According to a report released in the first quarter of 2018 by the National Association of Realtors, the national average for office vacancy rates increased 1.7% in the fourth quarter of 2017 due to supply outpacing absorption.
This trend poses a threat to net operating income (NOI) and the expected return of ownership for commercial office real estate. As the spread between cap rates and the cost of capital narrows, real estate companies would be wise to recognize that operating expenses are not as fixed as often assumed. The macro trends applying pressure to the market are out of anyone’s control, but there are large, controllable expenses on the balance sheet that deserve more attention.
Conventional wisdom has maintained that to remain competitive, the focus must be on increasing occupancy rates through improved marketing and amenities, and by reducing the friction of lease signings.
This is certainly not wrong; NOI is very sensitive to vacancy rates and continuous execution is required to ensure tenants sign and resign leases in competitive markets. However, intense competition also tends to create a marketing and amenities “arms race” that produces diminishing returns and higher costs over time.
On the other hand, there is no direct competition when it comes to the costs of operating a property and the only relevant comparison is the property today to the property before the operational changes or upgrades. Plus, as the saying goes: a penny saved is a penny earned. The contribution to NOI is the same whether it’s generated from rental revenue or saved from a reduction in operating expenses.
To better understand the financial opportunity of reducing operating expenses in the face of rising vacancy rates, we’ll use a hypothetical property.
Taking the benchmarking data from the most recent Building Owners and Managers Association (BOMA) report from 2016, we’ll apply the averages to a 250,000 square foot office property to get a simplistic view of rental income and operating expenses.
Applying the average vacancy rate of 10.12% and rental income per square foot (psf) of $26.62, we get a potential gross rent income of $6,655,000 and an actual gross rent income of $5,981,500.
On the other side of the balance sheet, we’ll apply the average operating expenses for each category:
|Security ($0.72 psf)||$180,000|
|Administration ($1.45 psf)||$362,500|
|Cleaning ($1.52 psf)||$380,000|
|Utilities ($2.16 psf)||$540,000|
|Parking ($0.61 psf)||$152,500|
|Grounds ($0.25 psf)||$62,500|
|Maintenance & repairs ($2.00 psf)||$500,000|
Subtracting the operating expenses from the rental income, we get an NOI of $3,804,000.
Now, we can adjust our assumptions in the model to see what the effects of rising vacancy rates will be on NOI. If vacancy rates increase 1.7% as they did in the fourth quarter of 2017 to a total of 11.8%, the NOI of the property will decrease by $113,100.
To combat this, we can look at the two largest controllable line items in operating expenses: utilities and maintenance. If we can achieve an 11% decrease in both areas (a 5.3% reduction in overall operating expenses), we will completely offset the increased vacancy rate.
Wait a minute - a 1.7% increase in vacancy requires a 11% reduction in the two largest operating expenses to be offset?
The short answer is yes.
The long answer is that the sustained impression of these costs as fixed combined with the outsized proportions highlighted above has led to an inaccurate perception of operating expenses and missed opportunity in many commercial real estate portfolios.
Recent estimates by the International Facilities Management Association (IFMA) put waste related to maintenance and repairs at 18-30%. The Environmental Protection Agency (EPA) has estimated that buildings waste 30% of the energy they consume.
Given the amount of waste in building operations, achieving double digits reductions in operating expenses related to utilities and maintenance may be easier than going head on against the macro trends that are driving higher vacancy rates.
A heightened focus on building operations can produce additional benefits as well. JLL performed a comprehensive study of equipment degradation due to improper maintenance and discovered a 20-36% reduction in the useful life of equipment if the systems are not properly maintained.
Although reserves for equipment replacement are not included in the textbook definition of NOI, in practice many analysts do include reserves for replacement in NOI. Better maintenance strategies not only reduce the direct costs associated with running a property, extending equipment useful life means that reserve funds are depleted less often, increasing NOI in the eyes of analysts and lenders.
Better building operations also feed back into the least expensive way to maintain high occupancy rates – tenant retention. There are countless stories of operations teams kicking themselves because they failed to perform a simple maintenance task, which eventually led to total failure of a piece of equipment. Any sudden shutdown of a piece of equipment critical for a building to run properly will negatively affect the tenant experience. Tenants who are left without hot water, stuck in an elevator, or have noticeably poor ventilation are more likely to move on when their lease is up. One CBRE study in San Diego found that vacancy rates were 4% lower in buildings that were operated more effectively than their peers.
Luckily for those who have thus far treated building operations as a necessary evil that can easily be disregarded, the hard work has already been done for you.
For an investment of around four to six cents per square foot, Internet of Things (IoT) devices can capture real-time performance data from every piece of critical equipment.
In the past, this data might have gotten lost in the shuffle as on-site staff go about their tasks of (hopefully more) routine maintenance and (hopefully less) emergency repairs. Today, this data is used by submetering solutions to instantly compare to the performance hundreds or thousands of similar pieces of equipment.
More importantly, as monitored equipment have had motor bearings wear, filters get dirty, pipes corrode, and schedules drift, the specific pattern of the data has been recorded. Now, when something goes wrong, the result is mapped to an ever growing “insights library” to detail to on-site staff exactly what is happening and which solutions to apply.
Not only are operational expenses not as fixed as they appear, the focus required to achieve sizeable reductions is lower than ever before thanks to IoT-based predictive maintenance solutions.
The explosion of new, often tech-based, amenities cannot be ignored, and real estate companies must adapt to the market to continue to attract tenants. But there is no competitive advantage to following a trend that everyone knows about, even if it is the right strategic move.
Data-driven building operations represents a true competitive advantage because there is an enormous opportunity and currently few companies are taking advantage to drive asset value.
Convinced of the benefits of operational cost savings? Enertiv will survey your portfolio for free to identify the best opportunities for improvement.