THE DOLLARS AND SENSE O F C A P I TA L EXPENDITURES
Greg Romundt
Bob Dhillon
Jason Ashdown
President and CEO, Centurion Apartment REIT
CEO & President, Mainstreet Equity Corp.
Co-founder and COO, Skyline Group of Companies
Randy Daiter
Dean Pandurov
Vice-President, Residential Properties, M&R Holdings
CEO, PAN Group Developments
RENTT R e n t a l
E x e c u t i v e s
N a t i o n a l
T h i n k
Ta n k
In this month’s issue, our esteemed RENTT (Rental Executives National Think Tank) panel discusses topics related to capital expenditures (capex), including how to determine which projects take priority, the capex planning process, the importance of tenant involvement, tying capex projects to marketing strategies, signing contractor agreements, and more.
Welcome, everyone, to RHB Magazine’s RENTT panel. Thank you for taking the time to participate and share your insights and experience. We are sure that our readers will learn a lot from your responses. Today we’d like to talk about capital expenditures, or capex, projects.
RHB: To begin, whom or what do you rely on when determining which capex projects should take priority? Randy Daiter: We consider an abundance of factors including property condition assessments (PCAs), as well as input from internal staff, contractors and engineers. Jason Ashdown: Skyline is a fully integrated company: we raise the money, buy the assets and perform all asset management and property management within our group of companies. As a part of our asset management group, we have a designated team to manage capex. This group also has a hand in managing new developments, major repositionings and portfolio efficiency initiatives. Greg Romundt: We have an internal technical services team but we also support this team with external consultants’ reports and engineering as required.
RHB: Bob, I understand that you don’t engage in many capex projects. Could you explain why? Bob Dhillon: Under our business model, we buy only distressed buildings, meaning neglected or deferred maintenance, so every building we buy, we gut to the studs and reposition them. Most of the buildings, after they have gone through the Mainstreet Value Chain, do not have a lot of capex.
RHB: Interesting. So, what is your decision-making process when prioritizing capex projects? How do you decide on choosing one over the other, or doing certain projects first? Bob Dhillon: As stated, we gut every building we buy, and every building goes through a complete transformation. Randy Daiter: In addition to what I said earlier, we consider many factors, such as a review of the Facility Condition Index, on-site inspections, energy efficiency and related savings, tenant comfort, curb appeal, marketing opportunities, tenant feedback, life-cycle costing analysis, physical obsolescence, environmental benefits, simple-payback calculations, and more. Greg Romundt: We prioritize based on a ranking system with five categories in terms of declining importance, where one is immediate high importance and five is low importance. The categories are one, fire or life safety, risk management or bank undertaking; two, improved marketability, near-term benefit; three, energy savings or reduction of operating costs; four, improved marketability, long-term benefit; and five, deferred maintenance.
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RHB: I see. How about you, Jason and Dean? Jason Ashdown: When it comes to choosing which projects take priority, capex items fall into two categories – “needs” and “wants.” Projects that we “have” to do put people or property at risk – resident and staff safety is our first concern. Projects we “want” to do generally are accretive to make the property produce better returns from either reduced expenses or improved incomes. Dean Pandurov: Safety and building structural integrity must be primary triggers in the decision-making process. Tenant safety can never be compromised and therefore these two aspects go hand in hand when deciding what projects are taking precedence.
RHB: How important is energy conservation to your capex decision-making process? Bob Dhillon: Mainstreet was green before green became popular. Every building we buy, we install energy-efficient toilets, windows, insulation, showerheads, furnaces, and have been doing this for over 14 years. It is important to be leaders in the carbon tax footprint we leave. It also has long-term implications on net operating income (NOI) because all utility / water prices are going up, so the compounding effect of year-afteryear operating costs is a number one priority. Dean Pandurov: Energy conservation is certainly one of the top priorities. As a landlord or developer, green initiatives, LEED certifications and net-zero goals are just some of the scorecards we use to measure our ability to cut dependency on fossil fuels and conserve energy. Tenants are increasingly more aware and educated with respect to energy conservation and green buildings – and that’s great news. To maintain their competitive advantage when it comes to cutting energy costs and overall operating expenses, landlords must do all they can to cut building energy usage and make their buildings energy smart, as well as more appealing to today’s demanding renters. Jason Ashdown: Energy conservation is a huge driver for our capex decision-making. Buildings are valued on income – anything we can do to improve income increases the value of the asset. So projects that reduce expenses are equally as important as raising rents – and sometimes more achievable.
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RHB: So energy conservation is important.
RHB: That is an interesting view. Anyone else?
Randy Daiter: It’s extremely important. It helps us create a business case in justifying quantitative benefits, such as simple paybacks, due to decreasing energy consumption. It also creates qualitative benefits, such as better advocacy, increased tenant comfort and/or convenience. Environmental benefits are also considered, including a calculated reduction in greenhouse gas emissions.
Randy Daiter: In our experience, the installation of window / balcony door replacements and exterior insulation and finishing systems have the greatest impact on improving aesthetics. We have not only increased the amount of sunlight coming into suites by replacing solid spandrel panels in the transom above the balcony doors with clear vision panels, but also replaced solid 40+ year-old wood slab doors with newly insulated doors with operable windows.
Greg Romundt: It is very important, and we constantly strive for improvements in operating performance. However, it ranks third for us because other issues like life safety trump any other concern.
RHB: What significance is given to cosmetic upgrades when doing capex projects? Dean Pandurov: We rarely look at the building and say we just want to do cosmetic work and put a pretty dress on the structure. There is a lot of confusion when the landlord does work that is considered cosmetic. However, it is the consequence of more important undertaking that often requires structural repair and/or building envelope rehab. In this context, it is easy to understand why landlords frequently opt to do cosmetics afterward as a final step of responsible capex project completion. This often involves the coating of the building envelope or replacement of structurally compromised glass balcony railings.
Safety and building structural integrity must be primary triggers in the decision-making process. Tenant safety can never be compromised and therefore these two aspects go hand in hand when deciding what projects are taking precedence. DEAN PANDUROV
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Jason Ashdown: People want to be proud of where they live and will pay more to live in a nice place, so the cosmetic side of capex is important. Although it is sometimes difficult to know just how tangible the ROIs are on cosmetic upgrades, it is part of the overall positioning or repositioning of the property. The real trick is knowing where to draw the line for the property and target market. Greg Romundt: Residents may not see or appreciate the money you spend on roofs or brick work, but they see immediately and value the quality of the things they do see in the common areas and in their units. It affects rentability and the value perception of residents. Bob Dhillon: All of our buildings have interior and exterior upgrades, which is the same in all locations.
RHB: What is involved in the capex planning process? What timelines do you use? What is involved in budgeting? Bob Dhillon: We involve our designer, our VP Capex and VP Operations, and our operations team on the drawing board. As for the timelines, it is usually six months to 18 months. Our latest projects, 331 units in Surrey, took six months. As for the budgeting, it is involved in our business model, so it is not a budgeting process; it is a business model practice. Jason Ashdown: It is a daily, weekly, monthly and annual exercise. It starts with the due diligence of a property we are considering purchasing and then is revisited as required – but at least annually. The property is considered and reviewed on a number of levels – from structural, energy management and cosmetics and then a budget number and plan are put in place within a five-year framework. Greg Romundt: We use five-year plans by building and then break these down into yearly buckets by project.
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RHB: I see. What is involved in your capex planning process, Dean? Randy? Dean Pandurov: Capex planning is an integral part of building acquisition due diligence. It is an important part of every building’s budget. As the landlord prioritizes the capital work undertaking, the cost must pass rigorous scrutiny of allowable expenditure. Therefore, past the due diligence and approved budgets, we have timelines for different parts of the process. The actual capex budget involves proactive action or preventative measure to protect investment asset. As such, it is driven by two factors: increased asset value and improved NOI. It is also considered in an ROI formula and the reasonable time for the capex investment to be fully paid for. Randy Daiter: We start with building condition assessments being prepared by engineers for each property. The results are then parlayed into a major expenditure five-year+ (capex) budget, followed by a composite summary of major expenditures (broken down by category), and then integrated into a 15-year cash-flow projection.
RHB: How important are capex improvements to your overall marketing strategy? Dean Pandurov: It is crucial. Today’s tenant is becoming increasingly discriminating. New Millennials are truly dictating to landlords what kind of buildings they prefer to call home. In essence, we have a home ownership mentality versus old thinking that renters are forced tenants as a temporary solution. Tenants want to know that they live in healthy, modern, friendly and safe buildings. Greg Romundt: We spend quite a bit of capital on improvements. We believe this is key in driving marketability and ultimately returns. Bob Dhillon: Everything revolves around our Mainstreet Value Chain, which correlates to upgrading buildings based on our specs. Jason Ashdown: Once again, our customers – just like any consumer – are looking for good value, so we need to always keep our properties in good condition and “best of class” so that we can compete in our 46 different markets. We market efficiency initiatives, as we have found that many tenants want to live in a building that has been upgraded to reduce the carbon footprint.
RHB: For buildings subject to rent control, do you plan to take rent increases as a result of capex projects? And if so, how does rent control figure in obtaining rent increases for capex work? Greg Romundt: Yes, we will take rent increases. We assess all of our capex work and determine whether we can get an increase that would be supported in relation to market rents in determining whether we will seek a rent increase. Most of the time, there is room to do so, but not always. Whether or not there is a return to the capex work, properties still need to be maintained, and we will do required works. Bob Dhillon: We have not done this as of yet. The only rent control environment that we face is in Lower Mainland, and we have not used the capex projects for an increase in rental rates. Most of our properties are in Alberta and Saskatchewan. Randy Daiter: We conduct a comprehensive sensitivity analysis of what percentage of standing tenants in a building can tolerate an above guideline increase (AGI) for major expenditure projects. We developed an algorithm, to ensure we remain competitive, while not having a negative impact on retention of tenants who are close to market rents. To date, our data-based approach in analyzing AGI opportunities has not inhibited our interest in pursuing capex projects, notwithstanding current rent control legislation for standing tenants. We have been able to demand higher market rents on turnover in many buildings, as a result of capex improvements.
RHB: How about you, Dean? Jason? Dean Pandurov: Yes, anything else would be irresponsible. It is a specific formula used to calculate qualified capital project. Factors include number of tenants affected, type of amortization used for specific building remedy, interest rates and cost of project. The process also involves certain timelines and due diligence involving timely tenants’ notices, communication, etc. It is very specific and very exact. Jason Ashdown: It depends on the project – but yes, generally. In the case of property repositioning, its sole purpose is to achieve high rents upon tenant turnover and improve property value. Once again, depending on the project, a landlord can file for a rent increase above guideline from tenants, and we sometimes do. My experience has been however that the AGIs generally are a splash in the pan for the true cost of the projects.
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RHB: How much importance do you place on tenant involvement, and how do you go about getting them involved in the decision-making process? Jason Ashdown: Generally, projects are born from a recognized want or need at a property. Understanding tenants’ wants and needs are certainly a part of the process. One key piece however is the ongoing communication before and during renovations. It is generally the tenants’ lives that are disrupted during renovations – so having meaningful and clear communication with tenants is crucial to keep the peace.
RHB: Great stuff. What issues can or have gotten in the way of the success of a capex project? When issues arise, how can owners get out of a contractor agreement? Greg Romundt: The greatest issue in our experience is interference in resident enjoyment of the property and the impact on marketability while projects are ongoing.
Dean Pandurov: Tenant involvement is a must. It is now part of necessary due diligence. Proper notices and meetings are required. This aspect is not voluntary anymore. The best way for tenant involvement is a friendly all-tenants meeting prior to work commencement and after proper notification to discuss all micro activities that are vital to the overall success of the project.
Dean Pandurov: There are many issues that can arise. Project management involves being in control and on top of them. The issues may vary from misinterpreting scope of work, lack of proper work execution to late payment problems and tenant issues. Severing contractual obligations with an awarded contractor must involve mutual agreement or litigation/arbitration. In litigation cases, the landlord often has to fight a property lien first to successfully complete the project past the interruption.
Bob Dhillon: We change our specs periodically. We have a sample tenant group that we invite to get their input on image, operations quality control, etc. Some great ideas come from our tenants. We are transforming our company into one that is customer-service based. We no longer have tenants; we only have customers.
Bob Dhillon: The biggest issue is cost overruns, when contractors give a fixed cost budget and they never rely on it and sometimes we are at the mercy of contractors in the middle of a project. Needless to say, when it is this type of contractor, which is rare, we will never deal with them again.
Greg Romundt: We don’t often seek tenant involvement in determining capex priorities as these are a function of risk management and return priorities. The only times we generally seek resident feedback will usually concern amenities that we may be considering to add and we want to know what the residents value, whether it be a party room, gym or lounge.
RHB: I see. Randy, I understand that you have an engagement model for major capex projects. Could you elaborate? Randy Daiter: After involving our tenants in implementation of projects, we discovered a pattern. We achieved the greatest results when employing this model. This approach has become a priority when rolling-out major capex projects. The first step involves sharing your vision with tenants. We do this using a number of tools, including tenant newsletters, posters, notice boards and special events. The second step involves listening to residents’ desires and recommendations. By accepting feedback, we create a relationship that allows for higher buyin. It has also revealed new opportunities we wouldn’t have considered. A tenant’s small recommendation can have a huge impact on the success of your initiative. The third step is partnering with the tenants’ association. This creates a sense of unity between everyone involved. Finally, it’s critical to repeat this model over and over, throughout the duration of the project. Once again, by following this model, it’s helped us implement our most successful capex projects.
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RHB: Are there any insurance liabilities or riders to consider when undergoing capex improvements? Dean Pandurov: Absolutely. It is in everyone’s interest, especially the landlord’s, to ensure all liabilities are covered. Landlords therefore should always make sure that they are protected under their own umbrella insurance as well as contractor’s policy for specific projects, buildings and reasonable time after the project is completed. Jason Ashdown: Yes, always make sure your trades and contractors have WSIB and liability insurance as well as a good work ethic to always keep the safety of the residents in mind. Greg Romundt: Yes. You need to discuss with your insurance broker when you are undertaking large capital projects. Bob Dhillon: We take all precautions so there are no liabilities.
RHB: What capex projects do you prioritize directly after acquiring a new asset? Bob Dhillon: Like I have said, our business model is different that the REITs. When we buy a project, the whole building goes under transformation.
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RHB Magazine surveyed the RENTT panel on how they would rate different factors that affect capex projects. We used a non-scientific method to assign points to each participant’s answers and calculated a score by percentage.
Owners ranked capex projects in order of quickest ROI:
88%
68% 64%
Owners ranked capex projects in order of improving vacancy: 88%
92%
72%
Roofing
Mechanical systems
60% 48%
Cladding
Common areas
Roofing
Cladding
64% 64%
Windows and balconies
70%
Mechanical systems
Common areas
Windows and balconies
76%
80%
Cladding
Environmental impact
Payback required
Cost
64%
80%
Common areas
80%
76%
Windows and balconies
76%
Return on investment
Benefit to building tenants
80%
Roofing
88%
Owners ranked capex projects in order of priority:
Mechanical systems
Owners ranked the factors that influence their decision to engage in a capex project:
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People want to be proud of where they live and will pay more to live in a nice place, so the cosmetic side of capex is important. Although it is sometimes difficult to know just how tangible the ROIs are on cosmetic upgrades, it is part of the overall positioning or repositioning of the property. JASON ASHDOWN
RHB: What are the most important components to consider when signing a contractor agreement? Greg Romundt: Contractor reputation and experience matter more than anything to us over what is in a contract. If you need to end up referring to the contract, chances are you shouldn’t have selected that contractor. Contractor selection and due diligence are the best protection from problems. Dean Pandurov: Contractors’ reputation and experience, ability to perform timely work both financially and expertly, and zero exposure to any type of liability. Bob Dhillon: I believe the paper it is written on is worthless if you are dealing with dishonest people, so the reputation of the contractor and past experience on how they performed is more important than a piece of paper.
RHB: What would you add, Jason? Jason Ashdown: Making sure the scope of work and details have been covered – remove as many of the “grey areas” as possible. Most importantly, use trades you know and trust and check references.
RHB: Understood. How about the rest of you? Jason Ashdown: Generally, we look for accretive items that other landlords might have missed, like lighting and mechanical upgrades to save energy – but it is generally the overall condition of the property that dictates the work required. If the property is in good shape and has been well maintained and managed, then very little will be done other than rebranding. If the property was purchased in distressed condition and requires repositioning, it could require many months of work and many millions of dollars to stabilize. Randy Daiter: We find that capex priorities change based on market conditions, the physical state of the individual properties, targeted audience’s needs and the strategic business plan objectives established for each individual property. Greg Romundt: Life safety is the first priority and anything to do with risk reduction. Afterward, we are looking to our prioritization categories for guidance on the order of completion. Dean Pandurov: We also focus on tenant safety, including life safety systems and the building’s structural integrity.
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RHB: How should you structure your payment terms to ensure prompt and proper completion? Bob Dhillon: Part of the contact is where we schedule payment on progression basis; the key word is progression. They do the work, we inspect, we pay them. Dean Pandurov: Thirty-day payment terms are ideal. This is not always possible with large organizations and REITs with many monthly transactions. The approval processes are often convoluted but need to be accounted for. Therefore, terms need to be mutually agreeable, so there is no one formula that is ideal for everyone. Terms need to be agreeable and both parties must consider each other’s rights and the executed agreement to move on past the potential conflict. Randy Daiter: We pride ourselves on paying contractors and consultants on a consistently prompt basis. However, one must be careful when considering penalty clauses for scheduling delays, as they are often saddled with performance bonuses for early completion.
Thank you all for sharing your insight and experience. RHB