Top Four COVID-Inspired CapEx Challenges and Solutions

SAN FRANCISCO—Between all-time low hotel occupancy rates, fizzled retail rent payments, and an increase in office rent abatements and lease extensions, one thing has become evident across the commercial real estate landscape: capital expenditure spending is frozen, says Harris Cohn, vice president of commercial real estate with Carbon Lighthouse. Public first quarter 2020 REIT investor reports reveal approximately $600 million of previously announced capex spending in 2020 will be deferred.

For example, one office REIT ranked in the top 10 in terms of market value announced in fourth quarter 2019 it would spend approximately $500 million on development and repositioning to earn a 5 to 7% yield. At the end of first quarter 2020, the REIT announced it would put $73 million in “discretionary capex” previously planned for the rest of 2020 on hold.

“Based on the age of most US commercial buildings, many capex budgets were originally directed towards modernization of existing assets to reposition the property for increased rents,” Cohn tells GlobeSt.com. “But now, real estate owners need to make difficult choices between investing in existing assets, forgiving rent and making debt service payments.”

As CRE owners finalize 2021 budgets, there will be obstacles in optimizing properties for a post-COVID-19 world. Cohn says there are four capex challenges that have risen to the forefront due to the pandemic but there are ways owners and investors can address these obstacles:

1. Prioritize making buildings more resilient to virus transmission: Owners of office buildings need to act quickly to implement COVID-19 safety measures before reopening. While critical to boosting tenant confidence in a building’s safety, these measures can be expensive and significantly impact operations budgets. For example, decision-makers are taking an everything but the kitchen sink approach to implementing COVID measures in HVAC systems, such as running them 24/7. But data from Carbon Lighthouse’s AI platform reveals that if all extreme COVID HVAC measures were implemented, a typical 115,000-square-foot office building that spends $230,000 per year on utilities on average would increase that spend to $370,000 per year.

“And, some of these costly precautions don’t make the building safer,” Cohn tells GlobeSt.com. “Instead, CRE leaders can seek science-based data-backed solutions. This includes ensuring HVAC systems are set to three to four air changes per hour and that filters are upgraded to MERV 13-16, rather than the standard MERV 8.”

2. Backlog in required capex work: Moving into 2021, building owners will encounter a glut of capex projects. Decision-makers will need to reprioritize previously planned equipment replacement and maintenance now that capex must be reallocated to COVID-19 safety measures. Hotels will especially feel a crunch, as most have trimmed down staffs to a bare minimum.

“Fortunately, the way to prioritize capex projects is simple: fix whatever is costing the most money or most impacting occupants first,” Cohn tells GlobeSt.com. “Then, be honest about where your team might need support in the new year to execute on the remaining projects. Consider hiring a third party who can provide the same or more value for less.”

3. Lack of vendors that can prove ROI: With cost-cutting a top priority, owners must review the deliverables promised by vendors and only work with those that can prove ROI through data. By carefully reviewing vendor contracts, owners will better understand what deliverables are and can identify a specific financial return for each dollar of capex invested. Owners should also question assumptions and estimated return from vendors to get the maximum result for the spend.
4. Deferred capex will impact NOI: In an economic recession, it’s reasonable that portfolio managers and property owners will be looking to divest assets. But in the current climate, finding a buyer will be difficult–especially if the building has deferred capex.

To make a property more attractive, owners should invest in energy-efficiency measures to streamline operations, decrease overhead costs and ultimately increase NOI. Data shows that a $100,000 lifetime savings in utilities equates to a $1.5 million gain at disposition or roughly 250% return on investment.

For those in the unique position to buy, capex should be top of mind in vetting potential assets and throughout negotiations, as deferred spending could point to potential issues resulting from outdated or failing equipment which can directly impact NOI, Cohn says.

“Many uncertainties lie ahead, but CRE owners and investors must continue to drive their investments forward,” Cohn tells GlobeSt.com. “Asking the right questions, partnering with the right vendors and making data-informed decisions will help mitigate the capex challenges ahead.”