Introduction
Running a commercial real estate portfolio is largely an exercise in resource allocation and understanding the time value of money. Capital outlays made in today’s dollars are used to continuously pull in tomorrow’s dollars with minimal upkeep. The longer those capital investments last, the better the economics get. Any opportunity to make minimize upkeep costs becomes gravy on top.
But it gets tricky in the real world. Let’s say a property has had the same anchor tenant for 20 years. Their lease is coming up and they know the building well. The tenant believes that most of the equipment is due for replacement and they want a complete teardown and rebuild. Obviously, the landlord would prefer to smooth their capital outlays out over several years to preserve cash flows.
On top of that, the tenant only wants to sign a five-year lease. In this environment, that’s a tough pill for any landlord to swallow.
Before any big decisions are made, the first step is usually to gather more information. In these cases, that comes in the form of a property condition assessment (PCA).
The problem is that, right there in the first page, the report that cost $10,000 says the purpose was to observe and document readily visible defects, to present an anticipated end of expected useful life during the specified evaluation term, and to include an opinion of costs for future capital replacements.
Dig a little deeper and there’s often a clause stating that items included in the replacement reserve table are determined based upon estimates. Factors that may effect the estimates include, but are not limited to, the frequency of use, exposure to environmental elements, quality of construction and installation, and amount of maintenance provided.
In other words, the entire economic model relies on rules of thumb, opinion, and a fundamental lack of data. But it doesn’t have to anymore. Low-cost equipment monitoring can track the factors that effect useful life continuously and over time to dramatically improve capital planning.
Extending Useful Life
According to a widely cited study by JLL, equipment useful lifetime can be degraded by as much as 36% without regular preventative maintenance.
The implications of this are enormous. A piece of equipment with a 20-year useful life might only last 13 years if it is not properly maintained.
Engineers performing PCAs know this and are forced to use heuristics and their senses to take this potential degradation into account. Unfortunately, they are collecting their data in a snapshot in time based on what they can see, smell, hear and feel.
Multiply this by hundreds of pieces of equipment and it’s obvious that there could easily be underestimates in the remaining useful life. If major capital outlays could be pushed out by even three or four years, that can significantly improve the economics of the property.
Sensor data not only tracks the factors that effect longevity, the frequency of use, exposure to environmental elements, and amount of maintenance, it also powers analytics software that can actively improve these same factors.
Fault detection, runtime hour-based preventative maintenance, and other efficiencies have been proven to extend equipment useful life, perhaps beyond the manufacturer’s recommendation. In addition, because this data is empirical and captured in real-time, defects that are not readily visible can also be caught and remedied.
Purchasing Decisions
It’s true that reaching the expected equipment useful life can be achieved with proper maintenance and even surpassed with “conditions-based” maintenance.
But at some point, equipment will need to be replaced, retrofitted, or upgraded. Fortunately, the same equipment monitoring can be used at multiple levels of this process as well.
Perhaps the most exciting way this data can be used is the concept of equipment-level benchmarking, where the sensor data from tens of thousands of pieces of equipment across the industry is synthesized to score potential investments down to individual makes and models.
This could be matched to the investment strategy of the portfolio or property. For value add investments, the capital outlays could be made based on purchase price and efficiency. For core investments, the decision could be made based on total cost of ownership and observed useful life.
Dispositions
According to Clinton Capital Management, “nominal cap rates (cap rates before necessary maintenance CapEx) still dominate the real estate market. But if quoted nominal cap rates are achieved because of skimping on CapEx, the property usually later sells at an impaired price. At the end of the day, the economic cap rate (with necessary maintenance CapEx included) represents the true economics of the property.”
Sellers of commercial real estate can no longer get away with ignoring maintenance CapEx and exiting before the deferred costs must be realized. Increasingly, sellers must convincingly prove that there will not be unexpected capital expenditures early in the ownership period.
Buyers are just as wary of PCAs as operators are and generally price in this risk into the deal. Therefore, there’s an argument that equipment monitoring data may artificially compress cap rates by removing that risk.
Especially in an environment where rent increases and occupancy are less certain, demonstrating that maintenance has been performed consistently and effectively can make potential buyers more comfortable executing on a value-add strategy.
Acquisitions
Distressed fund investors were willing to wait for years for a market correction to take place because they wanted to purchase assets at a discount. Now that seems to have occurred, market conditions have changed so that it’s no longer sufficient to buy a distressed asset and continue the status quo. Even go-to strategies such as renovating the lobby and amenitizing the property will likely have no impact on cash flows in the short term.
That’s why some are now underwriting technology into new deals and installing equipment monitoring right away to quickly determine if it’s possible to push out any equipment replacements past the investment time horizon.
Trying times require creative approaches and questioning the status quo. Now, thanks to technology, an investment of 10 cents per square foot or less may help avoid a $700,000 chiller replacement. That can pay huge dividends for value add funds.
Conclusion
When most asset managers and engineers hear about equipment monitoring, their first thought is about operating expense savings, particularly through energy efficiency.
While that is certainly one source of value, there is an argument that the improvements to capital planning can have an even larger effect.
From delaying capital outlays, to making purchasing decisions, to compressing cap rates and being part of the underwriting process, equipment monitoring can have outsized effects on asset values. In a difficult operating environment, the portfolios that understand this will develop large competitive advantages.
Enertiv is an integrated operations and maintenance platform designed to “do it all.” Watch a demo video today to see how it works.
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