Real Estate and other cyclical markets swap playbooks as each cycle turns. The last decade has been a bull cycle in commercial real estate where without much effort, rents escalated, cap rates were stable and everyone benefited. Corporate facility managers similarly benefited from market tailwinds and ample budgets. Hard discussions…well, weren’t that hard.
Whatever the Corona virus is, it is the end of that cycle. This week’s forecast from the CBO of 15% unemployment means that however abrupt this change is, we don’t have the historical precedent to digest and understand the enormity of the wave headed our way. 2021 budgets are the scouts sent out to the front line, attempting to peer beyond the horizon and understand how to respond to the coming changes.
For battle-hardened real estate professionals, much of this will feel familiar from the Great Recession. Budgets will be crimped, the default position will be “No to everything” and the conversations will be difficult. Welcome to the CoroNObudget.
“A dollar saved is a dollar earned” will be the new mantra, an exciting opportunity for property managers and chief engineers that have toiled in the shadows of leasing for many years.
For real estate organizations, completely frozen leasing markets will turn management attention to operating costs. For corporates, real estate cost centers will be scrutinized and bullied into lower budgets, despite the harsh reality of largely fixed costs.
Even grizzled veterans may be surprised by this crisis in that the level of the shock is unprecedented. Since nobody can agree on the impact, caution will rule the day and worst case planning will dominate. Particularly for levered real estate organizations that are worried about carrying vacancy costs, almost nothing will encourage spending until the shape of the recovery is clear. We are already hearing anecdotes about massive budgets being completely frozen.
Is there no hope then, for those Gridium customers striving to improve their facilities, lower operating costs and enhance sustainability? If you are marching into a 2021 budget cycle, how should you position yourself for maximum success? What questions should you ask yourself about each line item in your capital request?
If your budget request is about improvements then usually the implicit trade off is operational costs reductions for capital. For those requests in your “Corona Budget” consider these questions to hone the sales pitch and get your improvements across the line.
What is our asset strategy?
As always, the best questions start with the fundamentals of your strategy. The usual questions about hold period, lease plans, and growth are fundamental, but COVID has layered on a new dimension to the process.
There’s infinite navel gazing about the market effects, but I found one recent comment on an earnings call from Gridium customer Kilroy Realty as a compelling as any:
While at this point demand patterns for real estate sectors are unpredictable in our discussions with our office and life science customers, it is clear there will be a flight to quality. They will focus on buildings that are sustainable, have modern systems and that can accommodate the changing protocols that companies are implementing.
Strategy is about choices, and part of pushing back against a default “no” position is pushing the question about what the asset strategy is. Will your building benefit from a flight to quality or does it lag? Can you demonstrate and trend zone-by-zone airflow for the next lease coming through or are you stuck with pneumatics that leave you flying blind? Will you reach your organization’s productivity goals if staff doesn’t feel comfortable with your space? Linking your project to the post COVID world is going to be critical for energy and sustainability professionals.
Whose cost is it?
Gridium real estate clients are used to facing a split incentive where energy savings can’t fully be recovered. Understanding how your project boosts net income, after cost allocations is fundamental to getting things through. And it’s not always intuitive. We’ve found opportunities where it’s actually better for the landlord to stomach the capital because maintenance expenses drop so much.
Similarly on the benefit side, it’s easy to focus on energy paybacks only. But perhaps your project will help attract a key tenant, or is really needed to safely keep your Energy Star rating? Non-cash benefits are critical to examine as well. For example the CARES act allows 100% depreciation for Qualified Improvement Property (QIP).
Finally, all budgets rely on static assumptions, but of course a key dimension of most replacements is risk. How many years left to do we have on that air handler? Will the chiller make it one more summer? If we cut our PMs will we really have a failure next budget year?
The last tactic is an especially pernicious penny-wise pound fooling trap to fall into, but sadly something we expect many organizations to suffer through.
Can someone else pay?
In a “Default No” environment, one great solution is to look for external capital solutions. Energy Efficiency as a Service (EEaS) has come a long way in the last few years, and market participants have hundreds of millions lined up for project financing. And utility innovations mean that in some locations these mechanisms are available to commercial real estate customers.
External financing does more than just clear a budget hurdle. It typically transforms energy efficiency in three key ways:
- Cash Flow: Financing provides return from day one by matching cash flow from savings with financing cash flows.
- Payback Risk: When you invest your own money its up to you to assure payback. Tools like Gridium M&V help, but that’s a very different proposition from energy financing where often the financier takes the bulk of the risk.
- Cost Recovery: On bill programs are especially relevant because they allow pass through of financing costs. Because the charge is on the bill, it swiftly and efficiently bridges any split incentive for both existing and new tenants.
For Gridium’s part, we’ve noticed a large uptick in customers inquiring about our Gridium Alpha finance offering since the coronavirus started, and we expect that to accelerate as the budget cycle starts in earnest. If you want to join the conversation, please reach out.
