Impact of COVID-19 on Real Estate Operating Expenses

Post by 
Dan Croce

It’s official: We are in a recession. Economic activity peaked in February of 2020, with the COVID-induced dip in March marking an end to 128 consecutive months of growth. The most recent run-up represents the longest period of economic expansion in the 175-year history of American business cycles, and coronavirus brought what seemed to be an indestructible economic engine to a swift and unceremonious halt. The news isn’t a surprise, but - wow, it sure is weighty. 

Through the public health crisis and associated economic shutdowns, real estate investors have largely been focused on how these events will impact revenue. This primary area of focus makes sense, as investors’ financial outcomes hinge primarily on the income stream. Everything starts with the top line, and that’s not lost on the industry nor on us. For Birgo, April and May collections were rock solid, and thus far June is shaping up to be another successful month - more to come on that in a future post, once we have ample mid-month data.

However, multifamily investors should not be so short-sighted as to only act to ensure the resilience of their income streams. We must also be thoughtful about other components of the cash flow equation - particularly the impact this recession will have on expenses. In this post, we’ll highlight a few key areas of consideration for the impact of the coronavirus recession on operating expenses.

Property Taxes

While this expense line item won’t move quickly, it is perhaps the single greatest line item of concern with potential to impact net operating income in the coming years. Despite the recent surprise news of the American economy having added 2.5 million jobs in the month of May in aggregate, state and local governments actually lost 571 thousand jobs. Had it not been for the steep decline in state and local government employment, the jobs report would have been materially better than an already strong surprise. As school districts and municipalities struggle to collect revenues from other sources of the tax base, it will be interesting to see what costs they attempt to impose on property owners. Real estate investors must be more conservative than ever when considering the potential negative impact to financial performance that could result from future attempts to increase property taxes.  

Insurance

Thus far, Birgo hasn’t gained much clarity regarding changes in the cost to insure properties that will result from this recession. Prior to the pandemic, industry-wide trends indicated rising insurance costs for “habitational structures” such as multifamily properties. While many consumers received rebates for auto insurance premiums due to reduced travel activities, such actions are unlikely to extend to property owners. In a few instances, we have seen premium rates decline as a result of delayed construction activities or just renegotiation, but, in general, it is too early for us to tell to what extent insurance costs will be altered going forward.  

Payroll

This will likely be one of the areas for real estate owners to opportunistically capitalize on shifts in the landscape. With the drastic extent of job losses in such a short period of time and a general consensus that many industries will suffer permanent damage from the shutdowns, the number of Americans looking for work has risen sharply. Prior to COVID-19, any real estate operator would indicate that the labor market was extremely tight -- it was by far an employee’s market. The national quit-rate level, a measure of voluntary separations which indicates how much leverage employees have in the labor market, was consistently climbing. That dynamic has clearly shifted, and property owners are now in a position to be intentional about obtaining the best employees they can find in a way that improves property financial performance.   

Utilities

Similar to property taxes, certain utility costs at properties may be in jeopardy of significant increases if they are controlled by governmental authorities that are otherwise in dire fiscal straits today. In our local market, we have heard from many water and sewer authorities that they intend to implement rate hikes which are, in some cases, quite drastic. Property owners will do their best to pass on these costs to tenants through RUBS (ratio utility billing system) programs, but even so, the impact of utility rate hikes to property financial performance could be substantial. Proactive communication with tenants regarding these issues, as well as intentional efforts to utilize green, eco-friendly infrastructure to reduce water use and limit dependence on natural gas, are measures that landlords can take to counteract the eventual risk of rising utility costs.

Repairs & Maintenance

In general, we believe the current economic climate presents property owners with an opportunity to eventually reduce the cost of repairs and maintenance. To an extent, the social distancing measures in place throughout the second quarter of 2020 have all but forced reductions to spending in this category as only the most urgent matters could be attended to in order to limit the risks of physical contact. In the coming months, we expect to see a temporary increase in spending as minor but necessary deferments of work orders led to a backlog of projects to complete. However, similar to the trends in the labor market, we believe negotiating leverage will be held by property owners with vendors. 

One noteworthy risk here is the impact of potential trade wars on the cost of purchasing physical materials required for routing property upkeep. While not specific to the recessionary environment, the recent flare up in international tensions could result in procurement challenges - real estate investors should be cognizant of this.

Property Management Fees

Property management arrangements are typically a fixed percentage of rents collected. In most instances a renegotiation of the fixed percentage is not likely to be productive.  Now, more than ever, property management companies are in a position of strength given the heavy reliance on them to produce strong results. If rental income is reduced, then surely these costs will go down as well given it is variable as a function of collections. Ironically, in this case, perhaps property owners should actually hope that costs rise! 

In general, we do not anticipate much change to this line item on the profit and loss statement, and we advise owners to tread cautiously, and perhaps to even think about ways to creatively incentivize property managers to overperform, as effective property management is critical to maintaining strong occupancy and collections.  

Other Operating Expenses

Other items that are included in a property’s net operating income such as marketing costs, general and administrative expenses (legal and accounting), and replacement reserves are all worth consideration. Marketing spend should continue (or even be increased), as it helps ensure high occupancy, and assets with strong occupancy rates are surely best positioned to weather an economic storm. We don’t anticipate much impact to general and administrative expenses, as these are necessary costs with little optionality. Many lenders are beginning to require more replacement reserves for new deals, but for existing portfolio assets and long-term forward-looking costs, our expectation is not to see a significant change.   

Non-Operating Expenses: Capital Projects & Financing Costs

While not a part of the net operating income equation, cash outflows for capital projects and debt service are also worth careful consideration. It’s difficult to know what the impact of the shutdown will be on the cost of capital projects. On the one hand, project vendors have been idled by the stoppage and are eager to get back to work. On the other hand, many projects were delayed, and there is likely to be a surge in demand to complete necessary work. We are taking a project-by-project approach: we’re considering the nature of the work to be completed and current demand for that work in our market, then plotting out revised timelines based on the combination of necessity and cost favorability. 

As for financing costs, this is clearly a much larger topic, but in general we are opportunistically pursuing interest rate reductions as loan modifications instead of refinancing. The market posture toward refinance transactions is still hesitant and likely will be for some time, so instead of pursuing complete recapitalizations through refinancing, we are working to capitalize on the lower interest rates by reducing the cost of our in-place debt through conversations with existing lenders. We expect this strategy to bear some fruit, allowing us to lower our interest expense without incurring the high transaction costs of a refinance.  

Summary

While it’s clear that focusing on ensuring the resilience of income streams is critically important, we believe it is equally crucial to be proactive in understanding how changes to the rest of the income statement impact cash flow as well. In our current economic climate, expenses may not grow in keeping with inflation as investors typically assume.  As such, it is prudent to stress-test forward looking cash flow models to account for the risk of changes in these expenses. More acute pain points in the broader economy will have a disproportionate impact on certain required cash outflows, and an in-depth ongoing monitoring of the likelihood of those changes in costs is to our benefit. We will be looking at these closely in the months ahead and look forward to sharing what insights may come.


Keep Up With Birgo

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
THere's More

Posts You Might Also Like

Birgo Capital

Why Birgo Capital’s Real Estate Funds are Well-positioned to Navigate COVID-19

Here's what Birgo Capital is doing (and has done) to maximize the performance of our real estate private equity funds in light of the coronavirus recession.
Birgo Capital

How Will COVID Impact Pittsburgh Multifamily Real Estate?

Will the relative resilience that Pittsburgh enjoyed during the last recession translate to similarly impressive performance through this one? Let’s examine several regional economic factors to determine how Pittsburgh multifamily real estate is likely to perform during the current crisis and in the years to come.
Birgo Capital

Collecting Rent During COVID: June Rental Income Update

Birgo’s rent collection took a hit in late March, but April and May were solid. How is June shaping up?
Birgo Capital

Four Strategies to a Stabilized Real Estate Portfolio

In a new economic landscape, these tips can help you find stability in real estate.
Birgo Capital

When is it Time to Buy?

As the corona-dust begins to settle, many investors are wondering how to know when it is the right time to begin acquiring real estate again. Here is how we are thinking about acquisitions during a pandemic at Birgo Capital.