Driving NOI during times of economic uncertainty with capital improvement projects
Real estate managers typically focus on net operating income (NOI) growth as a measure of a property’s economic success. While NOI will remain a key metric, relying solely on a property’s NOI doesn’t consider another critical component of calculating before-tax cash flow—capital expenditures, commonly referred to in our industry as “CapEx.”
The definition of CapEx varies from company to company, and real estate managers typically rely on the expertise of a CPA to determine which expenses get capitalized for tax purposes. However, despite the ambiguity of the definition, most real estate managers agree that CapEx refers to the use of funds by an owner to upgrade, enhance, or replace a property’s physical components to prolong its useful life and increase its value.
For budgeting and reporting purposes, CapEx typically falls “below the line,” a term used to describe expenses on the cash flow statement below the NOI. Therefore, the property owner or asset manager usually governs activity in this area of the cash flow statement. That said, the role of real estate managers is evolving, and understanding the CapEx process is becoming a critical part of our profession.
Most CapEx projects require a significant cash outlay from the owner. On the other hand, these projects will drive NOI and increase the property’s value if appropriately executed. Although real estate managers face many challenges in our post-pandemic economic climate, they’re adapting to these new norms and adjusting how they approach CapEx planning.
Flight to quality
Sherry Yarborough, director of multifamily management with Drucker + Falk, AMO®, says many clients are buying older multifamily assets with value-add opportunities, which drives their CapEx planning. “Investing in improvements allows for the opportunity to provide an upgraded unit at a more reasonable price point than newer developments that have been added to the market over the past few years,” Yarborough says. “We are focusing primarily on upgrading unit interior finishes because that is where we see the biggest return on investment.” Yarborough’s team spends roughly $16,000–$20,000 per unit on new countertops, stainless steel appliances, vinyl plank flooring, hardware, lighting, and cabinets. Returns on their investments have been between 12%–20% due to the increased rental rates they’re achieving, as renters are willing to pay a premium to live in an upgraded unit.
Retail properties are focusing on preventive maintenance and asset preservation after pandemic-related projects, says Jasmyn Sylvester, CPM®, ACoM®, vice president of property management at Pine Tree, LLC. “Operating expenses can typically be passed through to tenants, but sometimes an owner needs to invest in CapEx projects at their own expense to maintain the Class A status of their property,” Sylvester explains. “I don’t believe retail will ever die. It just pivots and adapts, and tenants seek out owners who realize this and adapt with them.”
For example, during the pandemic, retail owners not only needed to keep up with typical CapEx items like updating roofs and parking lots, but they also needed to add all-new features like curbside pickup locations, open-air spaces, and drive-through windows. Because so much of the sector adapted this way, the retail market remains strong for well-located, well-maintained properties.
Chase Crawford, CPM®, general manager at Granite Properties, says office traffic is still reduced following the pandemic slowdown, and many companies in their market have embraced a hybrid work environment. As a result, building owners are investing in new types of CapEx projects to help companies attract employees back to the office. “We want to create work environments where our customers are inspired to flourish,” says Crawford. “We also want to help our customers feel comfortable when reintegrating into the office lifestyle.”
Granite accomplishes this by allocating large capital infusions to enhance the customer experience. These updates include wellness-focused features such as clean air technology in all HVAC systems portfolio-wide and improved Wi-Fi networks. These networks allow employees to access their companies’ private servers while surfing the web in newly remodeled customer lounges, conference rooms equipped for Zoom meetings, or outdoor workspaces with a variety of seating and games.
“People can now work from almost anywhere,” Crawford says. “It’s why we focus on offering comfortable work environments, compelling experiences, and amenities that inspire interaction and productivity. We want our customers to be able to tell their employees that our buildings prioritize their comfort and health and are engaging and fun.”
ESG (environmental, social, and governance)
There’s a growing demand from tenants to align with building owners and management companies that show awareness of and embody operations rooted in strong ESG policies. As a result, more CapEx dollars are being allocated to projects geared toward meeting ESG objectives. “Sometimes our clients are required to invest in green technology and energy-efficient systems per the terms of their loan agreement; other times they do it as a cost-savings measure or simply because they think it’s the right thing to do,” says Yarborough.
Real estate managers can take many steps to save on energy and enhance healthy living in multifamily, like installing low-flow plumbing fixtures, purchasing energy-efficient appliances, outfitting apartments with smart thermostats, and creating outdoor exercise areas. While these items might cost more upfront, they will lead to lower operating costs, increasing NOI. These features may also help attract and retain residents. The 2022 AMLI Sustainable Living Index reported that 88% of residents surveyed are concerned about climate change, and 43% said green features factored into their decision to live in specific apartment communities.
Crawford is seeing a similar trend on the office side. “Socially responsible customers are driving many of the changes we’re implementing in our buildings,” he says. “Many customers want to drill down into their specific energy consumption for ESG reporting and benchmarking purposes.” Granite’s buildings are focused on reducing their environmental footprint, and many in their Houston portfolio are LEED-certified.
Some of their older buildings required installing new submetering equipment to enhance energy efficiency. Granite has also upgraded other building systems, such as converting lighting to LEDs and replacing old pneumatic controls with new digital systems to improve comfort and efficiency. During the pandemic, Granite also invested in new air quality and filtration technology. “All our buildings feature clean air technology offering MERV 13-level air filtration or higher, meeting the ASHRAE standards for mitigating airborne transmission,” says Crawford, who’s proud that Granite achieved Fitwel certification for eight buildings in 2022 and has a goal to certify 11 more buildings in 2023.
Sylvester adds that ESG is a factor in CapEx planning in the retail sector as well. “We work with many national big box tenants, many of whom are concerned about ESG benchmarking and initiatives,” she says. “To meet these needs, we are doing things like installing new drip irrigation systems, enhancing our recycling programs, adding more outdoor seating areas, and converting traditional lighting to LED.” While some of these projects could be considered CapEx and an owner expense, Sylvester and her team can get owners on board with paying for improvements by showing how these new upgrades create long-term savings through reduced energy consumption. The projects can also lower pass-through operating expenses for tenants, thus positively impacting NOI overall. This approach is a win-win for the tenant and the owner. But Sylvester explains that not every decision her team makes is driven by financial performance. “Some of the work we are doing is simply to try to help save the planet and grow as people.”
Economic headwinds have made real estate managers cautious with their CapEx planning and deepened their already-analytical approach. “We had to forgo some CapEx projects at the beginning of the pandemic but haven’t made any major adjustments to our CapEx planning for this year,” says Sylvester. “We’re mindful of the impact that a recession could have on retail tenants and are watching the macroeconomic indicators closely. We also understand that our owners are sensitive to spending money now, and we’ve had to have some hard conversations recently regarding costs increasing due to inflation and supply chain issues.”
Sylvester explained that they try to think like owners and asset managers. If they present a CapEx plan, they go in with all the boxes checked. This includes putting together a thorough cost-benefit analysis to determine if the project is feasible and what the positive impact on the property would be. This careful analysis is critical, given the economic challenges our industry is currently going through and could continue to face in the months ahead.
“Multifamily has remained strong for the last several years, so we haven’t had to modify many of our CapEx renovation plans,” says Yarborough. “We have had to keep a close eye on costs, though, as they have increased dramatically, especially with respect to supplies and labor. In the past, these increased costs have been offset by growing rents. However, as some markets soften and rents do not increase at the same rate we’ve seen over the last 24 months, we might need to dial back or find other ways to reduce costs.”
Yarborough says her company has developed a universal scope of work for interior renovations, down to the finishes and features. This helps them streamline the process, and their company size allows them to increase buying power, both of which help the bottom line. This approach is essential, given that many larger markets are starting to see a slowdown in rent growth.
Crawford is also dealing with inflation’s effects on capital planning in the office sector. “Inflation has had a significant impact on our pricing. For example, upgrades to HVAC controls can cost up to 200% more than they used to, and the labor to install them has gone up by 20%–30%,” he says. “Our vendors are subject to the same pricing changes as we are, and in some cases, they’ll only hold a bid price for two weeks tops. As we continue to put our customers and their experience first, CapEx planning and budgeting becomes very challenging in an environment like this.”
Our industry faces strong headwinds indeed. However, real estate managers, CPMs specifically, have never been better equipped to meet these challenges and are facing them head-on. Now is the time to rise to the occasion and show our clients the real value of owning professionally managed properties. Thoughtful, informed CapEx planning that positively impacts NOI presents the perfect opportunity to do just that.
Driving NOI during times of economic uncertainty with capital improvement...
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