Capital expenditures can be a contentious issue between owners and operators. The asset manager is charged with verifying that the capital expenditure budget is properly designed to meet the goals of ownership.
Fundamentally, the asset manager is the voice of the owner. Accordingly, the asset manager’s role is to implement the owner’s strategic vision for the property. The owner has expectations for the value of the property, the highest and best use of the property, and the return on investment for the property.
Consider a property comparing two possible major capital expenditures. The first is a new lounge that costs $250,000 to freshen up and build. The second is a new boiler that costs $250,000 more to get the energy-saving features. For the sake of the comparison, imagine that the owner expects the same benefits from either. But in the first case, the lounge generates revenues, which then produces more cash flow. Here the operator gets paid both the base fee and the incentive fee. Both stand to increase if the lounge succeeds. In the second case, the boiler will reduce costs. The benefit comes in the form of cost savings. Here the operator’s benefit would likely be smaller, because they only would be entitled to an incentive fee. So the operator sees more upside from the lounge, whereas the owner sees the boiler as the safer and potentially more rewarding use of capital expenditures. This is a simple example of some of the moral hazard built into the Cap Ex planning process.
As the example suggests, the asset manager must be aware of the costs and benefits that accrue to both the owner and the operator in capital expenditure projects. The asset manager plays a key role in supervising the overall long-term planning by making sure that the property manager’s short-term plans are consistent with the owner’s long-term vision for the property.
Obviously the capital expenditures can be a source of friction between owners and operators.First, owners often believe the operator takes too much control of the Cap Ex process and invests in items that enhance the brand or operator to the detriment of the owner. Second, owners fear that the operator will lose control of the process and come in over budget.
The operator’s principal frustrations with capital expenditures are threefold. First, operators find that owners often have an inconsistent vision of the plan. Asset managers change, and a new asset manager often means a new long-term plan. Second, operators find that the owners do not communicate their Cap Ex vision effectively. Finally, operators contend that owners do not properly fund Cap Ex, to the detriment of the property. This is especially important if the property is not doing well and the Cap Ex is consistently deferred.
The asset manager needs to “communicate up” to the owner regarding the property condition, the life-cycle position of major capital items and systems, the anticipated short- and long-term Cap Ex needs, and the funding needed to execute the plan. The asset manager needs to “communicate down” to the operator the owner’s expectations and priorities.
There are additional considerations in the Cap Ex budgeting process. The asset manager needs to:
- Evaluate the reasonableness of operator requests
- Evaluate the thoughtfulness of operator requests (in other words, evaluate the quality of the analysis)
- Consider the importance of the anticipated holding period in determining the owner’s objectives
- Consider how economic conditions affect the funds available for Cap Ex
- Consider how returns available from alternate investments might affect the funds available for Cap Ex
The asset manager must take all of this…………and much more………. into account and communicate it to the owner and the operator.
Clearly, a good asset manager needs to be aware of both the owner and the operator positions during the Cap Ex budgeting process.