Budget season is upon us. But in reality, for strategically focused property managers, it never ends. “I’m even getting tired of the phrase ‘budget season,’” says Salvatore Dragone, CPM, CCIM. “The reality is that you’re constantly looking at expenses relative to budget and constantly making adjustments in spending so you can stay on track with the roadmap you created.”
Stephen D. Margerum, CPM, ARM, agrees. “Budget season starts officially in the summer and goes through the winter,” says the principal and founder of Cove Property Management, AMO, in Annapolis, Maryland. “Then in the spring, we get ready for the next summer. There’s a phrase that’s popular in IREM: ‘If you can’t measure it, you can’t manage it.’ So, we’re always reforecasting, analyzing and getting ready for the next budget season.”
Dragone is a senior vice president and director of property management at Rubenstein Partners in Philadelphia, whose affiliates own and operate over 12 million square feet of commercial office space in the U.S., largely concentrated on the East Coast. He says that being in a perennial budgetary mindset is critical to the accuracy of forecasts and the necessity of staying in line with ownership’s goals. To that end, he breaks his process into tiers: “We do a monthly variance report, in which our property managers go through each line item and provide a narrative explaining the variance from the annual operating budget.
Quarterly reforecasts of the annual operating budget are in the second tier. Since Rubenstein works on a calendar year, “The first quarter is a soft forecast because we have only so much information at that time,” says Dragone. “The reforecasts don’t change the budget. Once a budget is cast, it’s cast. But they give the property manager, the asset manager and me an indication of the direction we’re going in.”
Second- and third-quarter forecasts follow, each serving as “a stepping stone,” adding another brick to the formulation of the following year’s budget. By the third quarter, “We’re looking now more toward reconciliation, which will drive us through the next three months and help us determine what we have left to spend and what we need to throttle back,” Dragone says.
Margerum oversees some 1,800 units in 13 residential communities in the Mid-Atlantic. Ten of those are self-owned, with third-party investors holding the remainder. “Every property has its own challenges,” he says, “and understanding those differences and understanding your properties is key.”
Both Margerum and Dragone pore over the budget for each property, a massive task since, “There are quite a few, if not hundreds of items per budget,” to screen before the budget proposal gets passed up the line of command, says Margerum. He notes that different managers use different approaches, whether that’s a zero-based approach, which entails building a new annual budget from the ground up, or a history-based approach, which uses past actual financial data.
Both methods entail such critical details as calling the local utilities for usage rates and watching out for what Margerum calls outliers—the anomalies that can throw off accurate cost analysis. This past winter, with a nearly nonexistent snow-removal need, is just one example. “We remove outliers to ensure we’re providing the most realistic budgets,” he says.
Zero-based budgeting is clearly a great tool for a new building, but as IREM Academic member Terry Fields, associate professor and director of the Weidner Property Management and Real Estate Program at the University of Alaska in Anchorage, suggests, it can also be helpful for existing properties. “It de-emphasizes the historical data and forces the manager to reevaluate the item in a different context,” he says. “The exercise of tying the expense to your strategic plan instead of a historical figure may provide a more accurate assessment or at least act as a check on your historical analysis.”
Staying in step
The constant review and benchmarking are key to producing numbers that are both realistic and accurate. They also help you know where the property is headed and how close to ownership’s expectations you are. “Providing unrealistic figures in an attempt to impress the owner or asset manager doesn’t benefit either party in the end,” says Fields.
“Also, providing a strategy that’s not in line with the owner’s goals, regardless of its accuracy, is a wasted effort,” he says. “Managers should identify clear goals from the beginning, reaffirm those goals at the start of the budget process, identify strategies and projections and present these findings objectively as they relate to the owner’s expectations, completing the loop.”
For both Margerum and Dragone, constant checks of what is happening at their properties are essential to the accuracy part of the equation. For the alignment with ownership’s goals, “Over-communicating is essential, especially with third-party owners,” says Margerum, “and transparency is paramount. We have multiple owners and investors, and in times like these, when we’re dealing with the coronavirus, we’re in communication daily.” (More on that shortly.)
Dragone notes that there are pros and cons with both ownership structures. On one hand, when the owners are the operators and have in-house management, the managers usually receive “clearer direction on how the owners like to do things or what’s expected in terms of the level of operations. But that also means there can be a lot of ownership input or the need to create multiple budget scenarios in order to explore different results, potentially slowing the process,” Dragone says.On the other hand, third-party managers working with non-institutional owners may find the process easier at times since the owner has less familiarity with operating real estate and is putting their full trust in the manager. This translates to fewer budget scenarios or changes as long as the income meets their investment objectives. But that lack of a singular owner could mean multiple accounting systems and budgeting programs, as well as different reporting requirements.
Also, Margerum allows, “ownership goals do change. The ultimate goal of most owners is to eventually sell, and that could be at any given time as the world, cap rates and interest rates change. The only way to stay on top of that is through constant communication.”
COVID-19: the great anomaly
Among the outliers that can throw off accurate budget analysis, COVID-19 “takes the cake,” says Terry Fields. And at this point, it’s frankly too early to say with certainty how it will impact next year’s numbers.
When managers’ attention turns to their 2021 budgets, “there’ll be some interesting shake-ups in the process,” he says. “Mainly, relying on 2020 historical data may prove to be extremely unreliable. Figures on vacancy loss, turnover, delinquencies, fees, payroll, etc., could be wildly skewed.”
Nevertheless, he notes, there are lessons to take away. For instance, says Fields, “Seeing governments step in to stop evictions, freeze and suspend rents and stop business activities may force owners to reassess their comfort level with leverage and cash reserves. This could impact their capital allocations, debt behaviors and cash holdings moving forward to better prepare for unforeseen disruptions, pandemic or otherwise.”
Dragone agrees that, as of this writing, it’s too early to talk about the long-range impact of COVID-19. “There are obviously going to be some variances and wonkiness to 2020 expenses,” he says, “first and foremost in utilities. With so many buildings going vacant, we’re seeing decreases in usage from 5% to 20%. That’s going to be an important factor for next year’s budgeting.”
Ancillary income, such as charges for conference center or parking garage use, is also taking a hit. “We have public garages, and volume is down by 70% or 80%,” Dragone says. And the drop won’t simply correct itself when operations ramp back up. “It will take time for people to get back to their routines, and some of those may change forever. So that ancillary income has to be truly scrutinized, not just for now but going forward.”
There are proactive steps that managers can take, even as we find ourselves knee-deep in the here-and-now. As Margerum explains: “In March, we created a COVID-19 supplies expense category, so we can measure our expenses throughout the crisis.” That information will also help with any insurance claims as well as informing the outlier narrative for next year’s budget.
Indeed, it’s an odd time for budget forecasting. But the magnitude of the anomaly that property managers face right now makes it the perfect time to discuss how to create normalized and accurate data for your ownership. Because no matter the crisis, no matter how bizarre the times might be, budgets still need to pencil out.