June 10, 2014
Interviewed by: Privcap
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Renewals, Reinvestment & NOI Growth

Our panel of experts from Yardi, CBRE and Taurus discuss rent growth assumptions, being paid a premium for vacancy in key U.S. markets and the challenge of tenant renewals for older properties.

Our panel of experts from Yardi, CBRE and Taurus discuss rent growth assumptions, being paid a premium for vacancy in key U.S. markets and the challenge of tenant renewals for older properties.

Renewals, Reinvestment & NOI Growth

Successful Strategies for Driving Net Operating Income

Zoe Hughes, PrivcapRE:

I’m joined here today by Alan James of Yardi Systems, Chris Macke of CBRE Global Research and Consulting, and Peter Merrigan from Taurus Investment Holdings. Thank you all so much for joining me, gentlemen.

In the wake of the crisis, commercial real estate performance has very much come under the microscope by investors and managers alike. And as we look out today to rising asset valuations and the ability to use more leverage in deals, we ask ourselves what’s driving performance, particularly where net operating income comes into play in that and the ability to grow NOI. Peter, you’re on the ground with Taurus. Give me a sense of what’s been driving returns today and where NOI fits into that equation.

Peter Merrigan, Taurus Investment Holdings: 

NOI is not fitting in so much right now. There’s been a huge appreciation just in pure valuations that don’t seem to be tied terribly to NOI or even to cap rates in the last 12 months. I’ve seen a huge move in the marketplace in the major cities—if I would include London and New York, then if you look at Boston and San Francisco. I wouldn’t say valuation is working in lockstep with increases in NOI right now. That valuation is outrunning increases of NOI pretty significantly.

Hughes: What are your expectations as you look out over the next few years? Do you think asset valuations are going to increasingly outpace NOIs?

Merrigan: What’s happening is that people are pricing in a significant economic recovery now, at least in the U.S., and they’re pricing in significant rent growth as a result. If you remember back into the 1999 timeframe when people were paying for vacancy and they were paying more on a per-square-foot price, you’re seeing that dynamic back in the marketplace.

Hughes: Chris, to get a sense from you, where are you seeing the drivers of return and how does NOI fit into that equation?

Chris Macke, CBRE Global Research and Consulting:  

It’s very interesting because part of what Peter referenced was the fact that the depreciation rates, to a large degree, are a function of commercial real estate status as a most-favored asset class. As you look at all the asset classes out there, we are within one of the most desirable classes, which is real assets. Then, within real assets, commercial real estate is very desirable as well.

We’re not only seeing that, but we’re seeing that increase, especially among international investors. So, when you put that together with the pricing in of the expected future strong recovery you get effective, healthy appreciation rates.

So, the good situation we’re in is that if we do have rising interest rates, it will be because we’re going to have a stronger economy. That will help to drive that NOI growth we’re looking for. So, we’re really in a Goldilocks scenario.

Hughes: Alan, obviously at Yardi, you’re working closely with a lot of institutional investors, particularly on the reporting side and getting a sense of where they’re digging in and wanting to get information. Do you get a sense that they’re actually looking for greater asset-management skills, that ability to drive NOI? What’s your take on what you’re seeing on the ground?

Alan James, Yardi Systems:

For the limited partners, the LPs certainly on the institutional side, their expectations are that the operators of those assets are going to manage them with the greatest efficiency possible, whether on the expense side or not. There are certain elements within the expense area that are attractive, such as utilities, energy—that’s an obvious one—but also on the CAPEX side, managing CAPEX appropriately and the use of funds. Then, the obvious one is maximizing or optimizing revenue wherever possible through their leasing and tenant activities. In particular, what appears to be of great interest is renewables—focusing on keeping the tenant as opposed to losing the tenant and having to go out and find a new tenant. Some institutions we work with that are using third-party managers are focused on renewals and how effective the manager is in keeping the tenants.

Hughes: Do you think this is going to be an even greater focus as we look forward over the next few years?

James: We believe so. Again, I can only speak to what the LPs are asking us in terms of providing information through our technologies. But, once you have transparency made available to you in the operations of those assets, it’s hard to give that back. So, my suspicion is now that they have it with some of these managers their expectations are they plan on keeping it.

Hughes: The ability to drive NOI really stems from rental growth and occupancy. When we look at occupancy, we need to think about a supply. First, Alan, when you assess the ability to drive NOI, do all businesses have a clear understanding as to the cost of occupancy?

James: All firms have a very good idea of the cost of vacancy. They’re on top of their assets, the market rents, the markets they’re in, the deals going down. But it’s interesting—the challenge we see is measuring the effectiveness of either their external brokers that they work with or their internal leasing team or a combination of both on how effective they are in doing the deals. So, they’ll all tell you they’re doing deals, but what they can’t tell you is how long it’s taking to do the deal. If you boil down the metrics, it’s rather interesting.  You can take a 250,000 square-foot building, assume a 10% vacancy, assume a market rate, figure out the average daily vacancy cost or loss and what that costs you, and then put a five cap (rate) on it and figure out if you start shaving days off your leasing cycle, what that can mean to the value of the building. When you take those big numbers and knock them down into small numbers, you can see the impact that can have if you have some way internally of measuring how effective you are at renting your space.

Macke: I wanted to build on the prior point about the cost of vacancy because, since the recession, we’ve seen a fairly strong recovery. The cost of vacancy has gone down as the demand has gone up and we’ve seen a lower vacancy rate. So, yes, we are seeing new supply but that supply is very much in response to the fact that we’ve tightened up. We’re back to pre-crisis vacancy rates and even lower in multifamily and in some other asset classes as well. So, it would be expected that we would see that.

Merrigan: You’re not really being penalized for vacancy right now. You’re actually being rewarded in some ways because, again, people are pricing in a big rent spike. You can’t access the rent spike if your building is stuck in a long-term lease. So, it’s an interesting phenomenon where maybe if you weren’t doing such a great job on the leasing side, you’ll actually be covered for it by having such a big run-up on the per-square-foot valuations.

Hughes: Do you think you’re actually getting a premium, then, for having a greater vacancy rate in some properties?

Merrigan: That’s in the right locations, yes. Right now, it’s a strange dynamic in the market. Again, I go back to 1999 and 2000. It was a similar feeling back then where you actually were getting paid for vacancy in certain buildings. It’s not every building in every market, but in the growth markets in the U.S., yes, you’re going to get paid a big price per foot.

Macke: Assuming that we continue to have a healthy recovery but not a boom and bust recovery, hopefully that will continue, so the people who are paying more for the vacancy will have an extended amount of time to then be able to lock in those tenants on the long-term leases to create that value.

Hughes: How is the change of use of real estate impacting what you’re doing on the ground?

Macke: We’re seeing that across the country very much at the sub-market level. As you have a change in the economy, you have a change in the demand for space. You can see that with technology. The technology is driving so many changes in what tenants require, which is making some sub-markets that previously were the highest-demand sub-markets because they have older stock now those aren’t as much in demand as some new, up-and-coming sub-markets that fit better with what some new technology companies and even non-technology companies are looking for. Because, in addition to technology, you also have this next generation of Millennials that everybody’s trying to attract and that typically requires a different type of space.

Hughes: How do they remain competitive with older assets then, let alone driving NOI growth? How do they remain competitive in terms of the use of the space out there?

Merrigan: It really depends on what kind of older asset you’re talking about. If you’re looking at brick-and-beam space, which was out of favor before and now is back in favor (particularly in the Boston market where I’m from but also in some markets here in New York and elsewhere) that older, what was considered maybe a functionally obsolete asset, is now cool and people want to be there. And those neighborhoods are becoming cool. If you look at Williamsburg, Brooklyn, for example, which was not really a conventional office-space market, or DUMBO, or places like that with older buildings that are really great neighborhoods. Those are where technology companies are looking to be, because that’s where they can attract the talent.

Hughes: Is technology now a double-edged sword, looking at real estate?

James: It’s kind of interesting, and I’m sure Peter and Chris can speak to this more than me certainly, but hoteling is in, right? Going to an office every day is not necessarily in anymore. So, the amount of space that perhaps we need today is not the same as it used to be. Technology is making that possible. We have mobile devices. We have iPads and iPhones. We don’t have to work in our offices.

Merrigan: You’ll see more open plans. At least what I’m seeing in my portfolio is more open plans. You’re seeing very high-end finishes what I consider the common areas of the space—the conference rooms and lounge areas for employees and things like that. Then, the actual area where people sit is fairly simple. It’s an open plan with not even cubes, but there are really no walls anymore that you would see in some of the older spaces. They’re trying to squeeze more and more people into the same amount of square footage, but they have more interesting areas for meetings and for conversation, both internal and external. So, it’s a different kind of space. On the renewal side, that was an interesting comment before about the likelihood of renewal. I’ve been of the mindset that it’s going to be more challenging to accomplish renewals because people want different kinds of space and they don’t want to sit in that same space while it’s being reconfigured. Renewals are going to become more and more challenging as people look to compete for employees in different kinds of space.

Macke: You’re asking how do you grow NOI? One way you do it is an acquisition. When you look at a building, one thing we’re advising clients is how old is the space your largest tenants are in? If it was built 10 years ago and it’s a 200,000 square-foot tenant, that’s going to present some real challenges because nobody wants to live through the time it takes to get that space to be more collaborative, as Peter mentioned. That’s opposed to if you are buying an asset that your larger tenants—maybe they just had their finish work done a year ago; it’s entirely different. So, a lot of your NOI growth you can drive an acquisition.

Hughes: But what happens after acquisition? How do you drive it then?

Macke: Ah. That presents more opportunities and that gets into what Alan mentioned as getting to the asset level, getting to the specifics—the property management side, the leasing side, and driving the NOI. But it really does begin in acquisition. The other thing I’ll say is on acquisition, it applies to existing buildings as well because every day that you continue to choose to own the assets you own, you’re effectively making an acquisition decision that day again.

Merrigan: A lot of what is driven on that is reinvestment of the building, if you already own the building and you’re looking to turn over the space. Sometimes that’s restricted by the capital stack you may have in that particular building if you were highly leveraged or you put significant levels of mezzanine on it and you have to write large checks to reconfigure the space. You can’t do it. Sometimes the landlords can’t do it and that was a problem people ran into in the last peak, during the last cycle, where they were highly geared and got caught. Then, if you had declining rents, you were really caught. But I haven’t seen that level of capital structuring being put into the marketplace yet, so that’s encouraging. People actually have real equity in the deals and they can write real checks to reconfigure their buildings.

James: On what Peter was talking about on the reconfiguration of space or even gutting entire floors and relocating tenants, a couple of the LPs have mentioned to us on this renewal thing that they also consider moving a tenant from one of their buildings to another building within their portfolio as a renewal. It’s just a different type of renewal for the exact reason Peter mentioned. They’re going to repurpose the space. They’re going to gut it or do whatever. So, as opposed to completely losing the tenant, they’ll reposition it possibly in another piece of their portfolio.

Macke: There’s opportunity in that because, if the leases were signed in 2009 or 2010, especially in some of the gateway markets, the rents have increased significantly since then. So, that’s also part of how you can drive the NOI growth.

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