By Jeffrey S. Lapin, CPM, DREI
You did all your homework. You created a good scope of work, you got three qualified bids for the job and you put them on a spreadsheet to clearly compare and contrast the bids for your property owner. You are recommending the lowest bid as you know that the bid includes all the work. The bidder is well qualified, has the time and manpower to complete the job successfully and you are otherwise comfortable with them. You recommended the work as needing to be done for tenant comfort, etc.
But the owner just rejected your proposal outright. Why did this happen and how could you have prevented this outcome? The basic answer is that you and owner are speaking a different language.
The Language of Finance
Have you ever tried to have a conversation with someone that speaks a different language only to give up in frustration? If you were dropped into a foreign country where no one spoke your language, you would need to learn some key words and phrases to express to others in a meaningful way what you are trying to say. To have someone understand you and vice versa, first you need to share a common set of terms and the meaning of those terms. In other words, you both have to speak the same language.
Many property managers experience this frustration when speaking to the property owner or the owner’s representative. The fact is that most of these folks, especially those who have spent considerable time managing assets or who have advanced degrees in business or finance, speak a different language than property managers when it comes to money. Let’s call it the language of finance.
If you, as a property manager, want to communicate effectively with your clients (which all of us should) and particularly with regard to capital improvement projects, you will need to learn this language. I’m not suggesting that you go around using financial terminology in your day to day conversations with your tenants, family and friends. That would be off-putting as they do not likely speak the language of finance.
But when speaking to the owner or asset manager, most of whom analyze investments in terms of payback period, ROI and cap rate, an understanding and proper use of such terms when appropriate will allow you to get their attention and hopefully, their buy-in to what you are proposing.
The Project – Repair or Replace an Air Conditioning Unit
Let us consider a typical project for which property managers need to seek approval – a new rooftop air conditioning unit. Assume that your property is 25 years old and still has several of the original rooftop package AC units. You have had long-standing problems with this particular unit and have had numerous service calls on it because the tenant constantly complains that the unit is not cooling sufficiently. Now your trusted HVAC technician is advising that an expensive component, the compressor, has failed and needs to be replaced.
The cost to replace the compressor is $3,500.00 including parts and labor. The HVAC company is telling you that they cannot guaranty that, even after replacing the compressor, the unit will not have additional components fail. This type of equipment, according to ASHRAE (American Society of Heating, Refrigerating and Air-Conditioning Engineers – www.ashrae.org ) generally has a useful life of about 15 years. As stated above, this one is 25 years old. It is well past its useful life.
The replacement unit, including the equipment itself, the labor to haul away the old one and install a new one on the roof including the crane needed to do that, will cost $8,500.00. So, as mentioned above, you do all your homework (you think) and present your bid analysis to the owner, along with your recommendation to replace the unit. But the owner rejects your proposal based on the information that you provided.
The owner’s decision was made solely based on which option cost less right now. In other words, it was based on approval or rejection of an “expense”, not on approval or rejection of an “investment”. These are entirely different perspectives.
The property may be experiencing some vacancy or has had a lot of large repair costs recently and cash is tight. Whatever the reason for the owner’s decision, it was clearly made without the benefit of all the relevant information. And just as clearly, you did not present the proposals to the owner in a way that leads him/her to the best decision.
Instead of just sending the owner the comparative proposals and asking him/her to bless your recommendation, consider instead a better method. Approach the decision from the point of view of the owner. In other words, propose the project using the language of finance.
You know from experience that replacing a major component like a compressor in an old rooftop package unit is a bad business decision. Once an expensive piece of equipment like an air conditioning unit gets beyond its useful life, it is almost always better to replace it with a new unit. But you need to convert that knowledge into a presentation that will appeal to the owner’s financial acumen and which will lead him to the same decision.
One of the criteria that financial managers consider when they look at investment decisions is payback period. In the simplest terms, payback period (PP) is the amount of time it takes for an investment to produce enough revenue to cover the cost, after which we make money on the investment. The formula is as follows:
PP = Cost of the Project/Investment ÷ Annual Cash Inflows
So in our example, the cost of the project is the replacement cost of the AC unit or $8,500.00. The annual cash inflows are the savings from operation of the new unit. Here is where it gets interesting. We need to determine from our contractor or the manufacturer of the unit, how much that new, energy efficient unit will save in utility, repair and maintenance costs over the existing, outdated unit.
Let’s say that we learn from the manufacturer that the unit we are considering is designed to be very energy efficient. In fact, the manufacturer projects that the unit will save over $700.00 average per year in electricity and maintenance costs over older, less efficient units. Note that no manufacturer will tell you with any degree of certainty what the exact savings will be for your building – there are just too many variables.
Plugging the projected savings into our formula above, we see that the payback period is 12 years ($8,500.00 divided by $700.00). Is that good? The answer is “It depends”. If the owner of the property considers any investment that has a five year or shorter (shorter is better of course) payback period to be a good investment, then this one would not be a winner. The minimum payback period is different for every owner. Do you know what your client’s minimum payback period is? You should find out.
Payback period is a fairly elementary form of investment analysis. But we have considered it first here as a way to introduce these concepts. Consider that we have now gone from a decision about what costs less now to a decision about how long it will take to recover our investment and start making money.
In this case, a payback of 12 years seems on face, to be a bad investment. But if the unit will last at least 15 years (our existing one has gone over 25), after recovering the cost (12 years), we’ll be in positive territory. Not a bad deal.
Would a real estate investor look at two competing property investments purely on which one costs less now? No, they most certainly would not. Even the most unsophisticated investor would look much beyond the immediate cost of a property and consider the net revenues over a projected hold period. This is what using the language of finance is all about – thinking about these things as investments, not expenses and proposing them to the owner in that way.
Return on Investment (ROI)
Sticking with our HVAC repair or replace decision, let us consider the next type of investment analysis, ROI or Return on Investment. This is a cousin of the payback period. ROI is a measure of the return on our original investment, expressed as a percentage. Here’s the formula:
ROI = Total Revenue – Total Cost X 100 ÷ Total Cost
Here, we would take the total revenue (savings in our case), subtract the initial cost and divide by that initial cost factor. We said that the savings were projected to be $700.00 per year. Let’s say that over the projected useful life of the new unit (15 years), we will save approximately $10,500.00.
And using our cost of $8,500.00, we end up as follows:
ROI = $10,500.00 – $8,500.00 X 100 ÷ $8,500.00
This investment would produce an ROI of 23.53% on our initial investment. Now how does that stack up against the repair decision in which there is no return on investment? In fairness, the owner would have to hold the property for all 15 years to realize the full return on his investment. And the unit would have to work well for the entire 15 years without us having to put a lot of money into it (normal maintenance). But all investment decisions are made on a set of reasonable projections.
So, if you can determine your owner’s minimum acceptable ROI on investments (and again, you should know that) and propose these type of projects as “investments” rather than “expenses”, you will get a better outcome, I guarantee.
The last type of investment analysis that we will discuss is the cap rate. This is an abbreviation of the term capitalization rate but most people that speak the language of finance simply refer to this as cap rate analysis.
The cap rate is the ratio of net operating income (NOI) to the value of an asset. Most owners use cap rates to compare two or more proposed investments. The one with the higher cap rate is the one that provides the investor with the higher potential return (all else being equal).
In our case, it is the ratio of the projected savings from the new AC unit compared to the cost of the unit. So, using our previous assumptions about the savings per year ($700.00) and the cost ($8,500.00) of our proposed investment, the cap rate analysis is as follows:
Cap rate = $700/$8,500.00 = 8.24%
So is this a good investment? Again, the answer is “It depends”. If the owner or owner’s asset manager considers any investment that has a cap rate of 8% or higher to be favorable, than yes, this would pass that test. You need to find out what the minimum cap rate threshold for this owner is before presenting this investment for consideration.
For many property managers, the language of finance and the methods of investment analysis presented here are new. For others, the terms are familiar but they have not used these types of analyses when seeking the property owner’s approval for such proposals.
For CPM’s ® and CPM® candidates who have taken IREM’s ® course entitled Budgeting, Cash Flow and Reporting For Investment Real Estate , these terms, concepts and methods are familiar and applicable ways of presenting proposed projects.
For property managers with ambitions to move into an asset management role in the future, understanding and using these concepts is a must. In such a role, you will be analyzing and comparing investments and financing alternatives using these and more complex analytical tools on a regular basis. And then you will welcome this kind of perspective coming from those managing your properties. It shows financial folks that we are not just collecting rents and cleaning buildings (a very unfortunate but all too common perception of what we do).
The next time you need to get the owner’s approval for a large projected repair or replacement project, think about it in terms of an “investment”, not an expense. Consider not only the immediate cost of the proposed investment but the cost over the projected life of the item (known as life cycle costing) and the return on investment from savings over time.
In other words, use the language of finance. Try it and let me know how it goes.