Articles

Why does the cheaper refurbishment package lose money at the exit?

A capital decision tested over the hold period, rather than over the life of what it buys, picks the cheaper option and is corrected at the sale by the buyer.

Julian R. Sterling · from The Real Estate Asset Manager

The plant package costs 1,400,000 less than the fabric package and clears the same mandatory standard, so on the hold period alone it wins. Over a ten-year hold it still loses by 501,000, and it loses at the exit. The plant is installed in year four with a twelve-year life, so a buyer at a ten-year exit inherits two years of remaining life and deducts 1,590,000 to replace it — more than the 1,400,000 saved on the contract.

The building, and the three routes

The example is an office of five thousand square metres let at two hundred and fifty per square metre — a passing rent of 1,250,000, of which eight per cent is lost to non-recoverable costs. The building sits one performance band below a standard that applies from year four. Two leases representing sixty per cent of income expire at the end of year three; the rest expire at the end of year eight. The hold is ten years, discounted at 7.5, and a compliant building exits on a 6.25 per cent yield. The technical adviser offers three routes.

The three technical routes offered on the same building.

Route	What it buys	Cost
Plant package	Clears the standard; twelve-year life	1,800,000
Fabric package	Clears the standard; thirty-year life; supports a ten per cent higher rent	3,200,000
Combined package	Both	4,400,000

On the hold alone the plant package wins, and it wins comfortably. It costs 1,400,000 less. It clears the same mandatory bar, so the building is lettable either way. And the ten per cent rent uplift the fabric package supports does not repay the difference over a ten-year hold. An asset manager who tests the two routes across the hold period will choose plant, and will be able to defend the choice with the model.

Where the plant package loses

It loses at the exit. The plant is installed in year four with a twelve-year life. A buyer at a ten-year exit inherits an asset with two years of life left in the component that makes it compliant. That buyer deducts the cost of replacing it, inflated to the date it falls due and discounted back: 1,590,000. The deduction is larger than the 1,400,000 saved on the contract.

The last line is not the difference of the first two: it also carries the higher rent the fabric route supports across the hold, discounted at 7.5.

Line	Favours	Amount
Saved on the building contract	Plant	1,400,000
Buyer's deduction for the plant's remaining life	Fabric	1,590,000
Net disadvantage of the plant route	Fabric	501,000

Any capital decision assessed over a hold shorter than the life of what it buys will systematically favour the cheaper, shorter-lived option, and will systematically be corrected at sale by someone else. The word for what the fabric package buys is durability. The buyer's word for its absence is a deduction, and only one of those two words appears in a price.

The same error, one decision earlier

Choosing between routes is the second decision. The first is whether to do the work at all, and on this building doing nothing costs 4,770,000 in present value — one and a half times the price of the work that would have avoided it. Stated the other way round, the fabric package is not an expense of 3,200,000 but a saving of 1,570,000.

The composition is the instructive part. Of the 4,770,000, some 3,130,000 is rent never earned, because from year four the expired space cannot be let and by year eight the building is dark. But 4,035,000 is exit value forgone: a wider yield applied to a smaller rent, less the capital the buyer must now spend itself. Against those two sits a genuine saving of 2,396,000, the capital not spent. The larger of the two losses lands on the price at sale, not on the rent collected along the way. Move the non-compliant exit yield from 6.50 to 9.25 per cent and the cost of doing nothing runs from 3.7 million to 5.6 million, and never falls below the price of the work.

Timing obeys the same logic. Planning the work into the year-three void rather than into the year-four deadline is worth 1,302,000. The contract itself is cheaper by 1,120,000 in cash, which after discounting the different payment dates is worth 613,000 today. The remaining 689,000 — the majority — is income: rent abated while a contractor works around occupiers, and a year of the higher post-refurbishment rent earned earlier because the programme started earlier. More than half the value of a void is not a discount on a building contract at all.

What to do with it

• Appraise capital over the life of what it buys, not over the hold. A twelve-year component installed in year four and sold in year ten is priced by the buyer, not by the model.
• Put the exit deduction in the approval paper as its own line, with its own figure. Here it is 1,590,000 against a contract saving of 1,400,000, and it decides the case.
• Map the performance deadline against lease events before the work is priced, because the void is worth 1,302,000 and the majority of that value is income rather than construction cost.

The same asymmetry decides what a buyer pays when nothing is done at all. The work can be done once, in a void, at 3,200,000. A buyer cannot: it arrives after the deadline, prices the work at the deadline rate rather than the void rate, adds execution risk, and applies a yield a hundred and fifty basis points wider to whatever income remains. Three deductions where there would have been one cost — a discount of 8,318,000 against work costing 3,200,000. Telling the valuer what is coming reduces the value today. Not telling them does not reduce it; it moves it to the moment a buyer's technical adviser finds it.

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