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Capital planning for repair and replacement.

There are a number of key players in the successful management of a real estate property. First there is the site maintenance staff, who attend to the property's physical needs. Next, there are property and regional managers, who run the day-to-day operations. Higher still are the asset managers, who keep an eye on the bottom line and plan where the property and portfolio are going in the long run.

All of these people can do their individual jobs well and still fail to achieve the highest value for a property if their interests and concerns are not integrated into a coherent approach.

Capital planning - a disciplined effort at assessing the current and projected physical needs of a property, establishing the costs of maintaining and/or modernizing it, and creating a strategic plan for addressing needs within financial constraints - is essential to achieving enhanced property value.

Simply, capital planning is a series of questions, posed and answered.

* What physical components of this building will wear out in time? How much of it (or how many) do we have?

* What shape are things in? What needs to be done and when?

* What would it cost to repair, rebuild, replace all things today?

* How do these projected expenditures compare to available resources, either cash flow or reserves?

* How do maintenance and resource needs bear on value and plans regarding refinancing or disposition?

The answers to these questions form the basis for developing a comprehensive capital plan for a property.

What do we have?

Developing a comprehensive inventory of a property's physical systems is a worthwhile exercise in its own right. It enables managers and staff to know a property better.

The tendency among most of us is to not ask about what we do not know. An exercise that makes people ask what is around them yields a better appreciation of how complex their building is. It can also demystify things and sometimes explain problems.

An inventory should be as comprehensive and inclusive as possible. The temptation is to focus only on the obvious big-ticket items, e.g., roofs, boilers, in-unit components, and finishes. Yet seemingly minor things such as window caulking or pipe insulation can affect the useful life of major components and bear on operating efficiency.

Also, little things can quickly add up. The occasional broken thermopane seal or the infrequent heating zone valve that fails are inconsequential until they start to multiply.

The inventory should also quantify things as specifically as possible. For example, the make, model, and size of mechanical equipment, square feet of paving and roof, and counts by type and size of window should be noted precisely. Accurate quantity information is essential in developing cost estimates. Architectural plans will generally yield better information and can make this part of the job much easier.

What needs to be

done, and when?

The field evaluation cannot be limited to counting things. The current condition of every building and site system needs to be noted as well. There are two critical questions: What needs to be done to this component, and when? Many items are replaced with like materials when they fail.

However, for many systems and components, it is not this simple. In some instances, it may be possible to go over an existing roof covering with similar materials. In others, stripping and replacing (possibly with deck work required) may be necessary. Yet there is a significant difference in cost associated with the two actions.

There will also be questions about alternative approaches to certain capital needs. Should deteriorated wood siding be replaced with vinyl? These questions may ultimately be answered in light of what the job can afford at the moment. However, at this point in the process, it is important to define the best approach in construction terms.

If something does not need attention now, when will it? For some things, the answers will be fairly apparent. Refrigerators that have been failing after 1? years of service can be expected to continue the pattern. Shingle roofs pushing 20 years of age can be assumed to need replacement, and so on.

The actual remaining useful life of any given system will be a function of age, design, material type and quality, nature of use, maintenance, and even local environmental conditions. Kitchen cabinets constructed of laminated pressboard in a family development will have a shorter expected life than all-wood cabinets in a seniors' building.

Determination of appropriate estimated useful life can be based on the manufacturer warranty (such as 20-year shingles), other industry standards, or a development's actual experience (clapboard requiring painting every seven years).

In some instances, actions may be prompted either by market conditions (e.g., replacing mustard yellow appliances with contemporary colors, even though the older appliances are functional) or by the opportunity to improve operating performance (such as replacing older 5-gallon toilets with newer 1.6-gallon water-saving units).

What are current repair costs?

For many items, the answer will also be readily apparent. Often items such as carpet or appliances can be costed by consulting newspaper circulars or the local retail store. For an older property, management will often have direct experience to rely on for such costs. This experience may extend to larger architectural or mechanical systems. If not, such historic information may be available from other properties.

Other costs, particularly for major architectural or mechanical components, will take some effort to develop. Here, the value of accurate and reliable dimensional information becomes readily apparent.

There are a number of published cost estimation sources, such as R.S. Means and Marshall & Swift. A weakness with these third-party sources is that they do not directly account for the vagaries of working in an existing facility. New construction costs usually differ from rehabilitation of existing facilities. Local contractors can also be a good source of cost data. Finally, good capital planning specialists with customized cost files offer meaningful cost information.

Who should take the lead with these first levels of analysis? Site staff are the likely candidates. However, they rarely have the technology skills to evaluate all substantive components in a given job. In addition, staff on location day in and day out frequently lack the fresh perspective to rigorously and objectively evaluate the property as needed.

Where management firms have construction affiliates, using their talent may be an option. This is especially true if the affiliate was involved in the property's development.

Interdisciplinary specialists in capital planning, with strong inspection skills and with A-and-E expertise, are another option. Working with pre-existing field protocols, they can inventory and evaluate properties thoroughly, objectively, and efficiently. Good firms will also have authoritative useful-life and cost data. Take care in selecting such a specialist. You do not want an ambitious home-inspector who does not understand real estate management.

Relating needs to resources

Having identified expected capital actions, ascribed costs to them, and projected when they are likely to occur, the next step is to project the impact of these costs on the bottom line. A capital spending plan should present what total capital costs are likely to be in a given year, be it three, seven, ten, or even twenty years from now.

Spreadsheet programs permit this to be done quickly and accurately. They also facilitate adjustments for the future inflation of capital costs, an important consideration. One need not be overly concerned with fine-tuning appropriate rates; assuming 4 to 5 percent annual inflation of capital costs will remind one of the time value of money.

If the initial evaluation has been truly all-inclusive, it is possible now to review which recognized needs are appropriately considered operating items and which are capital expenditures.

Timing issues can also be looked at at this point. For instance, ff a plan calls for substantial rooftop HVAC work a few years after roof re-covering, it may make sense to adjust the program to coordinate the two activities, as intrusive HVAC work subsequent to roof work might void warranties. Phasing work over time may be seen as necessary given limited available resources. However, the phasing may need to be judged against lost economies of scale.

Getting needs to a bottom line can be quite useful in the development of annual budgets and longer term proformas. Where developments maintain replacement reserves, as in the case of assisted housing and condominiums, the adequacy of funding levels can be evaluated and optimal funding levels can be identified through an interactive process.

Where reserves are not a routine aspect of management, as is the case in most conventional rental housing and commercial properties, greater attention to "capital expenditures" in budgets and projections is necessary.

There are other uses for capital plans at the site level. Capital plans and analyses of useful life are opportunities to evaluate the value of contracted services and to develop or refine preventive maintenance programs. Capital plans are a good tickler for monitoring ongoing improvement programs.

Thinking about site staffing is another potential benefit. For example, if a property, manager knows that he or she has a lot of carpentry work ahead in the next few years, the manager should keep that in mind when filling vacant maintenance positions.

Capital needs and value

Perhaps simplistically, optimizing value can be seen as a matter of miximizing net operating income. While all good management people think about such matters all the time, tying NOI enhancement to other capital concerns can make a difference.

Undertaking minor detail redesign in connection with exterior siding work, to give older townhouses a more contemporary look, may well support a marketing plan. Doing so as a part of a necessary improvement effort heightens effectiveness and achieves certain economies of scale.

If timing issues are of concern to site people, they are also important to senior decision makers. In assisted housing occupancy is generally high and stable, and investment horizons are fairly long. Conventionally financed housing is much more captive to rental markets. There is only so much that can be done to manage this. Investment and financing windows also tend to be quite short, making properties vulnerable to the credit markets as well.

Clearly understanding current physical needs and anticipating longer-term concerns can help managers control risk, making the most of advantageous credit opportunities and avoiding unnecessary refinancing in unfavorable markets. In soft markets, there is often little that can be done. In improved markets, however, asset managers would be well served by addressing capital concerns with property resources while the opportunity exists.

Capital planning in use

The capital planning process should be interactive, involving those who understand the physical assets best as well as those who ultimately will use the analysis and make decisions. Third parties, who know both building technology and real estate, can be valuable facilitators in this regard.

To better understand the process and benefits of capital planning, consider its use at Pondside. This middle-Atlantic development was built in 1973. Its 17 garden-style buildings are wood frame, with clapboard exterior and pitched roofs. Heating is by electric baseboard radiation; there are electric DHW tanks in each building.

Conventionally financed, it had not historically maintained replacement reserves. Cash flow and periodic refinancings enabled the property to keep up with most physical needs. However, the property needed sprucing up to remain competitive with new products on the market. A refinancing, either with Fannie Mae or FHA, was under consideration; the owners were anticipating a 7-to-10-year loan. Either of these financing sources was likely to require some combination of upfront work or funded reserves and regular replacement reserve contributions.

Pondside's capital needs for the 10-year analysis period were heavily concentrated on dwelling units in the early years, and on envelope work in the middle years (Figure 1). This distribution as shown in the 10-year plan reflects the outcome of the interactive process of physically required work and those actions deemed necessary for marketability.

[TABULAR DATA OMITTED]

New signage, entry fencing, and landscaping were provided for in Year 1, under "site systems"; future site work is determined to be an operating expense. A modest expenditure on electrical timers improved lighting controls for both building-mounted site lights and hallway lighting.

The key to the plan's financial viability was in the determination that roofs were in sufficiently good condition that re-roofing could be deferred until Years 4-7 (Figure 2). Given the quality of initial materials and installation, it was concluded that aggressive maintenance would support a decision to defer major capital work. Deferring this $58,000-plus expenditure enabled major in-unit work to be completed in Years 1-3. Here the priority was on kitchen and bathroom renovations, to make them "like new." A 35-to-40-percent turnover allowed management to phase the work over this period.

[TABULAR DATA OMITTED]

Management initially sensed that all new kitchen cabinet systems might be needed, at possibly prohibitive cost. Refinishing 75 percent of the cabinets with new doors and drawers was ultimately deemed possible. Installation of new coordinated countertops and sinks was authorized. Old mustard yellow appliances were replaced with contemporary colors. Microwave ovens were added, another marketing decision.

Bulk purchase via a consolidated contract served to control prices on all appliances, realizing savings over earlier purchasing patterns. Similar savings were realized by bulk purchase of carpeting directly from the factory. Recarpeting every seven years was to continue, unless the improved grade being installed proved to extend life.

Bathrooms were upgraded with vanities, sinks, and accessories. At the same time, water-saving toilets were installed. Though somewhat more expensive, the redesigned toilet models were specified, a recommendation by site staff to minimize maintenance calls.

The new toilets and water-saving devices on faucets and showers lowered escalating water costs and cut electric bills by reducing the volume of domestic hot water used. These combined energy and water savings had a modest, but valuable, impact on NOI.

Just as the creation of the work plan for Pondside was interactive, so was the financial strategy. The estimated cost of the projected capital needs was approximately $90,000 annually for Years 1-3 and approximately $50,000 for Years 4-7. The owner was concerned about maximizing takeout from the new financing.

The first financial plan (Figure 3) called for initial annual reserve contributions of $13.75 per unit, per month, roughly the amount in the current operations budget for "capital" items. This would necessitate a $310,000 initial deposit to reserves or repair escrow in order to maintain positive reserve balances over the term of the loan.

[TABULAR DATA OMITTED]

If the operating budget (Figure 4) could be fine tuned to double contributions to reserves to $27.50 per unit, per month, the amount of upfront capital required could be reduced to $210,000. This would allow the owners to take out an additional $100,000 from the refinancing. Given the owner's interest in maximizing take-out, this was seen as the preferred option.

[TABULAR DATA OMITTED]

Conclusion

The Pondside case illustrates the benefits of capital planning. Ultimately it facilitated the development of practical and cost-effective solutions to the physical needs of the property.

The owners, managers, and maintenance staff also found a new way of looking at the relationship between the physical and financial circumstances of the property. The differing interests of the key players had a forum for expression and resolution. The objectives of each were identified, reviewed, and integrated into a workable program.

Without question, the challenges of property and portfolio management in the 1990s are many. Capital planning helps prioritize the use of limited resources - physical, financial, and human. It is a state-of-the-art diagnostic tool with benefits in both routine and special-purpose applications. Whether the risk being managed is the physical or the fiscal asset, capital planning is a means to achieving important objectives.

Thomas E. Nutt-powell, Ph.d., AICP, is president and founding principal of On-Site Insights, and a nationally recognized housing, planning, and development expert. The firm's activities include project planning, field inspections, cost estimating, feasibility analysis, and training.

Dr Nutt-powell is the author of Manufactured Homes: Making Sense of a Housing Opportunity. He has served on the MIT faculty, where he headed the Masters in City Planning program, and has directed the Manufactured Housing Research Program for the Harvard-MIT Joint Center for Urban Studies. He has served on the Board of Governors of the American Institute of Planners.

David Whiston is senior associate and director of marketing for On-Site Insights. He is primarily responsible for helping clients develop financing solutions to capital problems.

Prior to joining the firm, Mr Whiston specialized in workouts for the Boston Financial Group, a diversified real estate investment firm. He was also with the Massachusetts Housing Finance Agency, focusing on equity resyndications and workouts. He holds an M.Ed. degree from Harvard University.
COPYRIGHT 1991 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Nutt-Powell, Thomas E.; Whiston, David P.
Publication:Journal of Property Management
Date:Sep 1, 1991
Words:2778
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