Academic journal article Real Estate Economics

The Economics of Maintenance for Real Estate Investments

Academic journal article Real Estate Economics

The Economics of Maintenance for Real Estate Investments

Article excerpt

We propose a theory of urban decay. Following a negative real estate demand shock, property managers optimally suspend maintenance and the probability that they ever restart can be modest. Because maintenance expenditures are proportionately less risky than are the incremental building profits they generate, managers impose a more demanding profit standard on maintenance than on the initial investment. This differential in profit standards means that rather than maintain existing investments, property managers favor new investments, which, if marginally acceptable, they also leave unmaintained. Contractually required maintenance (e.g., for publicly subsidized real estate investments), increases the minimum profit for the initial investment acceptance and discourages subsidized real estate investments in favor of unsubsidized investments. However, the required profit for acceptance of a permanently maintained investment is below the profit boundary for maintenance if maintenance is not contractually required. Consequently, the subsidy that induces the investment is least expensive if maintenance is not required, more expensive if maintenance is permanently required and most expensive if maintenance is induced immediately after initial construction but thereafter is at the discretion of the manager. All of our findings are strongest for poorer quality properties.

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In its 1999 study "Places Left Behind in the New Economy," the U.S. Department of Housing and Urban Development (HUD) notes that even at the peak of the last economic expansion, many urban areas saw no substantial revitalization or economic growth. (1) In this paper, we propose a theory of maintenance for real estate investments that explains this disturbing finding. For a significant fall in operating profit that leads to maintenance suspension, there is a large probability that maintenance is never resumed even as new construction takes place elsewhere. If normal maintenance expenditures are largely determined by the physical attributes of a building and are unrelated to its profitability, then they are less risky than the incremental building profits they generate. Maintenance adds proportionately more to the value of investment expenditures than to the value of operating profits, and, therefore, maintenance adds to a property's value only if a manager imposes a more demanding profit standard on maintenance than on the initial investment. This more demanding standard for maintenance means that managers optimally neglect maintenance in favor of new investment. This result holds even if managers can suspend and recommence maintenance at no cost. We interpret our findings to mean that urban areas that see decay during an economic downturn may never recover even when economic conditions improve elsewhere. HUD's finding is therefore not surprising, although still disturbing.

We find that managers' inclination to neglect maintenance is most pronounced for poorer quality real estate properties. To the extent that initial quality is related to the economic means of an area, our model implies that properties are more likely unmaintained in lower income neighborhoods and have less likelihood of maintenance resumption. The most vulnerable segments of the population are the first to experience urban decay and the last to benefit from general economic expansion.

Our research has important implications for various assisted-housing programs of HUD and other government agencies around the world. (2) The goal of these programs is to provide a subsidy, usually in the form of a loan guarantee, for financially marginal projects that achieve important social goals such as affordable housing to low-income families, minorities or seniors. These subsidies can improve cash flows for an investment above the profit boundary for investment acceptance, but they may be insufficient to meet the maintenance boundary. Our model suggests that if these real estate properties are to be maintained, the subsidy must be large enough to induce not only the initial investment, but also subsequent maintenance. …

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