Drought Surcharges are Penalizing Efficient Water Users

California Drought

California is in a severe drought and most water districts have enacted mandatory restrictions designed to reduce water consumption and encourage conservation. In the bay area, there are multiple water districts, serving unique areas and utilizing difference reservoirs to supply water. Some of these districts are more advanced, providing gray water (recycled water) for landscaping and non-potable purposes, while others are severely lacking. In Pleasanton, Zone 7 is just starting to implement recycled water for city owned parks and direct access to this water (via the water system) for public use is a long way off.

The lack of investment in the water infrastructure has required Zone 7 customers to cut back water usage more than other water district customers. Contra Costa Water District is requesting (meaning voluntary) a 10% cut back. East Bay MUD (Municipal Utility District) has a required 10% reduction. Zone 7 has a strict 25% reduction requirement and severe penalties for those that don’t meet it.

drought reduction calculationWhile the intent of the mandatory reduction is good and I fully support it, the process in determining each customer’s success is significantly flawed. To determine if a water account has met the required 25% reduction, water usage for the current period is compared to water usage from the same time period one year prior. This may work well for residential households with limited to no fluctuation in occupancy, from a commercial building standpoint, it doesn’t work at all.

First, Pleasanton Corporate Commons has been actively working towards reducing domestic (water use inside the buildings) water consumption since the first LEED certification done in 2007. Second, the property’s occupancy has increased several percentage points since last year. Third, density (the number of people in the buildings) has increased as well. Finally, we’ve done all we can from an engineering perspective to eliminate or reduce water usage.

This arbitrary approach to measuring water reduction fails to consider all of the above items. In fact, it penalizes properties that have been forward thinking and taken action prior to now to conserve water. Perhaps most annoying about this, are the articles in the local weekly paper highlighting large business parks that have reduced water consumption by more than 70%. “Some have done much more, he said, including Koll Center, a business park that has reduced its consumption by 71% over its 2013 usage” (link). I’m sorry, but if you can reduce water consumption by 70% year over year, you’ve clearly been overusing water in years past.

Irrigation usage is much the same. Our conservation efforts from prior years are now being penalized. Pleasanton Corporate Commons has taken many measures to reduce irrigation usage through the removal of plant material, installation of EvapoTranspiration Controllers (ET Controllers) and more efficient sprinkler nozzles.

The water municipality and City should develop an alternative method for measuring water reduction requirements. A more intelligent and advanced approach would be to compare the current case water usage (for domestic water this would be based on occupancy and fixture types, for irrigation it would be water coefficient, plant type and coverage, evapotranspiration rate and irrigation efficiency) against base case usage to determine total percentage of reduction. Granted this method is not as straight forward as simply comparing year over year usage, but it’s much more accurate.

One final thing before I stop ranting about water usage. Actively managing water use is one of the many things good property managers and firms do when overseeing the operation of a property. I can’t help but wonder how much higher operating expenses are in a property that is overusing water by 70%+. That not only makes the cost of occupancy higher for the tenants, but it hurts the valuation of the project during an appraisal or sale. And if water is being mismanaged, what else is?

The Annual Plan – A Property’s Playbook for the Upcoming Year

It’s a bit weird to begin budgeting for the upcoming year without passing the half way mark in the current year. For many Hines buildings, the following year’s budgets are not due to the investors/owners until September or October. Internal reviews begin much earlier and culminate in a detailed package about each project, the operational performance and highlights from the year’s performance. This package functions as the property’s Annual Plan for the coming year. The process, review and resulting product are what make Hines one of the best in class real estate operators in the world.

The Annual Plan development starts with a complete review of the property’s current performance – marketing, finances, operations and construction – and how that relates to the current year’s budget. The projections that are compiled help forecast what the activity will look like for the remainder of the current year. The projections function as a good gut check on the status of the current year against the goals established for the year during last year’s Annual Plan process.

With the current year projections complete, it’s time to begin developing the Annual Plan for the upcoming year.

Property Condition Assessment

Projects that have traded recently can leverage the third-party Property Condition Assessment (PCA) report for potential items to include in the budget. In many cases the PCA can serve as a reference when developing a capital improvement plan for the immediate years following the report’s creation.

In the instances where a recent PCA is not available, Property Managers are tasked with developing the 15 year capital plan and necessary operating expenses to maintain or improve the property’s appearance, performance, marketability, etc. This process creates the foundation for the development of the property’s Annual Plan.

What makes up the Annual Plan?

Aside from the financials, there are a number of other components that make up a property’s Annual Plan.

  • Executive Summary – essentially an overview of the project, ownership, size, debt and other key facts about the project that aid in summarizing the asset.
  • Org Chart – highlights the roles of the onsite team, but also covers the details of those that support the onsite team or provide guidance, contract approval and other keys roles for the asset.
  • Vision – perhaps unique to Hines; each year we define the vision we have for the project and how we plan to operate the asset in upcoming year. In 2014, the vision we set for Pleasanton Corporate Commons was: To Maintain High Water Mark Rental Rates and Enhance the Property’s Profile With Leading, Innovative, Sustainable Programs and Amenities
  • Stacking Plan – A visual aid showing the tenant mix, expiration dates and current lease rates.
  • Lease Related Information – Over several pages we review the tenant mix, lease expiration dates, revenue projections, debt coverage and other key financials important to fiscal and operational health of the asset.
  • Team Triumphs – The teams big wins for the past year.
  • Best Practices – With over 270 operational and engineering best practices developed, this takes a look at how well we’re doing implementing those practices at the property.
  • Three Way Comparison – A detailed financial breakdown showing the current year’s budget numbers vs. current year’s projected numbers vs. upcoming year’s budget numbers. Significant variances are analyzed and explained.
  • Value Creation – How world class operational platform impacts the overall value of an asset.
  • Market Comparables – On a dollar per square foot basis, how are we performing against similar assets in the market? This is important because operating expense make up a portion of the tenant’s rent (in some leases) and it confirms spending in each category is appropriate in line.
  • Annual Plan Slide – A look at what was accomplished in the past year and the defined goals that will be accomplished in the upcoming year.

While the time spent creating the budgets, annual plan and other supporting documents is immense, the package that results in the end is extremely valuable. I am a big fan of the entire goal creation and management process. Writing goals down is a practice very few people do, but has been shown to be a big driver in creating results. Adopting this concept at the building level makes a ton of sense and provides a good guide for the onsite team in the upcoming year.

Are there items you include in your budget preparations that I’ve left off this list?

Weighted Average Occupancy and the Gross Up Clause

All of the office leases that I have been involved with through the years include a gross up clause (usually 95%).  The gross up clause applies to the operating expense reimbursements tenants pay as a part of their triple net or base year lease.  The distinction in the type of lease is important.  Certain leases, single net, double net and full service (also known as a gross lease) do not contain an operating expense reimbursement clause.  42floors has a good overview of the different types of commercial leases.

The operating expense reimbursement is a payment that occurs in addition to the base rent the tenant pays. At the beginning of each year, an operating expense estimate is provided to each tenant with their annual rent letter detailing the monthly payment based on the current years budget.  Each tenant pays an amount based on the percentage of the building they occupy. An example might help explain this better:

Rent Letter Sample

The sample rent letter above outlines the annual payments for the tenant on a monthly basis.  In this example, the tenant’s lease is a base year lease, meaning the tenant pays for the increase in costs above the base year as established in the lease (which is typically the year the tenant moves into the building unless they negotiated a new base year during a renewal).  This $250,000 increase is multiplied by the tenants proportionate share of the building, 2.00% (3,000 RSF / 150,000 RSF = 2%).  Divide that number by 12 and you have the monthly operating expense payment the tenant pays.

Where the Gross Up Comes In…

The gross up clause (let’s use 95%) affects the $250,000 escalation number. In instances where the Weighted Average Occupancy of a building is less than 95% (in some leases this number is 100%), then variable operating expenses (those expenses change as a result of more people being in the building) are grossed up as if the building were 95% occupied. Variable operating expenses would include expenses such as utilities (electricity, water, gas), cleaning costs and supplies, and trash removal. Expenses that do not change as a result of occupancy are taxes, insurance, landscaping and some repair accounts.

The variability of operating expenses can be challenging to figure out. In a suburban campus setting, using the operating expenses from a vacant building is the ideal scenario. In a high-rise office tower, it gets more complicated. One approach to determining the variability is by measuring the operating expenses of a vacant floor. With some adjustments, the cost to operate the building when vacant can be reasonably determined. The same method can be done in reverse for a full building and once you have the respective expenses you can determine the variability.

Putting the expense variability aside for the time being, a high level example may help explain the impact of grossing up the costs a bit better[1]:

Occupancy

Actual Costs

Tenant’s Share

Other Tenants

Landlord’s Portion

 100% $10.00  10% = $1.00 90% = $9.00 $0.00
 50% (no gross up clause) $5.00  10% = $0.50 40% = $2.00 $2.50
 50% (with 95% gross up) $5.00  10% = $0.95 40% = $8.55 $0.50

When the property is 50% occupied, the $2.50 that would be the Landlord’s costs shrink to $0.50 with the gross up provision.

Is This Just Good for the Landlord?

While the gross up clause seems to favor the landlord, it does protect the tenant from receiving significant bumps in the operating expenses charges each year.  In the instance of a base year lease, the tenant pays only for their percentage share of the escalation above the base year costs.  As long as the base year costs are also grossed up, the tenant shouldn’t experience a huge increase in their operating expense charges. This method also makes it easier for the tenant to budget for rent related expenses.

How the Weighted Average Occupancy Fits Into This

How do you know if the building is 95% occupied? It’s not simply a matter of comparing the total occupied square feet to the total rentable square feet at the end of the year.  The percentage of time occupied also needs to be considered. This is where the Weighted Average Occupancy calculation comes into play.  With each tenant, the percentage of the year occupied is calculated and then multiplied by the tenants proportionate share of the building. Thus if the 3,000 RSF tenant we saw at the beginning occupied the building from January 1 – September 30 we would take that into account for the total occupancy calculation.

The math looks like this: (3,000 RSF / 150,000 RSF) * 75% (occupied Jan – Sep) =  1.5%.

Tenant’s proportionate share of the building * Percentage of time occupied = Percentage contribution to the overall building occupancy for the year

The sample tenant would contribute 1.5 percentage points towards building occupancy for the entire year.  Adding together that same calculation for the remaining tenants in the building will result in the Weighted Average Occupancy. And, if it’s less than the gross up percentage in the lease, then there’s further gross up work that needs to be done. If occupancy exceeds the gross up percentage, then the actuals are used for the operating expense estimates and eventually reconciliations.

 

References:

[1] Holland & Hart has a good post on Gross Up Provisions. I borrowed the table above from their write up (with a few modifications).