RHB Magazine Nov/Dec 2021 - Financing Capex Projects RENTT

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Financing CAPEX projects

In this month’s issue, we asked our esteemed RENTT (Rental Executives National Think Tank) panellists to discuss financing of capital expenditure (CAPEX) projects. We took a slightly different approach with this RENTT feature. First, we spoke to rental property owners about how they categorized different types of CAPEX projects, what types of projects they focused on to get the best return on investment, considerations when deciding which projects to choose and finance, and how projects are financed. Then we spoke to financing professionals about changes in CMHC’s funding rules, how rental housing providers are financing different types of CAPEX projects, evaluating CAPEX projects for financing, the future of interest rates, and how rental housing providers can take advantage of today’s low rates. 14 | Nov/Dec 2021

By David Gargaro

Rental property owners

RENTT experts:

Bob Dhillon, Founder, President and CEO, Mainstreet Equity Corp.

Randy Daiter, Vice President, Residential Properties, M&R Holdings

RHB: Welcome to RHB Magazine’s RENTT panel. We appreciate the time and effort involved in participating in today’s discussion and sharing your experience. Our readers will benefit from your input and experience. How would you categorize different types of CAPEX projects? Bob Dhillon: First of all, you have to understand that the majority of buildings in Canada are aging, and aging rapidly. There are many types of renovations that we undertake. First, those which go to the “bones” of the building, the infrastructure: energy-efficient roofs, boilers, plumbing, mechanical, security features, etc. Second, there are the “inside of the box” renovations: low VOC paint, upgraded kitchens, bathrooms, flooring, ceilings, lobbies, etc. Third, there are the energy-saving renovations that we do: double pane, energy-efficient windows,

Brian Jessop, Vice President, Operations, Killam Apartment REIT

water-saving showers and kitchen taps, Energy Star appliances, dual flush toilets, energy-efficient lights, etc. We have also started to do exterior wraps, depending on the building, such as upgraded balcony doors, railings and resurfacing, hardy board siding, metal cladding, insulation, and aesthetically pleasing finishes.

Randy Daiter: Energy-efficient capital projects

we have either considered implementing or have implemented include reviewing pumps and motors for efficiency levels, doing lighting retrofits, upgrading CO sensors, controls, and other equipment in parking garages, analyzing and optimizing chillers and cooling towers, and improving pool pump efficiency. To reduce natural gas consumption, we have tracked and measured usage, installed more efficient equipment, installed programmable thermostats and radiator heat deflectors, switched to more efficient laundry room dryers, and applied for government incentives. To address water usage,

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we’ve conducted water audits, installed high efficiency fixtures, transitioned to low water landscaping and removed irrigation systems, and implemented water maintenance programs. To deal with structural issues, we’ve done repairs and upgrades to balconies, roofs, and garages. For the building envelope, we’ve added roof insulation, weather stripping, new windows, and balcony doors. We’ve also looked at elevator modifications, exterior parking lots, common area corridors, and lobby refurbishments.

Brian Jessop: We look at CAPEX projects

similarly. However, we break the categories into building envelope, maintenance, energy, curb appeal, commercial, insurance, appliances, and repositions.

RHB: Aside from mandatory CAPEX projects, such as building repairs, what types of CAPEX projects do you focus on, as they have the best ROI for increasing rents and revenues? Bob Dhillon: CAPEX that creates the greatest

increase in rental rates has to focus on the largest percentage of renters, the Millennials and Gen-Z in our case. Let’s take Millennials’ preferred locations out of the equation for now; we’ll focus just on what it is they want from a building. Often, they are looking for more minimalistic kitchens with updated appliances including dishwashers and microwaves. They also love technology, which is why we’re piloting things like the Telus SmartHome system currently installed in units at our Sunalta 1913 property in Calgary. These tastes evolve, and so should your CAPEX expectations. We focus on our audience, our customers, and their requirements, excluding the geographic locations, because that is our most important criteria in deciding which CAPEX has priority.

Randy Daiter: For hydro, sub-meters save

approximately $50 to $76 per month in electric bills per suite, and provide tenants with tools to save and manage their electricity bills. Variable frequency drives provide both electricity and gas savings when installed in fans, domestic water and HVAC pumps, make-up air units and air handling units. Lighting retrofits switch old T12 and T8 lights to LEDs in different areas, including exit lights, exterior lighting, corridors, stairwells, lane lighting, and more. Radiator heat reflectors produce 28 to 33 per cent savings in heating costs. Ultra-low-flow toilets provide simple payback in less than three years. Water maintenance programs that include monitoring consumption, checking for leaks, and doing regular toilet and shower head inspections also produce significant savings.

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Brian Jessop: Our highest ROI comes from

projects in energy and repositions. Energy projects result in savings in operating costs, and repositions provide rental lift opportunities.

RHB: What are the major considerations for each type of CAPEX project that get the most weight? Bob Dhillon: The most important consideration

is knowing our audience, our customers; you have to know who you’re serving to know what they want. We cater our brand and our projects to those customer requirements. Environmental, social, and corporate governance (ESG) plays a very important role in these variables, especially the inclusivity aspect. We are working hard on finding environmental efficiencies beyond those mentioned previously, to further reduce our carbon footprint, but pushing the importance of diversity and inclusivity has been crucial to every aspect of our business. This even extends to CAPEX decisions, where community stakeholder feedback and collaboration helps us address issues in innovative ways, which sometimes avoids spending on CAPEX. This inclusivity makes our tenant base more willing to work with us when it is time for a project, though, because we don’t just know how to communicate with them; we are them. You would be hard-pressed to find a more diverse and inclusive team in this industry.

Randy Daiter: We take both quantitative and

qualitative considerations into the analysis. Typically, projects with a one- to three-year payback or that increase the overall comfort, aesthetics of curb appeal or suites take priority. For example, we have replaced windows at many buildings. Key benefits of these projects include improvement in building aesthetics and better curb appeal, improved tenant retention and referrals, increased resident comfort through warmer suites and significantly reduced traffic noise, cost savings through both energy savings and reduced maintenance costs, increase in overall building value, and reduced ambient noise, air, and water infiltration. The ability to recover costs in an AGI are also taken into consideration.

Brian Jessop: Considerations for support of

different categories is savings or ROI, protection of asset, such as leaking roofs and water damage, tenant comfort, such as leaking windows or air infiltration, curb appeal, and the professional appearance of our buildings. We also consider stewardship or long-term protection of the asset. ESG is important but many times this comes out of projects that have other positive returns. continued on page 20

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RHB: In financing CAPEX, what major considerations do you pay the most attention to?

Financing professionals

Bob Dhillon: We have been very fortunate

RENTT experts:

over this last while, as we have enjoyed long periods of low interest rates. Conditions like this make some building renovations feasible that may not be at other times. We have an annual spend of approximately $40 million on combined maintenance improvements and major capital improvements. Our financing charges have been at all-time lows, around 2 per cent. Our rate of return has only had to exceed a very low hurdle; this has really helped us to expand our ability to provide quality affordable homes.

Randy Daiter: Cash-flow and the cost of

financing are major considerations. Grants and incentives are also taken into account in evaluating payback periods or ROI.

Evan Pawliuk, Assistant Vice President, Commercial Lending, First National

Brian Jessop: Our priorities would be the

comfort and safety of tenants, long-term protection of the asset, curb appeal, and payback. This is the reason we have multiple categories, each with a defined budget amount, so that we support each category and stay disciplined to all versus investing in one category over the demise of another.

RHB: How do you finance different types of CAPEX projects? Bob Dhillon: We finance in a variety of ways,

depending on market conditions and the nature of the project, among other considerations. Our methods include using free cash flow, obtaining low-cost debt financing or retained earnings. We also use bank facilities / lines of credit, utilizing whatever is most appropriate for the project.

Randy Daiter: We have participated in financing through the City of Toronto’s High-Rise Retrofit Improvement support (HI-RIS program). We used this in replacing windows at two high-rise apartment complexes. Overall, we thought it was a very interesting program and there were a lot of benefits to it, including no need to register a mortgage on the property, which meant not encumbering the property’s title. It was also quicker, cheaper, and easier than obtaining traditional financing.

Brian Jessop: We finance our capital program through our earnings.

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Paula Gasparro, Vice President, Real Estate Financing, CMLS Capital

RHB: Welcome to RHB Magazine’s RENTT panel. We appreciate the time and effort involved in participating in today’s discussion and sharing your experience. Our readers will benefit from your input and experience. Since CMHC changed its use of funds rules in May 2020, what changes have occurred in how rental housing providers are planning or financing CAPEX projects? Paula Gasparro: CAPEX must be spent after

the CMHC insured financing takes place in order to satisfy the new rules. If the CAPEX was done prior to the insured financing, it cannot be a use of funds under CMHC’s changes. As a result, some rental housing providers may be delaying CAPEX projects until after refinance has occurred.

Evan Pawliuk: With CMHC’s equity takeout

requirements, this has made rental housing providers plan their capital expenditures around their financing events, such as a maturity of an existing loan. In the past, rental housing providers may have gone ahead and spent on their capital expenditures out of cash on hand or through cash flow from the properties and then repatriated the funds through a CMHC loan. That is no longer possible. We have been engaging with our clients to discuss their plans for their portfolios to ensure the proper planning is put in place. There are other solutions available to groups to allow for the capital expenditures to go ahead without delays, but planning with your lender is very important.

RHB: In your experience, how do rental housing providers tend to finance different types of CAPEX projects? Paula Gasparro: Most rental housing providers have strategies as to which CAPEX projects they work on in a calendar year. Generally, these are funded via equity or accumulating reserves from NOI.

Evan Pawliuk: Depending on the size of the

rental housing provider, some would do this through financing or cash on hand that has been earned off the cash flow from their portfolio. One area that CMHC’s equity takeout rules provide some flexibility is that the financing from one building can be spent across the rental housing provider’s portfolio versus toward the building that was financed.

RHB: How do you evaluate different types of CAPEX projects with respect to approving financing? What criteria do you use for different financing situations? Paula Gasparro: Any capital improvement to a multi-family building that involves spending dollars to complete is considered CAPEX. At CMLS Capital, we require the borrower to provide us with invoices for work completed and it would be helpful to have before and after photos.

Evan Pawliuk: The criteria for an allowable

capital expenditure is quite simple. If the capital expenditure is related toward an improvement that is not recurring on an annual basis, then we would accept that as an allowable capital expenditure.

RHB: Where do you expect interest rates to go in the short term?

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Paula Gasparro: We have been very fortunate

over the past few years to be in this very low interest rate environment. All good things usually come to an end. I see the Bank of Canada raising rates slowly starting in Q2 2022.

Evan Pawliuk: Unfortunately, this is a question no one really knows the answer to. In the recent past, there has been a lot of volatility within the bond market because of the uncertainty of the path of recovery of the economy going forward, and questions around the nature of the inflation that is being experienced currently. I am an advocate of mitigating any risk within business where possible. Real estate is a cash flow business, and one of the biggest pieces of determining what your cash flow will be is understanding what your principal and interest costs are going to be. To help our clients remove this risk, we created an Early Rate Lock program to allow for rental housing providers to lock in their interest rate up to six months in advance of the funding date. We have seen a lot of take up in this product lately, given the rise in rates being experienced.

RHB: How are rental housing providers taking advantage of today’s low borrowing rates when financing their CAPEX projects? Paula Gasparro: We are seeing borrower

select longer terms when financing their projects, ten-plus year terms when available. There has been a lot of refinancing. There have also been acquisitions and construction of new multi-family properties.

Evan Pawliuk: There are a couple of ways to

take advantage of the current rate environment if you do not have an upcoming mortgage maturity, or a property that is free of any debt. You could look to refinance one of your properties with a maturity date in the near future, or through a CMHC second mortgage. With the upcoming maturity option, I would recommend looking at the cost of borrowing by incorporating any prepayment costs to determine what the additional funds being borrowed will cost for that term, and compare toward what you could invest those funds into. With a CMHC second mortgage, there is a similar cost of borrowing as a CMHC first mortgage.

RHB: Thank you for your participation.