Risky Business: Real Estate, Utility Expenses, & Investment Due Diligence

by ‐ Tags: property management, financing

Since 2010, WegoWise has provided valuable utility analytics and building performance benchmarks for the multifamily industry. We accomplished this by providing a powerful yet intuitive tool for owners to quickly assess properties across their real estate portfolios and compare them to peer buildings in our 26,000+ building database. Owners can identify problem areas and focus their capital budgets on improvements that can generate the maximum returns. Our customers have saved millions of dollars while enjoying those benefits at an affordable price.

Deploying WegoWise to uncover efficiency opportunities is only one way our tool is used. Our company was founded on the much broader view of the relationship between utility consumption, real estate investment, and the capital market. There is a lot of uncertainty in the real estate business and we see utility analysis as a key component to good risk management.

Whether you are a lender calculating debt service cash flow, an acquirer seeking to reduce variance in the building's pro forma, or a seller hoping to maximize sales price by demonstrating solid cash flow, assessing a building's utility performance can offer deeper insight into its market value. With utility expenses making up 25-35% of a building's operating budget, a clearer understanding of those utility spendings, their sources, and their trends should be an integral part of any investment due diligence process, not just when you are considering efficiency upgrades.

We see too many owners accepting their utility expenses simply as a cost of business and not as a source for increasing cash flow. We also see owners make the dangerous assumption that utility expenses they saw in the past is what they can expect in the future.

What about the appraisal report?

Property transactions, especially those involving lenders, are usually backed by a valuation report undertaken by a professional appraiser. Generally, appraised property values are based on two major approaches.

You might ask, "Doesn't the appraisal report already take utility expenses into consideration because we know what was spent in previous years?" Well, that would be like saying the Red Sox will surely win the World Series next year as long as the team roster stays the same.

A building's efficiency and utility consumption levels can dramatically affect a building's financial performance and value but here is more food for thought. Energy prices historically have fluctuated greatly and are generally on an upward trend. Water and sewerage prices are very localized but studies have shown they are increasing much higher than the Consumer Price Index and annual increases average 4% and have been as high as 12%. Then there is the effect of weather. Perhaps the historical data reflects a particularly mild winter or cool summer. So even if your building is technically performing as expected, your operating finances will still be at the mercy of price volatility and weather.

 Annual Residential Natural Gas Price

Annual Retail Heating Oil Price

Annual Residential Electricity Price

Water and Sewerage Maintenance

Source: US Bureau of Labor Statistics

What is the holding period of your invested building? What are the loan terms? What is your exposure to such expense fluctuations? According to the US Energy Information Administration, homes heated primarily with natural gas will see a double digit increase in expenses for the 2013-14 heating season. Just because a property appraises at a certain value today does not mean it will perform financially as expected tomorrow.

Percent change in fuel bills from last winter

But the appraisal report says it makes comparisons to expected utility expenditures?

Some appraisers, recognizing how significantly utility costs contribute to a property's operating expenses, do take the additional step to adjust the estimate of the subject property's utility costs by comparing them to those of other properties or applying the average usages as reported by sources like the US EIA through their Residential Energy Consumption Survey (RECS). This is a great first step but should not be where the analysis ends. For starters, RECS does not offer averages for water and sewer, which can often be a property's biggest utility expenditure. Plus, RECS is a survey conducted every 4 years (most recently in 2009) that only present general categories of housing types and therefore non-specific average consumption figures. A 100 unit brick high-rise apartment building will have a very different performance profile from a 10 unit wood-framed structure.

Why is analysis from WegoWise better?

The real estate market's traditional reliance on historical utility spendings and broadly defined comparisons is understandable. It has simply been too difficult and time consuming to collect more detailed data and generate better information on building utility performance. So while today's appraisal reports contain much useful analysis on a property's cash flow and value, utility expenses are often glossed over in a single paragraph. This is where WegoWise can help.

WegoWise was developed specifically to scale the collection of large datasets about buildings, their system characteristics, and their utility consumptions, so we have the raw material to produce analyses that is more precise and with richer details. We can benchmark your property to a true set of peers and provide in-depth intelligence on this major component of a property's cash flow. Among the information we deliver are:

The real estate sector is full of unknowns. Population shifts and employment numbers affect occupancy rates and rent rolls. The cost of capital is always in flux. This is a risky business. The one aspect of the real estate market owners do have control over is how effectively and efficiently they operate the building. With WegoWise, they can tackle the biggest segment of that operational risk: how much is spent on utility expenses.

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