Reposition Underperforming Property Serving SMBs

Governments are preparing to re-open their economies as vaccinations complete for the US population by the early part of Summer 2021.  Stimulus funding includes a large infrastructure bill to put the public back to work en-masse.  Large enterprises are using a hybrid work environment of on-prem and cloud.  Mid-tiers are planning to engineer it into workplace solutions for the foreseeable future.  Small businesses may be more agile about workplace location to maintain productivity.

If a hybrid work environment and socially distanced layout is likely for the foreseeable future, it prompts evaluation to reposition underperforming properties within your portfolio.  Repositioning includes capital expenses to strengthen attributes of public health, capital improvements to make the property more attractive, updating hard and softscapes, changing the tenant base, rent rates, and lease expirations.  A repositioning plan needs to be planned, prepared on paper, then sharpened to meet investment objectives.  View leases as a portfolio of investments within each property; a property could benefit from repositioning to capitalize on future economic cycles.  (Note: commercial property prospers during economic cycles when it meets the needs of a tenant mix and has lease terms to realize ROI objectives over a holding period.)

Assessment

Run a financial analysis to assess room to raise rents and whether operating expenses are supporting economic performance.  Categorize each property by asset class (e.g., A, B, C).  Key financial ratios such as operating expenses to effective gross income, breakeven, and DSCR express the economic health of a property.  Identify comparable properties and compare incumbent rent rates to external listings in the space market; this informs how offered and lease rents compete with substitute properties.  Evaluate how the tenant mix helps or harms property operations and performance.  For example, a high traffic use above a second floor could increase maintenance costs of HVAC, elevators and common restrooms, causing capital expenses to upgrade them before projected useful life.  Functional systems and cosmetics per floor should match the impact of use by tenants.

Market Research

A repositioning plan is positioned to succeed when the asset manager and property owner understand how market conditions can impact [the terms of] lease renewals and relets.  Tenants sign leases because the building, lease terms, and landlord relations enable them to reach future operating objectives; when that stops, tenants relocate to other buildings (which may include subletting their space).  Such facts in mind, thorough market research influences the success of a repositioning plan (e.g., competing buildings, concessions, amenities, asset class).  The asset manager should fully understand how a property competes for tenants, retains them, and what upgrades are worth evaluating to improve ROI from the property.

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Current, Transitional, Progressive Economics

Its useful to run economic models of income, expenses, debt service, and capital expenses to determine how current, transitional, and progressive economic plans will affect ROI.  The property owner and asset manager should know what a property could be worth every few years if the owner chose to sell to revise returns from the property (and for the portfolio) and/or reward investors with profits from sale.  Substantial investors in real estate expect to be paid for use of their equity; real estate is a fixed investment that pays a planned return over a holding period of years.  Be aware of how your properties will generate returns for equity partners and how long you’ll need use of their money to generate portfolio returns.  (I recommend reading my post on “Efficient Frontier” to optimize ROI per property.)

Repositioning Plan

Maintain as-is.  A repositioning plan could be achieved by talking with your tenant base about their interest to pay more rent if the property were upgraded.  (Note: It’s likely cheaper them to renew their lease and endure a refresh project than invest time and money to relocate.)  These meetings could identify opportunities to change space allocations, the tenant mix, and lease terms.  Completed results could be used to revise economic projections for the property.

Transitional Plan.  A transitional plan could be useful to renew rents to provide time and funding to build a cogent progressive plan.  A fully leased building provides funding for a fixed number of years to plan to refresh a property.  It also gives tenants lead time to prepare to endure the refresh project, carry out strategic planning to change economics, or carry out a relocation project. This plan is carried out via project management to ensure the objective is met on-time and within budget.

Progressive Plan.  This is your capital improvement plan; the objective is to refresh the property to raise its asset class, perhaps add a mix of uses per floor (e.g., retail, healthcare, office, data center, multifamily or hospitality), realize economic performance in the future, and compete for a different class of tenants.  This plan is also carried out via project management, yet timelines and resources are monitored and controlled closely.  The project must be completed on time and within budget; ROI and promises made to tenants depend on it.

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Course of Action

A repositioning plan should explain how alternate courses of action could impact ROI for the property.  The repositioning plan should be compared to alternate choices to evaluate which plan to approve for implementation.  This represents decision support to decide which course of action helps the property owner achieve their investment objectives at scheduled future dates.  The plan to approve should be explained as recommended course of action.  Economic projections and supporting data should be presented in Appendices of the repositioning report.

BREG Team can prepare a detailed property management plan to reposition each property of choice from your portfolio; it’s influenced by a certificate in Asset Management from BOMI and a graduate course in commercial property management from Boston University (based on IREM). If you find the above approach useful to properties in your portfolio, please select the About Us webpage. fill out “Request a Consultation” at the base of the page. Enter “Reposition” in the subject line; please include the name, email address and telephone number of you or your executive assistant in the message body; I reply within 24 hours to arrange an exploratory conference call.  Thanks for reading and listening.###

Apply Efficient Frontier to Guide Property Returns

 

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Are you bringing spaces to market for re-let 1-3 months ahead of the lease expiration date?  Are you applying the same lead time for lease renewals?  (Even 6 months lead time puts your property cash flows [and relationship with tenants] at undue risk).  Do you know if market competitive lease terms, or transactional renewals and re-lets are good for property returns?    Consider viewing your multi-tenant property as a collection of investments (i.e. leases) that generate a portfolio return from the interaction of cash flows.

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Efficient Frontier

Apply Modern Portfolio Theory (MPT) and Efficient Frontier (EF) to your renewal and re-let efforts to curate preferred property returns consistently.  Investopedia.com defines EF as follows “The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.  Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk.  The efficient frontier rates portfolios (investments) on a scale of return (y-axis) versus risk (x-axis). Compound Annual Growth Rate (CAGR) of an investment is commonly used as the return component while standard deviation (annualized) depicts the risk metric. The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a cornerstone of modern portfolio theory.”

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View the multi-tenant property of focus as one investment portfolio.  Identify the rate of return your organization would accept from alternative investments to earn on equity invested in the property (e.g. other properties, notes, equity or debt securities); that rate is the opportunity cost of capital (OCC) to discount cash flows of potential rents.  IRR is the annual return derived from the interaction of positive and negative cash flows, assuming profits are re-invested into the property.  As noted above, leases are individual investments whose cash flows generate a trend of IRRs that achieve EF for the property over a holding period.

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The EF can be realized from renewals and re-lets by determining the market value of: renewals, most likely uses of re-lets from basement to rooftop, optimal subdivisions of floors, and exterior signage on highly-visible exterior walls.  Give yourself enough lead time to evaluate whether to change tenants and lease terms to sharpen performance of the EF.  (The lead time enables social responsibility for the incumbent tenant to relocate within a reasonable period of time.)  Projecting the discounted cash flow (DCF) will enable you to identify the rent psf required from each lease over its term to achieve EF over a defined holding period.  The DCF is necessary to factor the rent roll, expense schedule, and debt service to identify equity returns, NPV, and IRR for each year of the investment’s holding period.  Discounting NPV annually at OCC will show EF trend per year from cash flows.

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If your organization is a long-term holder of property (i.e. up to 30 years), I suggest viewing EF in cycles of microeconomics that factor lease terms of your anchors.  Lock-in lease terms ahead of declining microeconomic conditions to ride out the cycle until rents begin rising and concessions decline.  For example, storage, retail, loft, office, healthcare, and multifamily spaces each have different market values with different needs from leases.  If your anchor leases are 20 years and microeconomic cycles are 7-10 years, cash flows from anchors are a hedge against market cycles, improved by cash flows from mid-range leases (e.g. 7-10 year terms), and improved from volatility of transient leases (e.g. 3-5 years).

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Ensure lease templates match the needs of use categories, yet are fine-tuned to economic and legal terms negotiated with each tenant.  The sum of lease templates per space category contributes to posture the property with inherent strengths and residual risk to support its market value.  This posture plus accurate financial reports showing EF can attract capital markets or buyers, extracting the most market value from the property (to finance or sell).

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Prior Planning Guides Efficient Frontier

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Re-letting space at favorable market terms may not perpetuate the EF.  IRR can be negatively impacted if space is brought to market within a few months of becoming vacant, causing lost cash flows from systematic (e.g. uncontrollable) forces of supply and demand.  Months may pass when no lease terms or property sale can recover all lost cash flows from vacancy; that state could also bring DSCR too close to NOI, upsetting your investors and lender(s).  In contrast, if renewals or re-lets are planned to factor lead time and market timing to complete them at preferred lease terms, EF is maintained, optimizing returns derived from cash flows (e.g. rent roll, expense schedule, debt service).  (Note that EF helps to improve tax benefits derived from depreciation and interest expense.)

Therefore, factor microeconomic forces of supply and demand to restore cash flows from new leases; add lead time for construction permits, construction, and rent concessions.  Each expiring lease should be evaluated with 6-8 months lead time from tenant’s move-in date.  Add time to secure construction permits, building materials and labor, for lease negotiations, space tours, and space marketing; the lead time could become 18-24 months ahead of a lease expiration date.  Any tenant should know whether they’ll remain in a space two years ahead of lease expiration.  Marketing to re-let spaces should occur when rents are full and robust; tours of units to become vacant are carried out per notice terms in the lease.  The goal of re-let is to optimize cash flows from a synergistic rent roll at lease terms approved to realize EF for the property.

Summation

Commercial real estate has evolved into market consciousness as an institutional investment grade option among equity and debt choices available from primary (investment bankers) or secondary (stock exchange) investment markets.  Therefore, factor investment objectives for your multi-tenant property over the holding period, approaching economic management from an asset manager’s perspective.  Realize objectives by determining most-likely uses of space, fair market rent, cost-effective operating costs, low financing and re-let costs.  Model these attributes into a DCF projection, add sensitivity analysis to test tuning attributes.  Optimize your rent roll through anchor, mid-range, and transient leases as outlined above.  Discount annual NPV at the OCC to determine rent needed to achieve EF from the interaction of positive and negative cash flows.  EF is achieved when the rent roll (IRR from cash flows on x-axis) equals risk (lease years on y-axis).  Hold mindshare meetings with senior staff to agree on lease terms the leasing team will secure to achieve EF.  Hand an abstract of the approved lease terms to the managing agent or agency leasing rep to guide them to secure from renewal and re-let deals.  This is a spiral process of steps as renewals and re-lets come due within 30 months.  Re-model terms of the abstract within 12 months of each new microeconomic cycle; the results will position your property to achieve EF from its next holding period of cash flows.

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I trust the approach outlined above has been helpful to shaping economic performance of your multi-tenant property.  BREG prefers to take leasing assignments by applying Modern Portfolio Theory to achieve the Efficient Frontier from stabilized cash flows.  BREG can create the Efficient Frontier for your property by applying template spreadsheets in MS-Excel; we will prepare an asset management plan for you to review and edit or approve.  Please click “Request A Consultation” link in the upper right of the screen.  Enter “MPT: Efficient Frontier” in the subject line; please include the name, email address and telephone number of you or your executive assistant in the message body; I reply within 24 hours to arrange an exploratory conference call.  Thanks for reading and listening.###