Consider the Leased-Space Market

May 11, 2009
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One of the major markets for commercial HVAC contractors in the Northeastern United States is the leased-space market. Just a few years ago, these were difficult areas to contract new work providing maintenance or energy upgrades, due to the difficulty of getting to the decision maker: the owner. In today’s real estate market, however, the power has shifted to the tenant in many of these situations, and with this shift has come a renewed opportunity for contractors to increase their revenue.

It’s a renter’s market.

Increasing a building’s energy efficiency and comfort also makes the space more rentable or valuable to the owner. These are things that successful HVAC contractors in the leased-space market have educated themselves on, especially in the Eastern United States, where leased commercial spaces abound.

“A lot of tenants supply a lot of work to us,” said Jim Whitescarver, president of Commercial Express HVAC, Chantilly, Va. “We’re always chasing the value proposition, something better than the competition can offer.

“Our best client is a highly educated consumer,” he said, whether that’s the tenant or the owner. “They know what’s available and they can differentiate between the good, the bad, and the ugly. We’re dealing oftentimes with cheap engineers who are either understaffed or the job is too much for them; or property managers who need happy tenants.”

The contractor is just dipping his toes into Leadership in Energy and Environmental Design (LEED) certification, which is also being market driven. “Property management companies are asking for suggestions on how to get their buildings LEED certified and use more energy-efficient systems,” said Whitescarver.

“We are looking in that direction because a great deal of our client base is either an owner or an operator,” said Lee Selph, senior project manager in Commercial Express’s design-build and plan-spec Installation and Replacement Group. “I don’t think anyone’s looking at mechanical systems the way they were 10 to 20 years ago.”



KNOW THE LEASES

When contractors enter the tenant-owner commercial market, they need to know about lease terms in addition to the mechanical systems in the buildings. This will give them a base from which to decide whom to direct their education to and which situations are more likely to influence energy-based decisions.

Tim Kensock of building performance-analysis firm AirAdvice, said, “The dynamic of who pays and who benefits is one that contractors need to understand and pay close attention to when they choose their targets. When the tenant is responsible for all operating costs, it’s certainly one where the contractor should develop a relationship with the tenant.

“The owner is impacted by a building that doesn’t operate at peak efficiency,” which affects the total cost of leasing a space. “The tenant wields a lot of power in those relationships,” Kensock said. “It’s one that building owners do pay attention to, but they may need a little prodding from their tenants. Contractors can act as a catalyst. Some of the service work may be contracted with tenants, too.”

According to Mark Jewell, CEO of RealWinWin Inc., three factors determine the effect of rising energy costs on the value of any income-producing property: Whether the leases are net, gross, or fixed base; whether the lease addresses energy separately or combines it with other operating expenses, such as utility expenses; and whether the actual operating expenses were higher or lower than any expense stop level or base year cited in the lease, both before and after the increase in energy cost.

“Under a net lease,” he said, “the tenant absorbs the full energy cost increase. However, the tenant may not want to renew their lease if the energy costs are too high, at least without renegotiating the rent.” Owners may see “downward pressure on base rents if net-lease tenants are forced to shoulder the entire burden of rising energy costs,” said Jewell.

Under a gross lease, the owner is the one who absorbs energy cost increases. “Any increase in the owner’s operating expense lowers net operating income (NOI),” said Jewell, “which can depress the appraised value of the property (given the income approach to appraisal and no change in capitalization rate). The owner may try to preserve NOI by raising the base rent for all new tenants by the same amount as the increase in his operating expenses.”

This strategy doesn’t work well in weak rental markets, where tenants seek - and can find - better terms. And existing tenants might also seek lower rental agreements if they feel they are absorbing too much of the operating expense. “In this market, management firms and owners are scrambling to make their properties attractive,” said Selph. “It’s absolutely the renter’s market. If there’s an owner who wants to rent the space, he has to have a pretty sweet deal. We’re part of that equation.”

“The terms of a fixed-based lease could allocate increased energy costs to the tenant, the owner, or both, depending on whether energy expenses before the cost increase were above, at, or below the expense stop,” said Jewell. “The tenant would be responsible for amounts above the stop, and the owner for amounts below the stop.”

Fixed-base leases can delay the negative impact of higher energy costs for the owner. Even if operating expenses are at or above the expense stop, the landlord may have to set a higher expense stop for future leases. Unless the owner can raise the base rent to compensate for this increased stop, net operating income will fall in the future, which may eventually depress the appraised value of the property.

There are other ways that the energy market can adversely affect the investment real estate market, he said. “Operating the building outside normal temperature ranges, for example, to control costs or cope with power unreliability can affect how current and potential tenants perceive the space,” Jewell said.

“On the other hand, buildings with better technology may see greater market demand and higher rents because increased energy efficiency reduces the building’s vulnerability to energy price spikes. Similarly, tenants may see advantages in leasing space with backup generation that can keep the building humming during a rolling blackout.”

Buildings with better-than-market electricity/gas supply contracts may also enjoy a competitive advantage, he said.



RENTER'S MARKET

According to Whitescarver, “I would bet that 80 percent of our maintenance contracts are direct with the tenant and 20 percent are with the property management group. Those tenants were often referred by their property management group.

“Things have been evolving back and forth,” between tenants and owners, he continued. “Right now, the landlords and management groups are providing more services to the tenants, to keep those spaces occupied.” In full-service leases, “the HVAC contractor that brings more than filter changes is beneficial to any property manager,” said Whitescarver. The major benefit to the landlord is to keep the tenant happy. “Discomfort is a major reason for a tenant to leave the space.”

In his market, “the biggie is comfort,” he said. “Yes, everybody is wanting to save their nickels right now on their utilities. One of the biggest things we can bring to the table is exceptional maintenance, lowering those utility costs.” This contractor strives to provide more effective maintenance. “We’re spending two or three times the amount of time, cleaning, getting compressors running more efficiently, performing coil cleaning. We find that a lot of contractors are not getting that done.”

“Some landlords are reacting to softer leasing demand by offering more concessions up front (e.g., more dollars for fit-outs, a longer free rent period up front) rather than wholesale reductions in base rents (which would have a greater impact on the asset’s value),” said Jewell. “One might speculate … that a tenant who did know enough to demand superior mechanicals (and who was planning to lease enough of a building to be able to impact the building’s choice of mechanical systems) could demand a more efficient mechanical profile as a condition of signing or renewing a lease, and in today’s market, such a request would warrant more attention than usual from a landlord desperate to fill (or not to create more) vacant space.”

Properly marketed, he said, “More efficient mechanicals could give a building a leasing edge. For example, a building that has an HVAC system designed around both efficient equipment and proper zoning could help a tenant in at least two ways: Lower cost of operation per square foot (saving money now, and offering a hedge against increasing cost per unit of energy in the future); and better zoning functionality could lower a tenant’s cost for afterhours usage (e.g., avoiding the need to heat/cool more than the tenant’s own space if that tenant needs conditioned air after-hours).”



GREEN MARKET

The Building Owners and Managers Association (BOMA) International pointed out that “despite a faltering economy, commercial building owners are continuing to allocate funds and resources to green their portfolios.” A 2008 “Green Survey (of) Existing Buildings” showed that more than 80 percent of respondents allocated funds to green initiatives that year; 45 percent said that their sustainability investment will increase in 2009.

The study also showed that energy conservation is the most widely implemented green program in respondent properties, followed by recycling, water conservation, and Energy Star® product programs. It focused on the application of green methodologies and technologies in existing commercial buildings and on the financial and marketing benefits of these efforts.

Furthermore, 60 percent of those polled said they offer educational programs to assist tenants in implementing green programs, up from 49.4 percent in 2007. And nearly 70 percent of survey respondents said they have implemented some type of benchmarking system to monitor energy usage and efficiency, while 80 percent say that their energy efficiency efforts have helped defray rising energy costs (which impacts operating costs).

Finally, almost 65 percent of respondents feel that their green investments have generated a positive return on investment (ROI), up from 60.8 percent in 2007. “The survey findings further support the critical role of energy efficiency and sustainability in the existing building market,” said Richard D. Purtell, BOMA International chair and chief elected officer, and portfolio manager for Grubb & Ellis Management Services Inc. “The energy and cost savings, coupled with healthy ROIs, are showing that green investment in commercial buildings is a smart business decision in any economic climate.”



SUCCESS TIPS

Both commercial real estate owners and managers want to reduce building operating expenses, pointed out Jewell of RealWinWin, an analysis software firm. “More important, they need to know that they will earn a return that is equal to or greater than their hurdle rate.”

Proposals that promise lower operating expenses, like HVAC upgrades, need to direct resulting savings to the owner to meet or exceed the owner’s required rate of return on that upgrade investment.

“Owners/managers and vendors have big incentives to work together on this issue,” he said. “Net operating income is the mother’s milk of real estate investors.”

With occupancy and rental rates falling in many markets, however, owners/managers of income properties need to focus on the expense side of the income statement to build net NOI and support increases in appraised value. Vendors, on the other hand, want better access to decision makers.

“One of the surest ways to get the owner of an income property to say yes to a suggested upgrade is to make sure that the proposal includes an NOI builder study,” he said. “Investors don’t make decisions based on watts or therms, but on financial returns. Citing the simple payback period of the upgrade won’t do it either, because the owner needs to know how much return to expect.

“From the owner’s perspective, a two-year simple payback period (SPP) project in a building where the leases allocate half the savings to the tenants is really a four-year SPP project. Similarly, knowing that there are rebates to help subsidize a project won’t always win an approval.”

In this commercial rental market, keeping the renter happy means keeping the building owner happy - all of which is good for the contractor’s bottom line.

For more information, visit www.airadvice.com, www.boma.org, or www.realwinwin.com. To obtain a copy of the complete BOMA survey and results, visit www.globest.com/green.

Publication date: 05/11/2009

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