How to Plan out Your Real Estate Capital Expenses over the Years - Part I

Published on Tuesday, 3 December 2013 09:10:04    Written by Marc
I have wanted to tackle this question for a while but never had a chance. Please keep in mind that I refer mainly to real estate capital expenditures here, as trying to plan capital expenditures of industrial equipment for operations would be practically impossible, unless one would try and do it for a single company at a time.

capex for real estateSo, let us start by asking what does planning of capital expenditure for your real estate mean and what can it do for a company.

Every company that uses real estate for their operations will need at one point to plan for capital expenses, be it a roof replacement, parking, HVAC systems, and an elevator replacement, maybe an energy saving project or an office renovation. In the end, you will end up with a need to plan for these expenses.

Planning

This brings us to the subject of planning and its importance. In theory, one could go from year to year without any other capital expenditure planning other than planning for the year to come. A company could look at everything that needs to be done for the following year, estimate the cost, and carry out the capital expenditure project. This requires little or no planning. However, the main problem with this approach is that you have no control over the amount of capital expenditure you will spend year after year. One year it might be a minimum amount and the following year you might have four or five major expenses.

From a budget planning perspective, this creates very choppy charts, with large ups and downs. If your company uses real estate for its own operations having capital expenses going up and down each year makes it difficult to forecast costs for the future, since you only know how much you will spend for the following year. Creating three or 5-year forecasts becomes impossible.

For building owners and managers who lease real estate to tenants and can recharge the real estate expenses to their tenants, having capital expenses that go up and down each year can have many negative effects on the tenants. First, if a tenant happens to be interested in leasing space in your building on the year that you are having a ton of capital expenses, this might scare the tenant, even if you plan to have little or no capital expenditure the following year.

Having capital expenses that go up and down year after year is also a problem for your existing tenant since they find themselves with larger lease costs on some years and smaller ones at other years. It makes it difficult for your tenants to know what to expect year after year. With proper planning of capital expenditure, you could forecast expenses to be similar year after year with, depending on your situation, a slight increase to account for inflation. With proper planning, both the building owner and the tenants win.

How to do proper planning

Here is a simple six items I often use for planning capital expenditure when managing buildings:

  1. Maximum horizon possible (lease/own)
  2. Complete audit
  3. Plan for the unexpected
  4. Amortization period
  5. Delay or advance dates
  6. Review each year your plan

Let us take each step individually and have a closer look.

  1. Maximum horizon possible. This should probably be the first question you have for yourself, “How long are you planning to keep the building (if you own it) or how long you plans to remain at the site (if you are leasing it)?” After all, if you are leasing a site, you have four years left on the lease, and you have no intentions on renewing the lease, then there is no reason to plan capital expenditures for the next 10 years.

    Same thing if you own the building and plan on selling it, unless you have an expenditure that will need to be done before you can sell the building or which will increase the value of the building prior to the sale. So knowing how long you plan on keeping the building should be your overall guidance factor, your starting point.
  2. Do a complete audit. Audits often have a negative perception. This is perhaps because of the fact that they hint that the auditor is looking for something wrong. Actually, a building audit is a good way to find things to improve and give you a status report on the building condition, and at time, alert you to take immediate action. Many companies try to do building audit internally, but the truth is that doing a detailed audit is relatively complex and often requires technical skills that many companies do not have in house. For example, in order to do a complete roof audit, you should probably conduct a thermo scan.

    However, doing a proper thermo scan requires not only the proper tool (thermo camera), but also the skills to interpret the tool and give you sound recommendations. This is why it is good to refer to specialized consultants for some elements of the building audit. Many consultants will claim to be able to do a complete building audit, but unfortunately, very few consultants are really specialized in all areas such as roof, parking, building structure, vac. actually, only sizeable consultants firms can truly offer all building audit services because they can use multiple professionals within their rank.

    In too many cases, I remember being offered a complete audit by smaller firms, only to understand later in the process that they were not really specialized in anything, but were more “jack of all trades” consultants. Do not be fooled by this, a good specialists in his/her field is worth his/her weight in gold and can save you money.

    As a short story to this, I remember about 15 years ago I was managing real estate for a fund which has shopping centers and one of these shopping centers had a roof that was about 13 years old, so naturally we asked guidance from consultants which came back to tell us that we needed to replace the entire roof. We got quotes from contractors who all came with prices and comments on how the roof needed to be replaced as soon as possible.

    Then before we started the roof replacement, one consultant, which had been referred to us, came in one afternoon and offered to go up on the roof to have a look. He was curious to know why a roof with only 13 years would need to be completely replaced. After his visit, he told us that the roof was still good for probably another 10 years. Obviously, we were in shock. The roof did not look great on the surface, but that was simply because the heat from the sun had melted a little the coating and the pebbles on the surface had been moved around (probably from the snow removal process we did each year).

    However, the roof was sound and not leaking. We cancelled the work and continued to monitor the roof. Eight years later when I left the company, the roof was still in fair condition and had not been replaced. Had we listened to the first consultant, would have changed the entire roof of approximately 300,000 sq.-ft.

    Doing a detailed audit will allow you to know what you need to replace or repair and when. With proper guidance, you can determine most capital expenses for the next 10 years, knowing of course that each year you will have to revise your plan, but at least you will have a good idea of things to come.

  3. Plan for the unexpected, or the worst case. Think about the things that could go wrong or that could arise sooner than unexpected. Do you have a transformer that your consultant thinks is still good for between three and five years? Plan for the worse and if the transformer does last five years then you will be happy.

Part II to be continued on Friday…