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Gain valuable knowledge on energy demographics, ownership structures, profitability strategies, property valuation, and more in the commercial real estate sector. Explore how to succeed in this dynamic market.
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“Seek first to understand, then to be understood” Stephen Covey The Seven Habits of Highly Effective People
Agenda • Energy demographics and commercial building markets • Ownership structures and motivations • How to make (or not make) money in commercial real estate • Property valuation • Economic drivers • Lease types and the behaviors they drive • Events that create action • Strategies for success
Energy Demographics 58% 98% Source: Commercial Buildings Energy Consumption Survey (CBECS)
Commercial Buildings Markets Source: Commercial Buildings Energy Consumption Survey (CBECS)
% of Total Floorspace Source: Commercial Buildings Energy Consumption Survey (CBECS)
Ownership Structures • Owner occupied • Employees of company owning the building occupy the space • Examples: • Corporate campuses, education, public • Company views property as an asset • May benefit from capital appreciation, but not primary motivation • Typically longer term view • Primary motivation • Profitability of business • Reduce costs associated with facilities
Ownership Structures • Investor Owned • Building owner leases space to other companies, who occupy the space • Company views property as a “box of leases” • Return on investment is primary motivation • May have very short term investment horizon • Examples: • Office buildings, warehouses, retail
How to Make Money in Commercial Real Estate Sell Price Purchase Price $ Profit on Sale Debt Debt Equity Equity Buy Building Sell Building
How Not to Make Money Sell Price Purchase Price $ Debt Debt Negative Equity Equity Equity Buy Building Sell Building
Even More Problematic…Refinancing Purchase Price Debt Market Value Max Loan Equity Buy Building $ Debt Cash Required for Refinance Equity Refinance Loan
Example • IDS Center • 1.4 million sf, 57-story office tower • Bought in 2006 for $278 million • Successfully refinanced property in January 2010 • $125 million loan to replace previous $161 loan • Financing package required $36 million of additional equity • Term of loan: 2 years, with option to extend to 3rd year • Property 98% leased
Distressed Commercial Properties • Between 2010 and 2014, $770 billion in commercial loans will be on properties in a negative equity position Source: Foresight Analytics
How Buildings Valuation is Determined Net Operating Income Cap Rate Property Value = • Commercial real estate is valued on the risk adjusted rate of return, or capitalization rate
How is the Cap Rate Determined? • By comparing NOI and sale price from recent sales of similar buildings, i.e comparable sales • Cap rates will vary greatly: • Over time • By geographical market • By building type
Net Operating Income • Revenue • Lease payments • Other fees • Operating Expenses • Management / leasing fees • Insurance • Janitorial • Taxes • Utilities Net Operating Income = Revenue – Operating Expenses
Where We’re Headed… • “Energy use is the single largest operating expense in commercial office buildings, representing approximately one-third of typical operating budgets”
Energy Savings Drive Higher Asset Value 20% lower utilities $3.4 million higher asset value
Turn Price Pressure into Gain • Example: • 100,000 sf building • $2 per sf in energy costs • $10,000 cost of PM agreement Scenario 2 10% Reduction Energy Costs 50% Increase in PM Price Scenario 1 10% Reduction in PM Price
Economic Challenge for Building Owners Declining occupancy… Increases competition for tenants which drives lease rates down… Which reduces NOI… Which investors see as increased risk, increasing cap rates… Which results in lower asset values… Which limits access to capital. But it all starts with OCCUPANCY
Behaviors Determined by Lease Type $1.90 Base Year $0.10 to Tenant $0.40 to Landlord Gross Lease Year 1Year 2 Net Lease Year 1Year 2 Gross Lease w/ Base Year Year 1Year 2 $2.00 per sf $0.50 to Landlord $2.00 per sf $0.50 to Tenant $2.00 per sf $1.50 per sf $1.50 per sf $1.50 per sf Motivation depends on relationship of current expenses to base year Landlord generally motivated to reduce operating expenses Landlord may not be motivated to reduce operating expenses
Must Understand Who Pays and Who Benefits Benefits Accrue to Owner Benefits Accrue to Owner Benefits Accrue to Tenant
Pass Throughs • A common lease clause, even in net leases, allows the building owner to recover capital costs from the tenants for improvements that reduce operating expenses
Lease Renewal • Buyer’s market • Building owners are willing to invest for the benefit of tenant as a retention tool
Case Study • 30,000 sf office building in Kirkland, WA • 3,000 sf tenant lease renewal • History of comfort complaints • Contractor proposed $30k project • Energy service agreement • Test and balance • Duct insulation • Building owner accepted proposal on the spot
Case Study • What’s at risk? • 3,000 sf x $30 per sf = $90,000 per year in rent • 7 year lease = $630,000 of guaranteed revenue • If tenant leaves? • Minimum 6 to 9 months of lost rent = $45,000 to $67,500 Building owner’s perspective: $30,000 to solve problem doesn’t seem so bad
Sale or Refinance of Building • Building finances will be heavily scrutinized • Revenues • Operating expenses • Cash flow • Condition of systems • 1-2 years leading up to event is prime time for action
Property Condition Assessment (PCA) • Evaluation of major systems in building • Roof, parking lots, mechanical • Lenders may require cash escrow for items found deficient • Immediate lump-sum reserve • Ongoing monthly reserves above NOI line • Replacement of major systems prior to refinancing can be cash flow positive
Energy Benchmarking Legislation • Legislation requires benchmarking: • Sale of building • Refinancing of building • Lease of building to single tenant • Most notable legislation passed in: • State of California • State of Washington • New York City • Washington, DC
Key Outcomes in Current Economic Climate • Occupancy is critical • Building owner is increasingly willing to invest for the benefit of the tenant • Improve marketability of space • Investment horizon is extending • Falling asset values forcing building owners to hold properties longer • Vacant space strategies • Building owners pay operating expenses for vacant spaces • Cash is king • Maximize asset value • Minimize capital expenditures, unless it can be passed through to tenant
Strategies for Success Bad Good • Sell to the right level • Financial decision makers, not building operator • When meeting: • Above ground is good • Below ground is bad
Tips for Selling to the Right Level • Ask financially based questions • If your contact doesn’t know the answer, ask them to who would • Gain a warm introduction to financial decision maker
Strategies for Success • Understand financial drivers • Lease types • Upcoming lease renewals • Investment horizon • Sale • Refinance • Willingness to pass-through operating expenses and capital expenses
Strategies for Success • Change the buying criteria • Offer something different
Change the Buying Criteria • Current – Price of maintenance agreement or project • New: • Impact to NOI • Impact to asset value • Impact to broader portfolio financial metrics
Strategies for Success • Key off action-driving events • Lease renewal • Sale / refinance of building • Energy benchmarking legislation
How To? Energy Services Delivery Model
Walk a Mile in a Building Owner’s Shoes • Owner-occupied & investor owned properties are motivated differently • #1 priority: Occupancy • Different lease types drive different behaviors • Understand who pays and who benefits • Events that create action • Lease renewal • Sale or refinance of building • Energy benchmarking • Strategies for success • Target the right level • Understand financial drivers • Change the buying criteria • Key off action-driving events
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