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Managing the physical asset for financial gain.

Maximizing value in a manner consistent with the owner's financial objectives is the ultimate goal of asset management. But adding value is no easy task. Not too long ago managers could expect, at the very least, that a property's value would keep pace with inflation.

However, in today's competitive environment, merely maintaining and upgrading the physical plant is not enough. One needs to recognize that real estate is more than simply a physical asset. It is marketing to compete with other buildings. It is also a financial asset to diversify institutional portfolios. To add real value, an asset manager needs to consider the perceived integrity of the asset within the market and develop and implement aggressive, market-driven strategies that keep the property competitive and desirable to prospective tenants.

The starting points for any program to add value are always the same. First, managers must establish clear financial benchmarks for the property, based on the investment objectives of ownership. At the same time, they must collect extensive market data determine the needs of targeted tenants.

These two aspects of the asset must be reconciled. Otherwise situations such as upgrading a Class B building when the market cannot bear that type of product may occur. In other words, all activities for adding value must be market-driven.

Value-added opportunity

As an example, our firm recently planned and implemented a value-enhancement strategy in suburban Atlanta. A major insurance company hired us to manage and lease a class B, 103,000-square-foot office building which our client had taken back through foreclosure in 1989. At that time, occupancy was less than 80 percent, below average for this type of product in the submarket. Further, the building's major tenant, occupying 57 percent of total area, had decided to vacate at the end of 1989.

As in many markets, a development boom had resulted in a severe oversupply of space. During the six-year period from 1983 through 1988, developers had added 8.8 million square feet of office space, a supply increase of 136 percent. Unfortunately, net absorption had been only 6.4 million square feet. In addition, new construction was continuing. Assuming historical absorption rates, an approximately six-year supply of space remained in the market.

Furthermore, the new development had significantly changed the submarket. Fully 73 percent of the new construction had been Class A with a much higher level of finish and quality than had been typical. This put many second-generation buildings (such as our client's) into a lower category, although they had been fine buildings according to traditional suburban quality standards.

The oversupply also resulted in a rent compression between Class A and Class B space, thus increasing submarket competition. In absolute terms, Class A effective rents approached former Class B levels, making Class A space much more attractive to tenants. The result was an apparent movement of tenants from Class B to Class A buildings and a greater than proportionate share of vacancy for Class B properties.

In this sort of competitive market, perceptions of value are key to successful leasing. Further, in this competition of perceptions, the physical asset plays a vital role. Unfortunately, our client's property held a poor price-to-value perception among tenants and brokers in the submarket.

A broker survey, performed for the long-range plan, highlighted the challenge. Among directly competitive buildings, the brokerage community rated all but one older business park as having a better image. More importantly, the building ranked very low in value. Although at one time a high-quality property by traditional suburban standards, our client's asset had a minimal market presence by 1989. The asset's competitive position had weakened to the point that it could not even be considered in direct competition with other, similar buildings in the same office park.

A thorough review of the property uncovered numerous weaknesses:

* Visibility. The site had better than average access from the local highway, but the building itself was hidden from the major access street, making for poor visibility.

* Appearance. The building was below par in comparison with its competitors. Specifically, it featured an outdated wood planking and field stone facade. Exterior detailing, such as benches and railings, were not complementary to the design. Interior common area colors and materials were drab and worn and also needed updating and coordination. Finally, the restroom finishes were well below prevailing standards.

* Lighting. The site and building were dark at night, which exacerbated the identity and visibility problems and introduced security issues for both current and prospective tenants.

* Condition. Many elements of the common areas, exterior surfaces, and parking lot were in obvious disrepair. While nothing presented a safety hazard, there was an overwhelming impression that the property had not been suitably maintained.

Rent rates demonstrated the property's diminished market position. When our company assumed management and leasing responsibilities, the property could achieve a rent rate of approximately $14.50 per square foot face rate (competitive concessions were also necessary). This compared poorly with rents at Class B competitors but was comparable to two Class C buildings of distinctly lower quality (Figure 1).
Competitive Gross Rental Rates
Class B. competitor:
No. 1 $17.50 No. 4 $19.50
No. 2 $19.50 No. 5 $15.50
No. 3 $17.50
Class C competitor:
No. 1 $13.00 No. 2 $14.50

These rents unfortunately suggested the leasing market viewed our client's building as comparable to a Class C property. Here, similar perceptions of quality forced lower rent rates in order to sustain perceptions of value.

Property perceptions also played a role in the investment market. Our client's asset was not an attractive investment property due in part to its generally poor perception. We believed that the property, if marketed, would attract only "value opportunity" purchasers and would command yield premiums in excess of 200 basis points.

In summary, this particular asset had marketing problems that seriously eroded our client's financial position. However, our examination of the market and the asset's position within the market offered some reason for optimism. First, the physical asset had intrinsic attractions to users. The property's location, floor sizes, and general quality of construction meant it could effectively compete if a proper price-value relationship were established.

Second, many of its particular defects were curable to some degree. These important conclusions implied that our client had a potential value-enhancement opportunity. In particular, the property's achieved rents were below those for otherwise comparable properties. Therefore, by improving the building's image, we expected to increase rents and still maintain a competitive perception of value.

A strategy for enhanced value

As with any value-adding management program, initial attention was paid to the physical plant. This step is critical. Along with location, an asset's bricks and mortar are at the core of its value.

Frequently, operating cost savings and extended systems lives alone justify an upgrade of building systems and routines. But even these basic building operating issues have marketing implications. Lower operating costs, obvious good maintenance habits, and efficient elevator and HVAC systems help attract and retain tenants.

With monitoring system in place, an asset manager's ability to respond quickly and efficiently to tenant needs is increased, thereby enhancing the value and desirability of the asset.

At our client's property, we found significant maintenance needs. Indeed, although the building was only eight years old, the effective age of the mechanical components was much older because of deferred maintenance.

Of particular importance was the HVAC system. Years of neglect had left a system that could not maintain an adequate building level of comfort. Indeed, complaints about temperature control were part of the reason the major tenant had decided to leave the building.

Our firm responded by implementing a capital program to correct the deferred maintenance issues. This, of course, enhanced the physical integrity of the building. More valuable were improved tenant perceptions of the property. Air conditioning complaints declined drastically in the first month.

From physical to promotional

Nowadays, honing he physical asset to peak operating condition is standard. For this asset, a larger task was refining the property's physical characteristics to support the second part of asset management--marketing. Here, the challenge was to attract tenants while maintaining economic viability. Aesthetic improvements to the building and site would enhance the asset's competitive position. However, competitive pressures limited the potential economic gains that a renovation could provide.

In particular, the property could not be established as Class A. Quality changes in the market had been simply too great to overcome, given the property's basic physical structure. Moreover, the character of neighboring properties in the business park would not complement a Class A renovation.

These important constraints mandated less lofty ambitions. For example, replacing the wood planking and field stone facade with more contemporary, luxurious materials would not have been feasible. From a technical perspective, this would have been a difficult and expensive project. More importantly, from the market perspective the property could not support a high-end renovation. Indeed, our review of the market suggested a maximum possible rental gain of only $1.25 square foot.

However, the limited rental gain potential was not a setback. Rather, the primary goal of an aesthetic improvement would be defensive in nature. The renovation program would serve to re-establish and reinforce the asset's Class B position. In other words, the objective became enhancing price-value perceptions.

Implementing the strategies

In conjunction with local architects, our firm's architectural and construction services group developed a low-cost renovation plan. The program included repairing and refinishing the exterior siding, exterior and interior common areas, and restrooms with coordinated and up-to-date material and colors. Further, the site and building lighting and signage were enhanced. The total cost was under $4.00 per square foot (Figure 2).
Renovation Program Costs
(Dollars per square foot)
Exterior $0.82
 Refinish siding
 Rework sidewalk and railings
 Paint benches
Signage 0.34
 Lighted signs at site entrance
 Rework building sign
Lighting 0.41
 Building exterior
 Parking lot stairs
Landscaping 0.15
Common areas 1.00
 Paint lobbies and corridors
 New corridor wallcoverings
 New corridor light fixtures
 Refinish doors and trim
 New flooring in lobbies
Elevator 0.17
 Recover walls
 Rework ceilings
 Carpet borders
Restrooms 0.45
 New partitions
 New wallcovering
 New countertops
Contingency 0.30
Total program $3.64

We expected that this program would be sufficient to realize the maximum potential rent gain. Further, with an enhanced perception in the market, the asset would enjoy intangible benefits such as higher occupancy, lower turnover, and reduced re-leasing downtime. Our cash flow projections showed a gross value gain of $19.75 per square foot over the "as is" alternative.

Clearly, the renovation program was feasible. The net present value of the recommended improvement was $16.11 per square foot ($19.75 per square foot value gain less the $3.64 cost). Moreover, the asset's value enhancement potential would drive its market value. Any purchaser of the property would price the asset based on this potential. Therefore, our client could realize this value gain immediately.

Alternatively, our client could assume the renovation program itself and achieve, in time, an even greater value. This plan necessarily would expose our client to the inherent risk of a repositioning program. However, the expected yield on the investment (foregone sale proceeds and renovation capital expenditures) would the 14 percent.

Four our client, then, the strategic decision was financial--sale versus hold. In particular, the decision depended on the relative attractiveness of alternative investments, given the owner's other portfolio needs. With a previously developed strategic plan as decision-making tool, ownership chose to hold and renovate. In essence, our client would act as the value-opportunity purchaser and take for itself the intrinsic worth of the asset. Ownership believed that the risk of the renovation program was not too great to prevent its going forward in hopes of achieving its long-term strategic goals.

The outcome

The renovation was successfully completed in the summer of 1990. Early indications are that the marketing goals are being achieved. In just six months, occupancy has improved to 90 percent, and the major tenant has extended its lease.

Further, the property enjoys heightened broker interest. The number of active prospects has increased ten-fold, and rent gain projections have proven to be accurate (despite a significant downturn in the market).

With these leasing market achievements comes investment market improvements as well. Our client now enjoys can asset with higher occupancy, higher rents, improved market image, and greater physical integrity.

From this successful program is suburban Atlanta we may draw several conclusions. First, a renovation does not need to create the most glamorous building on the street. Rather, the enhancements must fit the market. Often a more modest improvement with more modest expectations is a better investment.

Second, immediate disposition of foreclosed (or otherwise distressed) real estate is not always in the lender's best interest. Indeed, for this client, we demonstrated that a small additional investment (and a little patience) can create far better results than the sale of a distressed property in a weak market.

Third, and perhaps most important, planning is vital.

True asset management dictates linking a property's three components--its physical, marketing, and financial aspects. In addition, asset managers must consider the perceptions that characterize a property within these aspects. The ultimate success of any program to add value hinges on asset management's ability to consistently think in new and creative ways about the asset and its potential and to develop and implement clear market-driven strategies. Howard Weinstein is the president of Rubloff Asset Management and a member of the company's executive committee. During this 25-year real estate career, he has managed or supervised over 34 million square feet of commercial property and over 18,000 residential units. He has personally overseen such major properties as Detroit's Renaissance Center and Chicago's Carl Sandburg Village, and has served as a management consultant for several major institutions. Mr. Weinstein is a member and director of the Building Owners and Managers Association International and a member of the American Society of Real Estate Counselors, the Urban Land Institute, and Lambda Alpha Real Estate Society. Since 1930 Rubloff has been providing institutional, corporate, and private clients with a diversified range of real estate services. Through its regional offices, the company manages a portfolio of over 36 million square feet. The company's approximately 400 employees work in one of three divisions--Asset Management, Strategic Management, and Transaction Management. Among the services provided by the firm are commercial and residential leasing, asset and property management, financial analysis, disposition and acquisitions, and engineering and construction managers.
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Author:Weinstein, Howard
Publication:Journal of Property Management
Date:Jul 1, 1991
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