Investment property value is a function of net operating income, and controlling expenses is impactful to any investor’s returns. With a managed portfolio of about three million square feet (sf), Cushman & Wakefield | PICOR tracks operating costs by type of property and over time, identifying trends and opportunities.
Operating Expenses and Lease Structures
In our studies, total operating expenses (“opex”) incorporate all costs incurred to operate commercial buildings, including utilities, repairs and maintenance, roads and grounds, cleaning, administration, security, real property taxes, and insurance. While they are costs of ownership, expenses not typically included in opex are debt service, certain marketing costs, reserves for replacement and capital expenditures. While recovery of some of these items may be allowed by certain leases, we have excluded them from this study.
In a multi-tenant property, the tenant is typically responsible under certain lease types for their share of opex in proportion to their prorata share of the building. Expenses can be incorporated into their rent on a full-service or modified gross lease or can be passed through directly as a reimbursable expense as part of a net or triple net lease. In a single-tenant property the tenant or lessee is typically responsible for 100% of the opex.
The Impact of Labor on Operating Costs
With the passing of Proposition 206, minimum wage increases in Arizona began in 2017, increasing from $10.00 per hour to $11.00 per hour, stepping up to $12.00 per hour in 2020. Labor-intensive service providers have increased compensation to their staff in compliance with new requirements, passing through increased costs to their customers. Trades where this is most significant include janitorial/cleaning, landscaping, and general repairs and maintenance. While inflation since 2017 has averaged 1.8% per year, minimum wage increases have outpaced inflation and contribute to the rising costs detailed below.
We looked at opex trends over a five-year period for each market sector, including office, industrial, retail, and medical. Across all markets expenses remained flat in 2014 and 2015 and increased 10.2% from 2016 to 2018.
- Office: We tend to see higher operating costs for office property due to more intense services, more interior services, real estate taxes pegged to higher valuations, and the nature of full-service leases versus shared responsibilities with tenants in some other lease scenarios. That being said, the aggregate figures we report include a blend of full service and modified gross leases, so the trends over time are of more value than the total costs per sf as a comparable to a particular asset. Office opex increased from $6.05 per sf to $6.26 per sf from 2016 to 2018, a nominal increase of 3.5%.
- Industrial: For industrial properties, total expenses increased from $2.03 per sf in 2016 to $2.40 per sf in 2018, an increase of 18.2%. Again, this is a blend of actual costs under numerous lease scenarios, and the trend is the key figure. For instance, within this portfolio, some buildings do not include real estate taxes, or the tenant is paying them directly[1]. Industrial expenses trend lower than office because of shared responsibility for expenses, lower building valuations for tax purposes, less intensive services, and more understated grounds and common areas.
- Retail: For operating costs in the retail properties we managed from 2016 to 2018, expenses rose from $5.18 to $5.44 per sf or 5.0% from 2016 to 2018. Similar to industrial, total costs to operate shopping and strip centers tend to be lower than office, as tenants maintain responsibility for metered utilities, interior expenses, and often HVAC.
- Medical: Due to the size of our portfolio, we can track medical office expenses separately from office. Medical office opex increased 13.3% from 2016 to 2017 ($6.07 to $6.88 per sf), dropping 2.3% to $6.72 per sf in 2018. We attribute this decline to a reduction in property taxes due to successful valuation appeals. Medical expenses are typically similar to the office market with the addition of specialized requirements like medical gases and auxiliary power systems. While some medical office leases are full service, those reported here are modified gross, with responsibility for some utilities and janitorial expenses borne by the tenants.
Because operating costs directly impact asset value, controlling them is key. A few ways you can reduce building operating expenses would include:
- Update restroom fixtures – Old style faucets can be readily replaced with water-saving faucets. Consider installing hand dryers to save on paper supplies.
- Enter into preventative maintenance contracts - cost of maintenance is far less expensive that the cost of deferred maintenance or equipment failure. Prevention may not head off 100% of repairs, but it is prudent in mitigating both costs, down time and productivity impact on tenants.
- Perform an energy audit – Making minor adjustments to the HVAC system and lighting can positively impact the property’s bottom line.
- Routinely checking plumbing fixtures in both occupied and vacant space for leaks can save costly water losses.
- Hiring a professional management firm – Attentive management provides foresight and oversight as well as access to competitive and responsive vendors. By aggregating market share, a management firm can leverage its buying power for the benefit of building owners.
As we near the end of 2019, wage increases in labor-intensive services such as janitorial and landscaping will trend up. Construction costs have also been impacted due to both labor and materials increases. As we forecast into the new year, look for operating expenses to moderately increase in all sectors of the market In our annual budget process we poll utilities and service providers. For 2020 we expect an average utility cost increase of 7.0% and pass-throughs from trades such as janitorial, landscape, plumbing and sweeping. Because every $100 of expenses translates to $1,250 in building value (at an 8.0% cap rate), vigilant expense management is always of benefit to investors, and also controls tenant-shared costs. For a review of your property’s operating costs, contact us.
Tina M. Olson, RPA FMA is a Principal and Director of Property Management for Cushman & Wakefield | PICOR, having joined the firm in 1994. In addition to stewardship of C&W | PICOR's market leading management team overseeing over three million sf of commercial space, Tina is responsible for the management of TMC Healthcare's real estate holdings and non-acute facilities. She can be reached at tolson@picor.com.
[1] Note that municipalities collect sales and use/rental tax on all operating costs. If a tenant or ground lessee pays property taxes directly to a county assessor, rental tax is still due and the landlord/lessor will be held responsible for payment.
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