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Creating value - where and how?

While reasons for ownership vary, most investors have two objectives in common-immediate return on their investment and maximum capital appreciation over the term of the investment. A sustained increase in operating income creates the capital appreciation of a property, thus creating value.

Therefore, identification and exploitation of value creation opportunities can further the accomplishment of prime ownership objectives.

Many older commercial buildings and not a few newer ones hold the potential for sustained additions to net operating income. This article explores a few of these value creation ideas.

The search

Value creation may express itself in a variety of ways, but it always begins with an ideal. If the creative juices do not happen to be flowing at the moment, you can prime the intellectual pump by a review of existing conditions.

On a routine inspection tour, turn a fresh eye on the forgotten space. Is there space which is such an ugly duckling that improvements have been limited to a padlock on the door? Are there public spaces in the basement or elsewhere laid out inefficiently? Are there mechanical or operational spaces located in leasable areas for no sensible reason? Do several tenants in similar spaces have vastly different rentable areas? Does a comparison of interior and exterior dimensions make you feel that you overlooked a secret passage somewhere? Any of these situations may present an opportunity to begin creating value.

Continue the idea-generation process by reviewing the needs of your tenants and the needs of the marketplace. If you focus on ideas which are realistic and which fill an existing market demand, income will be produced and value created.

A periodic tenant questionnaire or routine meetings with tenant representatives are opportunities to acquire information about additional space needs or ideas about amenities. Visits to comparable buildings and discussions with brokers and other property managers help keep you abreast of the market. Research in real estate and architectural publications can provide useful concepts. Are the ideas beginning to come?

The tests

Fine. You have thoroughly inspected your property, polled the tenants, and surveyed the marketplace. You have several great ideas, and you are motivated. But before you move ahead, the feasibility of your ideas must be put to the test. Like any good test, it must be comprehensive to be sound. All the major aspects of the feasibility equation must be explored-the physical, the structural, the legal, and the marketable. Only then can you move ahead with your idea for creating value.

The first half of the test is "Can it be done?" Figure 1 poses the question in all four aspects of feasibility. If you can not answer "yes" to all the questions, you need additional information or a new idea. If your ideas survive these first tests of feasibility, you may proceed to the second part of the, test ("Should it be done?"), or the cost/benefit analysis (Figure 2).

In order to assess the viability of any idea, you must first ascertain the cost of preparing, building, and marketing any proposed new space or amenity. Depending on the nature of the use proposed, an architect or engineer may be required to draft plans or supply information. Mechanical equipment such as sprinkler lines, HVAC ductwork, or electrical wiring may have to be relocated or extended to supply newly converted space. Substantial costs for a contractor who will obtain permits, supply mechanical and other subcontractors, and provide materials and supervision may be incurred.

Costs related to new occupancies must also be considered. A review of lease terms or preparation of a lease might require the services of an attorney. Advertising, leasing commissions, free rent, fit-up contributions, or other leasing inducements may have to be added to the total required to install an income-producing use.

A tremendous amount of cost information may be obtained for free by consulting attorneys, architects, engineers, contractors, and other professionals with whom you already work. Often these "budget price" figures are sufficient to begin your analysis.

When total costs to be incurred have been calculated, determination of the economic and other benefits to be derived from the project must be made. Research the supply of and demand for the projected use in your market. Based on these statistics, a rental rate can be determined for the proposed use. Brokers can provide such market information, as well as information on concessions, inducements, and the amenity value of certain improvements.

In many cases, a cost-benefit analysis will indicate that a project will not pay for itself immediately. However, if costs can be amortized in a reasonable period, the capital appreciation aspects of the equation might justify the expenditure. If the income created can be included in a valuation by capitalization, then the increase in value an expenditure which does not yield an immediate return.

In certain cases, the benefit of an amenity (a retail space, building storage, a vending area, or parcel-pickup area) might justify a project whose costs exceed the immediate return. The ability to please your tenants and improve your competitive position in your marketplace is of considerable value.

With a project that adds rentable space, the distribution of operating costs over a greater rentable square footage may outweigh the additional cost required to operate that new space. A lower per-square-foot operating cost for current and prospective tenants will improve your competitive position.

Often value creation requires a capital expenditure. If a situation requiring corrections for code or other mandated renovations can be combined with a value creation idea, the problem will be resolved and a valuable amenity will be added. If income is produced, it will also reduce the burden of addressing the capital costs.

When a value-creating idea can be combined with a capital expenditure which reduces operating expenses, amoritization of capital costs (as operating expenses) over a reasonable recovery period may be permitted. While value creation can be undertaken at any time, the capital contribution aspect makes the budget process an ideal time to bring forward your ideas.

The decision

In order to justify the expenditure of funds and make your ideas a reality, you must keep your original objectives in sight, and you must do your homework thoroughly. An overlooked cost or an ignorance of market forces will not only cause an idea to fail, but may call your judgment into question. Once the idea has been developed, the analysis successfully completed, and funding identified, the work can begin, and new value can be created.

Conclusion

Value creation brings some of the essential characteristics of a good property manager into play. It requires a creative imagination to visualize potential and practicality to realize that potential. The knowledge of one's property and one's market, feasibility testing, and project management are all elements of the property management profession. Value creation makes the best use of these elements to accomplish the objectives of ownership. Richard W Horgan, CPM[R] is an assistant vice president in the Management Department at Meredith & Grew, Inc., a full-service real estate firm based in Boston.

FIGURE 1 CAN IT BE DONE?

* Is it physically possible?

* Is the access functional and unrestricted?

* Does the area have useful dimensions?

* Can any physical problems with the space reasonably be cured?

* Water penetration

* Odors

* Excessive noise

* Presence of asbestos or other harmful substances

* Is it feasible structurally?

* Can a space be created without disturbing spaces above or below.?

* Is the existing structure sufficient for the live and dead loads of the proposed uses?

* Is it legal?

* Can the space comply with building codes?

* Is the proposed use permitted under zoning?

* Will existing lease agreements partially or completely restrict certain uses?

FIGURE 2 SHOULD IT BE DONE?

* What are the total costs involved?

* Engineering/architectural costs

* Permitting/construction costs

* Outfifting or equipment costs

* Leasing costs, including vacancy loss and inducements

* Financing costs

* is the other proposal marketable?

* How much of this product is available in your market.?

* What is the demand for such a product in your market?

* What does space for the proposed use rent for in your market.?

* What are the benefits to be derived from the proposal?

* Will the proposal meet the dual objective of a sustained increase in NOI and capital appreciation?

* Will a problem be resolved?

* Will a building amenity be created?

* Will your building improve its competitive position?

CASE STUDY 1 IS THE UGLY DUCKLING A SWAN IN DISGUISE?

A basement space was formerly used as a pit for newpaper presses. A full 40 inches below the level of the surrounding basement space, the area had two sump pits and several drain lines beneath it. No ventilation or lighting existed in the space. Three sides of the space faced exposed sub-sidewalk space, housing sprinkler valves, drain lines, and the like. The fourth side was a concrete block wall. The ceiling consisted of exposed wooden joists and planking with abandoned wires and dangling pipes.

To make this space usable, spine walls were built to raise the floor to the level of the surrounding basement floor During this process, hatches were installed to provide continued access to sub-floor sumps. Corrugated steel and a new concrete floor were laid down. Perimeter walls were added, creating light wells to windows existing at the ceiling level. The space was divided into three segments: two rentable areas totalling 4,775 square feet and a lobby with a stair to provide access to the street. HVAC and electrical systems were extended to accommodate the new space. The space was rented in shell condition.

A N A L y s I s

COSTS ENGINEERING AND ARCHITECTURE CoSTs $ 17,000 PERMITTING AND CONSTRUCTION C OSTS 129,000 LEASING By PROPERTY MANAGER) COSTS 7,800 TOTAL COSTS $153,800

FINANCING

This project was owner financed

BENEFITS

ADDITIONAL NET OPERATING INCOME GENERATED $ 33,425 VALUE ENHANCEMENT:

$33,425 10% capitalization rate = additional value $334,250

+ Net operating income figures reflect tax and operating expenses and effective rents

AMENITY BENEFITS

+ Addition of rentable square feet lowers each tenant's percent CAM costs

+ Tenant expansion needs are accommodated

A problem space is eliminated

PAYBACK

Two and one-half years

CASE STUDY 2 GET A NEW LEVEL OF TENANT INTEREST

A 3,000-square-foot basement space with 22-foot ceilings and windows at street level had been used as a photographer's studio. When the photographer vacated, a study was made to determine the feasibility of inserting a floor above the original floor level. An architect and engineer were engaged to design the floor space and to resolve structural questions. So that the upper space could be rented to a retail user and the lower space to an office user, separate stairs, entrances, and mechanical systems were designed. To add to the marketability of the lower space; a mezzanine floor was designed for the upper floor, leaving an eight-foot gap between the edge of the new floor and existing windows to permit the penetration of natural light to the floor below.

A N A L y s I s

COSTS

FEASIBILITY STUDY $ 2,000.00

CONTRACT DRAWINGS 5,000.00

PERMITS, CONSTRUCTION, MECHANICAL INSTALLATION 375,000.00

ADVERTISING COSTS 1,000.00

LEASING COSTS 11,857.50

TENANT IMPROVEMENT CONTRIBUTION ($25.00 PER SQUARE Foot) 65,875.00

ToTAL INITIAL COSTS 460,732.50

FINANCING

A maximum loan amount of $410,200 was permitted; the owner supplied the remaining $50,500. A construction loan was obtained for five years at two points over prime, or 12 percent. Principal and interest payments were $9,125 per month. Total FINANCING COsTs $547,500.00

OWNER'S INVESTMENT 50,500.00

Total PRojEcT COST $598,000.00

At a total cost of $598,000, including financing, the price of producing an additional 2,635 square feet appears to be $227 per square foot. However, the mechanical systems and the structural work involved upgrades to other spaces and public areas, which were omitted from this analysis for the sake of clarity.

BENEFITS

ADDITIONAL NET OPERATING INCOME GENERATED ANNUALLY $ 59,065

VALUE ENHANCEMENT:

$59,065 [divide] 10% capitalization rate = additional value $590,650

+ NOI figures reflect tax and operating costs and effective rents for the 2,635 s.f. area

AmENITY BENEFITS

+ Tenant expansion needs were accommodated

+ A retail amenity was added

+ Addition of 2,635 rentable square feet lowers each tenant's CAM costs

PAYBACK

Ten years
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Article Details
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Title Annotation:includes case studies on making space usable and adding floor space
Author:Horgan, Richard W.
Publication:Journal of Property Management
Date:Jul 1, 1990
Words:2045
Previous Article:When to decentralize.
Next Article:Short-term measures, long-term markets: a summary from the 1990 IREM Asset Management Symposium.
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