The property industry is the only sector that does not recognise the cost of depreciation and the inexorable road to obsolescence.
While most corporate profit and loss statements include depreciation expense for property, plant and equipment, a similar line - at least for investment property - is strikingly absent from the accounts of property corporates.
Indeed, in the US, the standard measure of profitability for Real Estate Investment Trusts (REITs), known as Funds From Operations (FFO), specifically adds back depreciation expense; pretending, for accounting purposes, that it does not really exist.
Neil Turner, head of Alecta, a property fund management company, has recently produced a paper on depreciation in the property industry.
The paper notes that academic studies, based on data in the Investment Property Databank, suggests that depreciation cuts growth in Estimated Rental Value (ERV) by anything from 1.2 to 1.4 per cent annually across a portfolio.
Similarly, analysts at Credit Suisse First Boston, in a paper that looked at property yields, estimated that non-recoverable capital expenditure - the rate of depreciation - varies between 1.2 and 1.7 per cent for UK office buildings, and can be as much as 2.5 per cent for regional industrial properties. However, Mr Turner's paper makes one significant finding; UK properties depreciate faster than do those on the continent.
"Is there anything unique about the UK property market which produces this direct relationship between age and rental value?" the paper asks.
"We argue that it is the low retention (re-investment) rate on UK office properties relative to other countries, which partly explains the phenomena exposed by all of the previous research." And the reason that capital re-investment rates in the UK are so low, he says, is because the inflexible nature of the long-term lease makes it so.
Long-term leases typically require tenants to pay for all costs of repairs and insurance. But because the tenant doesn't actually own the property, he has little incentive to do more than just keep it operational.
On the continent, where tenants can often break leases after as little as three years, strong incentives for re-investment prevail.
Mr Turner says the starting point for his research paper was that the fund began to notice it was spending much more money on updating and improving its continental European portfolio than on its UK portfolio.
Mr Turner's paper, entitled Property is not Microsoft, attempts to use dividend discount modelling to forecast how much growth in future income can be achieved through re-investment, or what he refers to as "retention" - that is, the use of retained earnings.
It's like Microsoft buying a business and then not re-investing in it," Mr Turner says. "It's like Microsoft just letting it depreciate." The study compares re-investment rates across Europe, which range from a low of 0.42 per cent of opening market value in the UK to a high of 1.9 per cent in Frankfurt in the 1998/99 year.
Not surprisingly, the UK also experienced the highest rate of depreciation, at around 2.5 per cent annually.
The study also found that depreciation hits hardest during the early years of a building's life in the UK.
