Investment and Capital Investment in Commercial Real Estate: Case of REITs

Abstract

Land, capital and labor are the three primary components of production. This basic relation can be readily applied to the commercial property market where land in a primary location, capital improvements (buildings) built on the land, and dedicated employees impact performance and returns. The present focus is capital investment conditioned on location (land) and management. Using a sample of U.S. equity real estate investment trusts (REITs) from 1995-2018, REITs with higher allocations of capital to improvements are associated with higher market valuations. The positive effect remains when an instrumental variable approach is employed to address potential endogeneity concerns, and when the sample is restricted to a REIT’s core property type. The study estimates a firm-level production function correcting for endogenous input choices, and shows that building capital investment contributes more than half of a REIT’s output, which suggests that building capital plays a paramount role in the overall production or revenue generation of operating commercial properties. The results highlight the role that capital improvements make in performance and returns.

Keywords: Land, Buildings, Market Valuation, Productivity, REIT

JEL Classification: D22, D24, G32, L22, R3