breea in CIRE Magazine; Adding value during the due diligence process
An article published in the March/April 2016 issue of Commercial Real Estate Investment magazine.
The due diligence process focuses on identifying building deficiencies and managing financial risk. A typical property condition assessment uncovers these deficiencies and includes capital reserves for building repairs and upgrades that can impact the negotiation process.
While identifying building deficiencies is a critical component of due diligence, evaluating building operations may reveal additional risks and opportunities that are not captured in the property condition assessment. Analyzing benchmarked utility data and underwriting low-cost operational improvements are two strategies that can reduce your client's financial risk and quickly increase net operating income and asset value.
Benchmarking to manage risk
Representing 20 to 35 percent of average annual operating costs, according to BOMA, utility costs are the most variable operating expense for commercial office buildings and can significantly impact NOI and asset value. While many benchmarking tools exist, the Environmental Protection Agency’s ENERGY STAR Portfolio Manager is the national standard with 40 percent of U.S. commercial building space benchmarked in the tool.
Portfolio Manager is a no-cost, online program that rates building performance on a 1 to 100 scale and compares it with similar buildings across the country. An ENERGY STAR score of 50 represents the national average, while a score of 75 indicates that a building is performing in the top 25th percentile of similar buildings across the country and is eligible for the ENERGY STAR certification, the industry-wide standard for energy-efficient properties.
While the Portfolio Manager program is not a perfect solution, it utilizes the largest data set and provides an apples-to-apples comparison, allowing real estate owners to compare the energy performance of their buildings with similar buildings in their portfolio and across the country. It should be noted that Portfolio Manager compares the end result, energy used per square foot, also known as energy use intensity or EUI, and there are many factors that contribute to a building’s overall performance.
An ever-increasing number of cities and states across the country, including California; Washington State; Austin, Texas; Philadelphia; San Francisco; and Seattle require the disclosure of Portfolio Manager-generated utility consumption and cost data during real estate transactions and refinancing. Disclosing energy performance data shows the buyer, lessee, and lender whether the property they are buying, leasing, or lending on is an energy hog or a high performer. This information provides a detailed history of property performance that may uncover hidden risks or opportunities and add value to the transaction.
However, benchmarking utility data in Portfolio Manager or a similar tool does not guarantee data accuracy. Potential buyers should request the trailing one-to-two years’ worth of utility bills and compare with the utility costs reported on the seller’s balance sheet.
The true value of this analysis is supported by the risk of under-reporting utility costs and the direct impact on NOI and asset value. For example, under-reporting annual utility costs by $90,000 in a 400,000-square-foot office building with full-service tenant leases at a 6 percent capitalization rate artificially inflates asset value by up to $1.5 million.
Once confirmed, annual utility costs should then be compared with tenant utility income on the balance sheet to confirm that utility costs are recovered in accordance with tenant lease requirements. This will minimize potential risks associated with over- or under-recovering tenant utility costs.
Building operational value
ENERGY STAR scores are a strong indicator of property performance. In general, the lower the score, the greater the opportunity for utility cost reductions. The due diligence period provides a window of opportunity to underwrite low-cost operational improvements to ensure the projects are funded and increases in NOI and asset value are realized. Targeting operational opportunities that improve the performance of existing building equipment, rather than capital-intensive equipment replacements, often provides the greatest returns for potential buyers.
Addressing energy savings opportunities during due diligence simply accelerates NOI reductions before operating and capital budget restrictions are in place. While this approach won’t make or break a transaction, it adds value to the deal — the icing on the cake.
To determine where to look for operational savings, it is important to first understand your client’s investment goals. If the property is a short-term hold and your client has limited capital to invest in improving building operations, look at those improvements with payback periods of less than one year to immediately increase NOI and asset value. If the property is a long-term hold, consider expanding the list of opportunities to include improvement projects with one- to three-year payback periods and the replacement of electrical and mechanical equipment nearing the end of its life expectancy.
Many utilities offer generous incentives for energy efficiency upgrades that can reduce project costs by up to 100 percent, significantly improving your client’s returns. For example, Duke Energy, AEP Ohio, and Entergy Arkansas all install compact fluorescent lamps and high efficiency faucet aerators and showerheads in apartment units at no cost. This project can improve client returns by lowering the cost of occupancy, increasing resident retention, and reducing lamp replacement and labor costs that typically fall under the operating budget.
Engaging professional help
Even in high performing buildings with ENERGY STAR scores greater than 75, a qualified professional can typically identify improvement opportunities that reduce property utility costs between 5 and 20 percent with minimal capital. Early in the due diligence process, engage an engineering or operations consulting company to perform a detailed operational assessment of the property. This assessment may be an addendum to the condition assessment, or may be performed by an operations consulting company with expertise in enhancing building operations.
When evaluating companies to perform the operational assessment, it is important to clearly communicate your client’s investment goals and request case studies and references to ensure the company selected has expertise in reducing utility costs through operational improvements, as many companies target capital-intensive equipment upgrades.
Many owners are wary of additional consulting fees and the capital required for building improvements, but a qualified professional can typically identify savings in many multiples of their fees, even if the building is a high performer. Before signing a contract, provide the consulting company with building drawings, maintenance records, utility benchmarking data, and other supporting documentation. Request that they demonstrate the business case for their engagement based on past experiences with similar buildings. Select a company that can look beyond the physical condition of the building and identify operational improvements.
Once the operational assessment is complete, identify no-cost operational improvements for immediate implementation and those to underwrite into the transaction. Request that the consulting company develop a detailed project implementation schedule that is aligned with your client’s investment goals. This strategy will ensure project funding and implementation, quickly increase NOI and asset value, and may improve rental rates, tenant comfort, and retention.
Building operations should not be overlooked during the due diligence process. Analyzing property utility performance and underwriting low-cost operational improvements can provide significant value to buyers across all stages of the ownership cycle. Including this strategy in your pool of resources can differentiate your services and build long-term value for your client beyond the transaction.
© 2015 CCIM INSTITUTE. Reprinted with permission from Commercial Investment Real Estate magazine, Vol. XXXV