Every commercial real estate development comes with some degree of uncertainty and risk but re-evaluating cost contingencies is the right way forward.
Numerous factors – both known and unknown – will influence overall yields. No amount of research, verification or preparation can guarantee returns for REITs.
One way to protect against the uncertainty of returns on investment is to include cost contingencies. Best practices involve setting aside reserve or additional funds as part of the initial property acquisition costs. A cost contingency will help to cover unexpected expenses when leasing up, increasing rents, making changes in management, undergoing unexpected renovations and cost overruns, rezoning properties or taking on rebuilding expenses.
Cover Negative Cash Flow
One key purpose of cost contingencies is to help cover negative cash flow, where expenses exceed revenues. Negative cash flow can occur when the owner invests in improving the property’s overall performance. Most commercial real estate has a standard contingency budget that ranges from five to 15 per cent of the total budget, depending on the type of asset and its performance. However, COVID-19 has led numerous tenants to vacate their units and properties, resulting in higher vacancy rates and less rental income. The pandemic has also required property owners to increase their maintenance, cleaning, and sanitation expenses. This combination of lower revenues and higher expenses has pushed cost contingencies to the higher end of the range.
Factoring New Occupancy Rates
Commercial property owners must consider a host of new factors to calculate cost contingencies, as many properties are performing below historical averages. One way to calculate cost contingency is to factor in new occupancy rates. Tying rates to the appropriate rent index will help to keep rents at acceptable levels.
REITs can also track the profitability of a specific portfolio based on the tenant mix. This will help to evaluate properties with specific types of tenants to determine if they are performing above or below average. They can use property valuation simulations to assess properties according to their expenses and tenant mixes. This information is crucial to making debt ratio adjustments when faced with the banks’ new lending requirements.
Create a Capital Reserve
Creating a capital reserve or replacement reserves fund is another way to establish cost contingencies. These funds are intended to either finance long-term capital improvements or cover expenses that exceed initial capital improvements. Examples include upgrading the building’s air filtration systems and making upgrades mandated by regulatory changes. Property owners must put these funds aside, equating to about three to five per cent of gross rents, before realizing positive cash flow. The actual amount of the capital reserve fund will depend on vacancy rates and rents charged to current tenants.
The Impact on a REIT
Calculating how much to put aside for cost contingencies and capital reserve funds depends on using the right metrics to create accurate reports. A cost report should include all known and expected costs, a forecast of the costs that are likely to be incurred based on estimates, and cost contingencies or capital reserves to cover unforeseeable costs. These figures will help with calculating how much to put aside before making purchasing decisions.
Creating more accurate reports based on expected expenses and revenues will help with calculating how much to put aside for a capital reserve before making a purchasing decision. Business transformation through technology has proven to get companies through challenging times like in 2020.
Organizations who have invested in proper technology managed to transition their business with ease while others may have survived the downturn but surely the growth projections were not delivered.
Domain 6 Inc. can help REITs identify requirements across the business and put together a solution framework that will allow you to transform while minimizing the impact on the running business.