• Wed. Jun 23rd, 2021

Why Your Real Estate Development Team Needs To Have Operational Insight

Vice President at Bayer Properties, overseeing financial services for the commercial real estate portfolio.

I would like to take a minute to talk with the people who are developing shopping centers, office space and mixed-use destinations. (Hint, this is good information for those buying those assets, too.) I want to make a point about the need for more than just construction and leasing when you are working on new centers. One of the common problems our organization runs into with assets we acquire is a distinct lack of communication between the development team and the managers and accountants who will be running the asset after the construction phase. 

I learned many years ago the value of having someone with property management experience vet some of the details during the construction process. One of our construction projects that benefited from the synergy of property accounting and construction accounting saved us from some costly mistakes.

We had a dynamic developer that had worked hand in hand with our project controller to build a robust ARGUS model for a new development. My first inkling that we had problems came from the exceptionally high recovery projections for common area maintenance. For those not engaged in real estate, this is the payment made by the tenant to help defray the cost of operating the center. It’s dictated by lease language and has a vast range of inclusions, exclusions, caps and floors that can greatly affect the amount the tenant is obligated to pay. The project controller and I had a lively argument over the possibility of full recoveries from all tenants. The developer had told him full recovery from all tenants, and that was what he was modeling.

When the developer arrived for a follow-up, I shared my concerns about the full recovery income the model showed. I told them I had never worked on a shopping center where tenant X didn’t want to maintain their own parcel and limit their contribution because of it. The developer looked blank for a moment and then replied, “Well, yes, they will probably want that same setup here.” As we proceeded to go down the tenant lineup, looking at each individual deal and the common lease language, his “full recovery” kept backing up further and further. 

After the meeting, the project controller said, “There are caps everywhere!” I responded that just because you don’t call it a cap doesn’t mean the lease language can’t function like one and limit the recovery. We went over his assumptions, got them to a realistic projection and discovered a way to improve the return with specific lease language.

I am telling this story to emphasize that each discipline has its own area of specialty, and you can greatly benefit from covering all the bases. My project controller had all the construction experience in the world. He had never worked on the day-to-day accounting for an asset. But the project needed both to maximize the return. 

It’s critical to include the property manager in the development process because of their operational knowledge. Without that operational experience, construction teams can make some unfortunate choices, in my experience. One center we encountered had a team that value-engineered out the roof anchors on a multistory office building. The operational expense for window cleaning should have been around $15,000 per year. But, with no anchors, there was only one vendor in the region who would touch it, and they had to bring their own ballast to anchor their cleaning crew. The center ended up paying $50,000 per year to clean windows. It left the owner with the option of paying that inflated operating expense each year or trying to install the necessary anchors at twice the original cost.

I have seen poor utility planning that ensured a nightmare for the property team trying to bill and recover the costs. For example, there was the shopping center that wrote all its leases to leave the cost of HVAC maintenance on the landlord rather than the tenant benefiting from the system. The only way to really protect against this type of problem is to get the accountant and the property manager involved during the development phase. Having property management review at key points and them blessing any major changes is generally sufficient to guard against most problems. 

Key points for accounting review include:

• Review of the form lease that will be used with tenants (how they defined the shopping center, recoverable income calculations, sales and percentage rent calculations).

• Utility setup and how it ties back to the lease recovery language.

• Review of the pro forma model for reasonableness compared to other assets. There should be a heavy emphasis on how the recoverable expenses are being calculated and projected.

Key points for property management review include:

• When the center has been laid out on a site plan, the operational people need to check the location of the dumpsters, grease traps and proposed employee parking.

• They can help assess the quality of various pieces of machinery, which can influence the brand you purchase for things like elevators, HVAC systems and utility metering.

• They should take your proposed plan and prepare an operational budget to include getting estimates and quotes from their preferred vendors.

• Depending on who manages tax appeals (accounting or property management), there is probably someone who works directly with a tax specialist. Providing them with construction costs and the pro forma will allow them to give you a more accurate number for the real estate taxes that will be assessed against your center.

If you want to maximize the return on your development, I recommend getting that experienced operational help on the front end so the maintenance of the asset and tenant billing are reasonable and effective. If you are looking at purchasing an asset, experienced operational help can identify whether the center has significant issues. Keep in mind, avoiding a problem in the first place always entails less effort than fixing it.


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