Most property managers concentrate on expense reduction because they don’t believe they can control income or capitalization rate. Untrue! A good property manager should be able to reduce expenses, lower the cap rate and improve income. The latter option—increasing revenue on an office property—will be the focus of this article.
Increasing income vs. decreasing expenses
The goal of most asset managers is to maximize the building’s value. The primary way we value real estate is by using the income capitalization method. Simply put, the income or net operating income (NOI) divided by a capitalization rate will determine value. Property managers should focus on increasing income because it has a greater impact on NOI and value than reducing expenses.
To illustrate this point, let’s look at median collections and operating expenses for U.S. suburban office buildings1:1Source of data: 12019 Income/Expense Analysis
Of the 723 suburban office properties in the data pool for these statistics, the total median collections were $21.63 per square foot (PSF) per year, and the total median operating costs were $8.59 PSF per year, which equates to an NOI of $13.04 PSF per year. We can see that total collections are a much bigger portion of the pie than expenses (71.6% and 28.4%, respectively). A 10% decrease in expenses improves the NOI by 6.6% to $13.90 PSF per year. A 10% increase in collections would equate to an NOI of $15.20 PSF per year, a 16.6% increase. If you use a cap rate of 5% on those NOIs, you arrive at values of $278 PSF per year by decreasing expenses, versus $304 by increasing income.
This example illustrates why managers should also focus on income. The same percentage change in the income has a much greater impact on NOI and value.
Finding income opportunities
Now let’s examine the sources of income to help you focus your efforts.Owners and managers should ask themselves if they can increase office rent, pass-throughs, retail rent, parking income or miscellaneous income. If so, how?
Rent is by far the largest source of revenue for office buildings. You can increase this revenue stream by increasing rate and square footage or decreasing concessions and vacancy. In the area of office rent, consider:
The rental rate: When was the last time you studied market rents, concessions and occupancy rates? It is important to do market surveys often and ask the right questions to ensure you are not leaving money on the table. If you’re 100% occupied, is your rate too low? Know your market and adjust your rent to market.
Do you have the right brokerage team? When was the last time you interviewed several brokerage teams to get different perspectives on the market and your building? Brokers are experts on the market and most likely have competed against your building. Get their ideas on its strengths and weaknesses. What rent and concessions do they recommend? How quickly do the brokers think they could lease your vacancies? You might be able to improve your building’s standing in the market and, hence, the rental rate.
Rent escalators: Use rent escalators in your leases to keep pace with inflation as well as increase your annual rental collections from existing tenants. Common escalators include:
- Stepped increases (for example, $1 PSF per year or 3% per year)
- Variable indexed increases (typically tied to an index that tracks the rate of inflation, such as the consumer price index, or CPI)
- Operating expense increases (base year, expense stop and triple net)
- Percentage-of-sales clauses typically found in retail leases
Capital improvements: Consider these upgrades to increase a property’s marketability and generate higher rental rates. Areas to focus on include the building’s curb appeal, renovations of common areas, amenities and green policies. These improvements seem to generate more velocity and rental growth than capital improvements involving mechanical or roofs.
Greater velocity: Vacant space is potential revenue that is lost forever. Create a sense of urgency about renting your vacancies. Every lead matters. If brokers and managers get only one or two chances a week to rent a space, how they handle those opportunities is critical. Create a scripted showing to highlight the property’s strengths. Make sure curb appeal, common areas and vacancies are in top condition. Do you have competitive market rent and concessions, as well as a marketing strategy? Monitor your closing success, and get feedback from the lost leads.
Short-term leases: Some tenants can’t do long-term leases. If your property can accommodate short-term leases, you expand your pool of potential tenants. For example, movie studios typically will not sign leases for longer than their promised funding. If a pilot show is successful, these short-terms tenants can become long-term tenants. In one instance in my business, a movie studio did a short-term lease with an office project in Burbank. They’ve now been a tenant for over eight years.
Square footage: The building’s rent revenue is rental rate per square foot multiplied by total square footage. Most owners, managers and tenants focus on the rental rate part of that equation. Property managers should also think about the square footage part. Can you increase the building’s rentable square footage? YES.
Remeasuring the property to the latest standards developed by BOMA International can increase the rentable area of your property and hence your gross income and value. BOMA 2017 for Office Buildings: Standard Methods of Measurement (ANSI/BOMA Z65.1—2017) includes the square footage of areas such as balconies, terraces and stairs at the lowest level of a building—a change compared to the previous version. This has been a trend. According to Peter Stevenson of Stevenson Systems, a company that specializes in measuring buildings: “Within the last 25 years, the BOMA Standards have implemented significant changes which have increased the area that determines the leased square footage (rentable area) of a building by as much as 24%.”
Implementing the new square footage can take time. Some leases will immediately let you change the square footage and rent, but most office leases will not. More typically, we change the tenant’s square footage as the lease renews.
For example, a client of mine remeasured a 93,400-square-foot suburban office building in Orange County, California. By doing so, the building picked up 2,300 additional square feet. Rents on this building are $15.60 PSF per year triple net. As a result, the potential gross income grew by $35,880. With this, the building’s value increased significantly. Buildings in this market have average sales prices of $300 PSF (2,300 sq. ft. x $300/sq. ft. = $690,000), and cap rates in this market have averaged 4.6% ($35,880/.046 = $780,000). Either way you value the property, the client created approximately $700,000 in value, and the total cost for the building’s remeasurement was less than $2,500.
Operating expense pass-throughs
Office pass-through clauses can be confusing and complex. However, it is very important to understand and enforce them. Owners and property managers who find them too complex and ignore them will lose money. When applied without being fully understood, they can be miscalculated to the detriment of the landlord. Again, lost income!
For example, the new property management team on a building in Los Angeles reviewed the historical pass-throughs and found the lease allowed the landlord to pass through the increases in ground rent. The ground rent had escalated approximately $100,000 over most of the tenant’s base years. The team decided to pass through the increase, which resulted in $80,000 in new revenue annually. This translates to $1,000,000 in value.
When it comes to pass-through mistakes, common ones include missing the deadline for the invoice; not grossing up comparison years for occupancy; and not including all expenses allowed, such as permitted amortized capital expenses, interest, ownership expenses and parking expenses. The bottom line is, if you don’t read the lease carefully, you may be losing income opportunities.
Can you create retail space out of office space? Ground floor space in larger office projects or projects adjacent to dense population areas with good foot traffic may be right for conversion. The addition of retail or other amenities can increase the rent on the office space.
Keep in mind that conversions are often capital-intensive. Less capital-intensive retail options include coffee carts, vending machines and snack shops.
Along with market rent for office space, you should survey the market parking rent often to make certain you are maximizing revenue. Do you have the right mix of reserved, monthly and transient spaces to maximize revenue? Can you raise rates on any of those categories? Periodically interview parking service providers to get their opinions on rates, mix and occupancy levels. Like remeasuring a building, can you create more spaces by restriping?
Is the parking deck or lot being underutilized? If so, consider leasing the unused spaces to non-tenants, such as an adjacent building’s tenants, car dealers or rental companies and government agencies. If your property is near a stadium or college, consider whether event attendees could pay to park there.
Miscellaneous or other income
Finding new sources of income can be more of a challenge. Get creative with adding amenities, services and fees. There might be opportunities for adding income through other services and amenities (see sidebar below).
In Orange County, the owner of an office building takes advantage of a particularly large and lovely lobby by renting it out on weekends for weddings and other events, including my daughter’s high school dance. The building charges $5,000 per event and has brought in roughly $50,000 annually.
Paying it forward
Maximizing your revenue from all sources is an ongoing process. Work with your team to keep revenue generation and value top of mind. Be creative and open to new ideas. Involve all stakeholders including owners, managers, accountants, vendors and contractors, who often have some of the best ideas for new revenue. As an IREM instructor, I always ask my class, “How have you created value?” I have “borrowed” some wonderful ideas from them as well.
A benefit of being a third-party property manager is all the accolades we get from tenants, owners and vendors. Just kidding! The benefit is learning from all these individuals and then bringing the best practices they generate to all your clients.
My sincere thanks to my team, owners, vendors and students for all that you have taught me!