn, the smaller tenants will pay a higher rent.

West, Von Hohenbalken and Kroner (1985) show that not only is the tenant mix important but that a well-planned center optimizes the location of the tenants within the center. They show that a well-planned center includes a proper mix of tenants that restricts excessive replication of tenant type. Eppli (1991) and Eppli and Shilling (1993) empirically test the effects of anchor tenant size and image on the surrounding non-anchor tenants. Both studies show an increase in nonanchor tenant sales from the presence of high image anchor tenants. Furthermore, the increase in sales is prevalent for virtually every type of non-anchor tenant.3 Brueckner (1993) developed a theoretical model of inter-store externalities. Given that the sales of a tenant are dependent not only on the space allocated to that tenant but also to the space allocated to other tenants, the shopping center owner can allocate space to various tenant types so as to maximize revenues. …