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NAREIM DIALOGUES FALL 2017 29 The above chart shows how the valuation changes for a property with $4million in operating expenses. A 1% decrease in operating expense generates $1million in asset value creation at a 4% cap rate. That is a 25x return on each dollar of savings. This has a meaningful implication for all portfolios but is particularly significant for portfolios diversified across markets and/or asset classes. Class A assets with lower cap rates stand the most to gain, so transitioning properties down the cap rate ladder via operating expense improvement initiatives or capex projects aimed at operating expense reduction will increase the value of operating expense savings. This can have a powerful impact on your approach to operating expense management, empowering managers to identify the properties where their time is best spent scrutinizing expenses. A key takeaway is the importance of scrutinizing operating expenses regularly as a defensive measure against a market downturn. When rates increase and property values fall, the cap rate multiplier can offset these losses through operating expense reduction. Operating expense reduction can also serve as a hedge against value destruction caused by a rate increase. Value Creation Effect of OPEX Reductions at Various Cap Rates Return on Savings Across Cap Rates This shows that even at higher cap rate levels operating expense savings is valuable. As an example, for a property valued using a 9% cap rate, lowering expenses can generate an increase of $500k in value. For a property valued at 5% cap rate, $1.5 million in additional value can be created. Take the following example: Before Savings After Savings Revenue $5,000,000 $5,000,000 Less: Expenses ($3,000,000) ($2,900,000) NOI $2,000,000 $2,100,000 Cap Rate 6.75% 6.75% Valuation $29,629,630 $31,111,111 Expense Savings $100,000 Value Creation +$1,481,482 Value Creation as multiple of savings 14.8x Here we see that saving just $100k in expenses increases the property valuation by almost $1.5million. That is compelling and achievable. With the right approach and tools that consolidate all the relevant information to provide a portfolio-wide perspective, immediate opportunities can be highlighted without the historic headaches. This is simple math – the impact of the operating expense reduction is magnified by the cap rate. At any single Cap Rate, the relationship between operating expense reduction and value creation is linear. Where it gets interesting is when you look at how this multiplier changes across different cap rates. 1 $650B calculated using the total SF in Office, Industrial, Retail & Multifamily asset classes per the Costar Group 2017 Mid-Year National Reports and NMHC tabulations of 2012 Rental Housing Finance Survey microdata, US Census Bureau updated 8/2015; multiplied by OPEX per square foot of $9.47 according to Waypoint dataset information 2 Applying weighted average cap rate of 6.23% from CBRE Cap Rate Survey First Half 2017 ©iStock.com/aydinmutlu Assumes property with $500,000 in revenue (Assumes property with $5million annual revenue and $4million in starting operating expenses and a 1% reduction in operating expense)