Recapitalization & Capital Renewal--What's the Number?

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Recapitalization & Capital Renewal--What's the Number?

The Problem of Planning For and Managing Waves of Expiring Assets

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Figure 2 Freddie Mac's Schedule

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Table 5 Replacement Guide

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Table 4 Time-Based Reality

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Table 3 Costing Model

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Table 2 Separate Line Item

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Table 1 Six Possible Variances

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Figure 1 Cost-Versus-Age Graph

A whitepaper on developing a basis for rational planning and budgeting and examining such issues as depreciation, flat-rate budget models, subsystem planning, and the "best practice" approach.

Editorial note: The original impetus to develop a whitepaper on the subject was a rash of phone calls in the course of one week to Tradeline President Steve Westfall seeking information about "benchmarks for recap numbers." Since the paper first appeared in January 2001, Tradeline continues to receive regular requests for this information. Hence, our decision to republish it now.

Sooner or later, most real estate or corporate facilities managers become very concerned with the issue of recapitalization rates. They may find that their historical way of budgeting for recapitalization has suddenly become totally inadequate, leaving them unable to put forth a rational budgeting argument to the people from whom you hope to get the money to fix the situation.

The implication is that the recapitalization numbers being used by some corporate real estate and corporate facility management organizations have proven inadequate. The underlying assumption here is that there is a "right number": a single percentage number that they can multiply by the replacement value of their facilities to determine how much to spend for "recapitalization."

This whitepaper sets out to accomplish six things:

1. It narrows the definition of recapitalization to mean the replacement of building subsystems.

2. It identifies recapitalization as a distinct budget category that is above and beyond maintenance, repair, and capital projects.

3. It dispels the notions that any sort of "flat rate" budgeting model can work or that building depreciation schedules in any way drive recapitalization budgets.

4. It sets forth and illustrates as a best practice the planning for recapitalization on the basis of the physical lives of individual building subsystems, modified by actual condition assessments.

5. It provides examples of companies that are moving toward the subsystem planning and management approach.

6. It illustrates the opportunity for the application of sophisticated software packages, data handling, and decision-making tools to the area of recapitalization planning.

Edited by
Steve Westfall, President
Tradeline Inc.
[email protected]

Contributors

Rick Biedenweg, Pacific Partners Consulting Group
Tom Henderson, Building Technology Associates
Phillipe Locke, DuPont
Bob Papa, Bristol-Myers Squibb
Tim Prime and Matt Kelly, Freddie Mac

What is "Recapitalization"?

Here's a working definition of the term "recapitalization" as it applies to buildings:

"Recapitalization is the replacement of building subsystems, which include among other things roofs, electrical distribution equipment, HVAC equipment (air handlers, compressors, chillers, boilers), building control systems, paving, and fire protection apparatus."

If you don't agree with this definition, at least in spirit, if not in exactitude, then read no further, because this paper is not for you. If you would rather use the term "capital renewal" in place of "recapitalization," that's perfectly okay as long as you ascribe to the notion that what is being addressed is the replacement of building subsystems.

You might be tempted to expand this definition to make it sound more sophisticated and management-like. For example, one suggestion was made to call recapitalization (or capital renewal) the planned replacement of building subsystems. It seems to the Editor that this is an unnecessary modifier in that even if you replaced a building subsystem accidentally, you have nevertheless replaced it, and in effect "recapitalized." Another suggestion was made to indicate that recapitalization should refer to subsystem replacements needed to extend the serviceability of the building. As will be shown later, there are other reasons subsystems are replaced that have nothing to do with the serviceability of a building, and these are valid reasons for recapitalization projects.

A more serious variant in the definition of "recapitalization" raises its head if the definition is made to include "upgrades," as in, "Recapitalization is the replacement or upgrade of building subsystems." This literally opens a Pandora's Box, because with that definitional construct we open the door to confounding maintenance and repair with recapitalization, and contravene the whole economic argument that maintenance and repair are one thing, and recapitalization is quite another — and that the two items require separate planning, budgeting, and management attention. As you will see below, IBM appears to have consciously addressed the "upgrade" issue with a policy decision on how to classify component changes ("sub"-subsystems replacements) made to building subsystems.

One particularly important terminology issue to clarify at the outset is the distinction between the terms "components" and "subsystems." Rick Biedenweg of Pacific Partners Consulting Group points out that "component" is used by many institutions to mean individual pieces of hardware such as light switches and sockets, while others might use "component" to refer to roofs or chillers. To avoid possible confusion in this paper the term "subsystem" encompasses roofs and chillers as opposed to switches and sockets.

Recapitalization Does Not Equal Depreciation

One of the first issues in addressing recapitalization is to dispel the notion that recapitalization is in any way influenced by the depreciation of assets. If you go down the path of saying that a building is being written off (depreciated) over 30 years at 3.3 percent of its original value per year, and therefore should have a recapitalization expenditure schedule equal to 3.3 percent per year of the building's cost, you will fail right in front of all of the financial people. The finance people will pull out their trusty present-value calculators and show you that your depreciation-equals-recapitalization logic leads to the irrefutable conclusion that you shouldn't spend any money to recapitalize at all, but rather run the building into the ground and replace the whole thing 30 years from now. Depreciation cannot be used as a budgeting model for recapitalization.

Depreciation is a non-cash expense charged against assets, and is managed by accountants and finance people. Recapitalization, on the other hand, is the physical replacement of old assets, and is managed by people who are running the buildings and portfolios of buildings. This means that it is the asset management people who give the depreciation people something to do, not the other way around. It is the real estate and facilities people who budget and do recapitalization projects, and it is the finance people who decide which expenditures to capitalize, which expenditures to expense, and how to depreciate the amounts that are capitalized.

When it comes to buildings, depreciation is a financial concept that spreads the reporting of large capital expenditures out over several years. Since depreciation is a non-cash expense, it has the effect of increasing cash flow for corporations by reducing income taxes. Depreciation expense (a non-cash expense) reduces reported earnings, which in turn reduces income taxes (a cash expense), thus increasing cash flow.

For non-profit institutions that don't pay income taxes, depreciation is generally used in calculating the annual cost of owning assets, where one element of that cost is the depletion of assets over time. This is done for the purpose of calculating overhead rates used for setting funding requirements and grant billings. Although income tax reduction is not a part of the non-profit depreciation rationale, to the extent that non-profit entities can get cash funding or reimbursements for depreciation (a non-cash expense), depreciation serves to increase cash flow for non-profits as well.

We depreciate buildings as if they will have little or no value at the end of 30 or 50 years. In some instances we find, to the contrary, that after 30 or 50 years buildings have actually increased in value. In other instances, we find that they are torn down and replaced before they reach their full depreciation lives. Rather than to wait and see what the final value is, the practice is to take annual depreciation expenses against building assets with the primary benefits being seen in the financial arena.

Illustrating further that depreciation may have little to do with the physical life of a building or a particular subsystem of that building, consider the depreciation practices between a leased and an owned facility. The fit-up of an owned building may be depreciated over the life of the building, while the same fit-up in a leased facility would be depreciated over the life of the lease. Also, a boiler that is part of a manufacturing line might well be deprecated over the life of the manufacturing line instead of the boiler's own life expectancy.
 

Managing the Depreciation Side of Recapitalization

 
Bob Papa, Director of Strategic Planning and Productivity at Bristol-Myers Squibb, points out that depreciation practices should, and do, impact how recapitalization expenditures are reported. Under Generally Accepted Accounting Principles one capitalizes (and then depreciates) expenditures that are made to improve the life, value, or productive use of an asset. Corporate finance people generally set these policies, and the depreciation tables that they use (in private industry at least), to make it financially attractive in the short term to capitalize expenditures. By deferring the reporting of those expenditures they potentially increase their reported earnings over the short-term. This means that there should be an economic incentive to accurately segregate recapitalization expenses from maintenance and repair, and not to "expense" expenditures of a replacement nature.

The negative side of capitalizing (and then depreciating) expenditures for the replacement of building subsystems is that this practice adds to the amount of undepreciated value of a building or building subsystem that has to be "written off" against earnings if and when that building is torn down or the subsystem replaced. For this reason, Papa points out that managing the "write-off" side of recapitalization is important — particularly if you are depreciating subsystems separately (e.g. a chiller), and specially if you are depreciating component parts of subsystems (e.g. chiller motors and valves). The problem arises when the overall building is being depreciated over a longer span than its subsystems, or that subsystems are being depreciated over a longer span than the lives of their component parts. If you don't fully write off the value of the old subsystems (or components) before capitalizing the replacements, you will end up with "double assets" on your books — the new subsystem and what remains of the undepreciated old subsystem. To keep building assets from being inflated and avoid paying property taxes on assets that don't exist (the old subsystem that was discarded), you need a depreciation/write-off system that is linked to the engineering side of recapitalization projects and to the department that files property tax information.

The issue of subsystems having lives greater than some of their component parts is addressed at IBM by not viewing the replacement of components as recapitalization outlays. Rather, they appear to treat the replacement of components as maintenance expense and the replacement of subsystems as capital investments.
 

Recapitalization is Not Maintenance

 
A major building subsystem is regularly maintained to keep it functioning in the manner for which it was designed. We lubricate pumps. We change the oil in engines. We clean carpets. That is maintenance and routine maintenance. When we discard the pump, engine, or carpet, and replace it with a new version, that's recapitalization.
The relationship between maintenance costs and outlays for recapitalization (major subsystem replacement) is based on the phenomenon of aging and failure. As major building subsystems age, their performance declines and they fail more frequently. If they have been properly maintained, they may last longer than if they have not been properly maintained, but eventually they start failing — that's part of the second law of thermodynamics. Since the repair costs are typically folded into maintenance budgets (maintenance & repair), maintenance costs rise as subsystems age. Figure 1 illustrates this cost-versus-age phenomenon.

As maintenance and repair costs rise for a building subsystem, there is a growing economic incentive to replace that subsystem in order to cut rising costs and eliminate operational disruptions associated with subsystem failures. At some point in time the present value of the replacement cost becomes lower than the present value of the projected maintenance and repair cost. When that happens, which should be at or around the subsystem's life-cycle date, the economic argument for replacement becomes very straightforward.
 

Agreement/Disagreement

 
These basic principles of recapitalization have the general approval of the contributors to this paper. The words "general approval" however, need to be stressed, since, as it has already been noted, some of contributors use different terminology to describe the concepts involved. The terms "building subsystems" and "major building components," for example, are favored by some contributors for building assets that are the issue of recapitalization.

Where major differences start to appear between organizations, however, is in the specifics of budgeting, planning, and defining subsystems. And that is the subject of the rest of this paper.
 

Recapitalization: A Separate Line-Item

 
For some firms, recapitalization is only a theoretical concept that does not show up as a budgeted expense, but is instead buried in maintenance and repair budgets or in projects. In this business model, the reality of recapitalization, that is, replacing major subsystems, never quite gets nailed down financially, and the term itself ends up meaning different things to financial and real estate people than it does to facilities operating people. Recapitalization, then, tends to "just happen" to the extent that maintenance and project budgets can afford it.

If recapitalization expenditures are subsumed under maintenance, repair, and project budgets, and those budgets are inadequate to address recapitalization needs, recapitalization projects will be postponed. When recapitalization projects are postponed, maintenance and repair costs start to climb as building subsystems start to reach the end of their physical lives. Postponement of subsystem replacements may also contribute to the accelerated deterioration and premature failure of other, interrelated subsystems, thereby driving M&R costs up even faster.

The commonly stated statistics regarding expenditures for maintenance and repair are not enlightening. In fact, they are dangerous to use because they do not specify whether expenditures for recapitalization are included. The range of two to four percent times the replacement value of facilities for an annual maintenance and repair budget is commonly cited in the literature. (NRC, Stewardship of Federal Facilities, National Academy Press, 1998, and The Whitestone Building Maintenance and Repair Cost Reference, Whitestone Research, 1999) There's a big difference between a two percent budget and a four percent budget — the latter being twice the amount of the former! Whitestone Research's 1999 client survey data puts maintenance and repair expenses at the four percent level. Because recapitalization is not identified as a separate budget line item, nor is it even mentioned, it is not clear if these percentages include recapitalization at all, or if the four-percent level does, while the two-percent level does not.

Reasons for the wide discrepancy in reported annual percentage numbers (two percent vs. four percent of replacement value) for maintenance and repair may very well have to do with recapitalization expenditures. As shown in Table 1 there are six possible variances in reported maintenance and repair figures to consider: (a) the age of a building and its subsystems, (b) whether or not recapitalization is subsumed under maintenance and repair expenses, and (c) whether or not recapitalization outlays are occurring.

If the building or building portfolio is relatively new, the issue of recapitalization outlays will not yet have occurred, thereby yielding low percentage numbers for maintenance, repair, and recapitalization. If the building or building portfolio is old, or many subsystems have simultaneously reached the end of their physical lives, then recapitalization is an issue that will raise reported maintenance and repair costs. If recapitalization is subsumed under maintenance and repair (high M&R costs), or if recapitalization projects are not being done at all, then high real outlays will result for maintenance and repair.

Recapitalization expenditures are a distinctly different class of expenditure from those made for maintenance, repairs, and capital projects. Unlike maintenance, recapitalization expenditures are occasional, discrete events. Unlike capital projects, recapitalization expenditures are not made to create new capacity. Rick Biedenweg points out that maintenance and repair expenses tend to consist of numerous expenditures of small dollar amounts, capital projects tend to occur in very large dollar increments, and recapitalization outlays tend to be in the mid-dollar category.

Table 2 illustrates recapitalization as a separate line item as well as the possibility that, depending on an institution's finance policy, it may be charged as an operating expense or capitalized depending on the magnitude of the outlay.
 

Three Different Planning and Budgeting Approaches

 
Where recapitalization is identified as a separate expenditure item, there are three general budgeting approaches being used to determine recapitalization budgets.

1. A "flat" annual budget number equal to a percentage of facility replacement costs,

2. A forecast of the replacements dates for all facility subsystems based on their expected physical lives, and

3. Subsystem replacement forecasting modified by data from physical condition assessments and current actual maintenance and repair costs.

In the first approach, the common practice is to calculate an annual recapitalization budget number by applying a fixed percentage to the replacement cost of entire buildings or portfolios of buildings. In the second approach, the recapitalization budget is determined by projecting over a period of several years the actual forecasted expenditures to replace building subsystems (roofs, chillers, etc.) at the end of their expected lives. The third approach is essentially the second approach modified by data acquired from actual field assessments of subsystem conditions and current maintenance and repair information for those subsystems.
 

Annual Percent of Replacement Value Number

 
The annual percentage-of-replacement-cost is the "rough justice" approach. The most common and least defendable application of this is picking a percentage number that is multiplied by the replacement cost of entire buildings or portfolios to give a flat annual budget number for replacement expenditures. If you take this approach, a common number used is two percent of the replacement cost of the building. Remember, this is in addition to whatever you are spending for maintenance and repair.

Planners at IBM, drawing on data from a Balderston & Guthrie study, (Balderston & Guthrie Headquarters Study, 1999, Lou Guthrie) put typical percent-of-replacement-value-numbers for maintenance, repair, and recapitalization for a broad sample of businesses at:

  • Annual maintenance & repair = 2% of building replacement value
  • Annual provision for capital renewal (recapitalization) = 2% of building replacement value

They have also developed a costing model to calculate a recapitalization rate based on the value of building subsystems. This costing model provides some justification for the two percent figure shown above. The calculation, which is shown in Table 3, uses a schedule of building subsystem costs (Facilities Planning Handbook, Tradeline, Inc., 1995, pg. 171) to which are applied factors to reflect whether individual subsystems were maintainable or not (foundations are not maintainable), as well as the expected lives of each subsystem.

The same IBM source makes an interesting distinction between recapitalization for renewal (that is, recapitalization connected with the physical life of subsystems) and recapitalization for transformation (recapitalization connected with productivity improvements). The refined budgeting model would then be:

  • Annual maintenance & repair = 2% of building replacement value
  • Annual provision for recapitalization, physical = 1% of building replacement value
  • Annual provision for recapitalization, economic change = 1% of building replacement value

IBM and DuPont both appear to be making use of this annual percentage approach. IBM is attempting to develop a workable modeling approach for its corporate-level planners to arrive at the right macro numbers, but not without hesitations. An internally published IBM report makes the following comment on using flat rate or formula models at the portfolio level for recapitalization budgeting: "..the flat rate or formula models should not be used [at the portfolio level] for benchmarking or industry standards."
 

The Problem with the Annual Percentage Approach

 
DuPont (and probably 90 percent of U.S. corporations) appears to be pursing the approach of benchmarking against other lab owners to arrive at the right percentage number to multiply by the replacement value in order to establish a recapitalization budget. The problem here is that any fixed percentage number, whether derived from a model or from numbers used by others in the industry, will not reflect the all-important timing issue. While the modeling approach or industry-norm approach may show two to 2.5 percent of replacement cost being allotted to recapitalization, a particular institution's number might well need to be four to five percent for a few years simply because it is experiencing a "wave of expiring assets" that needs to be addressed. Biedenweg states that he has seen situations where the outlays for any one year may well be two to three times what the average annual need is. As it will be shown in the Freddie Mac case study, peak recapitalization expenditure years can run as much as nine times the annual baseline number. Being able to demonstrate these "waves" in expenditures makes all the difference in successfully presenting a rational budgeting argument.

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For example, if the majority of your buildings were built in the late 1970s you are coming up on a period of heavy expenditures for roof replacement, since most of your roofs are reaching their 25-year lives. For the years between 1975 and 1999, any percentage of building replacement cost that was built into your annual budget to cover roof replacement would not have been used. Further, any flat annual percentage number you currently have built into your budget for roof replacement will be too small to cover the big roof-replacement expenditures that you are going to have to address within the next four- to five-year period.

Expand this illustration to lab buildings. If you built several lab buildings in the 1970s and 1980s, you most likely will have many high-ticket subsystem replacements looming ahead that up until now may not have required replacement funding. These range from HVAC systems to fume hoods, casework, and utility distribution systems.

This basic incongruity between a budgeting formula that sets level annual amounts (or percentage of assets) for replacing building subsystems, and the uneven timing of the actual replacement events, is a logic flaw in budgeting that makes arguing the average annual percentage numbers with financial people difficult. If it were possible to accrue a constant budgeted amount into a sinking fund from which you could draw funds when needed, then such a budgeting approach would work. However, there is no evidence that any institution does this.
 

The Case for Subsystem-Based Budgeting

 
The budgeting approach recommended by Rick Biedenweg of Pacific Partners Consulting Group is to build a subsystem-by-subsystem spreadsheet that reflects the actual years when you expect replacement dollars to be necessary for those subsystems. Over a 50-year time span, the expenditures may well tend to average out to be the percent-of-replacement-value numbers reflected in Table 3 of this report. However, they will have a time-based reality to them reflecting the fact that in some years, your recapitalization budget will be small, and in other years it will be large. Table 4 illustrates this concept.

The logic of the life-cycle planning model is that as building subsystems reach their life expectancies, maintenance and repair costs for those subsystems will start to rise. When that happens, replacement makes economic sense by virtue of a simple return-on-investment rationale: if you replace aging subsystems with new ones, you eliminate the portion of maintenance and repair costs that is rapidly rising.

Some types of building subsystems become technologically obsolete before they hit the rising-maintenance-cost stage of life. Building control systems fall into this category. An old building control system may work just fine, but by replacing it you may be able to greatly cut the costs of heating and cooling in your facilities.

The logic of the life-cycle planning model is that as building subsystems reach their life expectancies, maintenance and repair costs for those subsystems will start to rise. When that happens, replacement makes economic sense by virtue of a simple return-on-investment rationale: if you replace aging subsystems with new ones, you eliminate the portion of maintenance and repair costs that is rapidly rising.

Some types of building subsystems become technologically obsolete before they hit the rising-maintenance-cost stage of life. Building control systems fall into this category. An old building control system may work just fine, but by replacing it you may be able to greatly cut the costs of heating and cooling in your facilities.

Table 5 sets out a rough replacement guide that was created from information provided by Tom Henderson of Building Technology Associates. Henderson points out that the wide ranges suggest that the actual numbers are no more accurate than the "gut-feel" for expected lives given by an experienced local facility manager. Better forecasting can be done, according to Henderson, with models based on databases that reflect as-built characteristics, usage factors, and the knowledge of existing defects. Biedenweg echoes that view and points out that although published reference tables for the average lives of different building subsystems and components do exist, these tables should be tempered with actual institutional experience. For example, an institution may wish to start with an industry standard such as Means or Whitestone and then use actual institutional experience, operating data, and condition assessments to modify the life-cycles periods.

Freddie Mac has taken the subsystem-by-subsystem approach to recapitalization planning and budgeting. As described more fully later on in this report, an in-house team took eight months to assemble data on more than 400 major assets in their building portfolio from which they constructed a 30-year recapitalization replacement budget. The assets addressed by their budgeting model included, among other items:

  • Building heating
  • Ventilation and air conditioning systems
  • Roadways
  • Roofs
  • Computer room environmental support equipment
  • Lighting
  • Furniture and accessories
  • Cafeteria equipment

IBM is also going down this path with a program called Real Estate Value Management (REVM) which is described more fully below. REVM is referred to as a "modified life-cycle recapitalization model" in which the real estate portfolio is periodically inventoried and assessed at the site and building level in terms of systems and subsystems. Recapitalization projects are identified pursuant to the assessment process, which flags maintainability, reliability, and regulatory issues. Funding is made on a priority-ranking basis. In IBM's case, instead of forecasting seasons of replacement by subsystem as Freddie Mac is doing, IBM identifies subsystem replacement situations by examination.

It is well to point out that the life-cycle, or modified life-cycle spreadsheets being discussed here refer to building subsystems, and not building components — a distinction that was made at the outset of this paper. According to Rick Biedenweg, some institutions he has examined have indeed taken the approach of creating component-by-component spreadsheets in which they attempt to track and predict lifecycle replacement schedules for long lists of small hardware items on the mistaken notion that more is better. According to Biedenweg, they then end up with as many as 60 pages worth of components for a single building, all of which are being tracked on a life-cycle basis. Detailed spreadsheets such as this require substantial effort to implement and maintain and, according to Biedenweg, are no more statistically reliable than a subsystem-by-subsystem analysis.
 

Problems with the Subsystem-Based Budgeting

 
The primary weakness of the subsystem-based budgeting approach lies in the fact that the anticipated physical lives of the subsystems are simply estimates based on general experience, not facts pertaining to specific situations. The actual life of a subsystem in a specific situation is a function of literally hundreds of variables, and may vary substantially from the average life of all subsystems of that type. Whereas the subsystem-based budgeting approach is a great improvement over the flat percentage budgeting approach in helping facility owners anticipate waves of recapitalization costs in a general way, it is, by itself, still an approximation of future recapitalization expenditures.
 

The Subsystem "Plus" Approach

 
IBM, Freddie Mac, and Building Technology Associates (BTA) use the subsystem-by-subsystem approach to establish recapitalization budgets, but all three also use current field data on subsystems to establish actual spending programs. (See below for more information on the Freddie Mac and IBM programs).

BTA's approach to recapitalization is based on subsystem planning, but, in addition, it offers a full-blown database and software-modeling tool that incorporates field operating data and condition assessment information. The tool offers analytical algorithms for calculating optimum replacement plans, determining strategic repairs prior to replacement, and determining the economic value added and earning per share impacts of decisions on large numbers of subsystem assets. The company offers this package commercially as a financial asset management program.
 

Problems with the Subsystem "Plus" Approach

 
The main problems with the subsystems "plus" approach (adding real field data to a subsystem replacement model) have to do with the resources needed to make it work, namely people and tools. On the people side it requires qualified technicians who have the time to accurately make condition assessments, and it requires analysts to evaluate the data. IBM and Freddie Mac both dedicate people to do these tasks annually. On the tool side it requires a data-storing system for facts on many subsystems and analytical routines to churn out rationales for decisions.

IBM's reluctance to adopt a complete and detailed life-cycle forecasting approach to recapitalization budgeting is due to their assessment of the volume and cost of information needed to make the budgeting process accurate. They predict, however, that "with the advent of e-business and pervasive computing these constraints will rapidly diminish."

BTA is an example of a service firm that appears to be addressing this problem with a packaged service and well-developed methodology.
 

Where Does Lab Renovation Fit In?

 
Lab renovation projects fall into three basic types:

  • Maintenance-related recapitalization that is undertaken because old systems have reached the stage of escalating maintenance and repair costs.
  • Transformational recapitalization that is undertaken because the type of research or research processes have changed.
  • Technological obsolescence recapitalization that is undertaken because new building subsystems (usually HVAC) have become available, or are mandated, offering operating cost savings, greater safety, or a better work environment.

When HVAC recapitalizations are done for labs, the impact is usually so great that fume hoods are changed out as well. Transformational and technological obsolescence recapitalization projects also often impact fume hoods. Rarely are major lab renovations done in which it is economical to keep old fume hoods. A lab building with a 25-year-old HVAC system is a prime target for all three types of recapitalization arguments.
 

Freddie Mac's Asset Lifecycle Costing Project

 
In 1998, Freddie Mac undertook an asset lifecycle-costing project with the following objectives:

  1. Identify major assets (equipment, furniture, finishes, etc.) in use at Freddie Mac facilities.
  2. Obtain industry and historic data to determine the expected useful life of each asset.
  3. Determine "Freddie Mac" useful lives for assets based on the firm's usage patterns, maintenance practices, and long-range strategic business plans.
  4. Identify full replacement cost numbers (materials and labor) for major assets, which can be used for planning and budgeting purposes.

A project team was assembled with representation from each of the major functional areas that purchase and maintain facilities assets. A "Retirement/Replacement Matrix" was developed to collect data on assets that have a finite life span. The project team spent approximately 250 man-hours during an eight-month period identifying assets, recording estimated lives, determining the numbers of years in service, and researching replacement costs. Information sources used to obtain asset life expectancy information included but were not limited to, asset manufacturers, trade associations, newspapers and periodicals, and the hands-on experience of Freddie Mac employees.

The study addressed a total facility portfolio of 2.3 million gross square feet in which more than 400 major assets (subsystems) were identified. These assets included building heating, ventilation and air conditioning systems, roadways, roofs, computer room environmental support equipment, lighting, furniture and accessories, cafeteria equipment, and other assets. The information obtained for these assets represents the best industry and trade data available. Information on these assets was entered into the matrix to allow for manipulation of data to determine costs by year, by building, and by asset type. This information is used as a strategic budget and planning tool to anticipate increases in the capital budget and to demonstrate due diligence in planning for asset obsolescence.
 

Tracking and Adjusting for Actual Conditions

 
It is important to note that the lifecycle for each asset is based on performing ongoing, routine repair and maintenance. In other words, if Freddie Mac does not continue to maintain each asset at levels that meet or exceed manufacturer recommendations, the company would have to replace those assets sooner than expected. Therefore, there is a direct correlation between General and Administrative expenses for ongoing maintenance activities and capital expenditures for replacement costs.

Prior to the calendar year that an asset is scheduled for replacement, a field evaluation will be conducted to determine if, in fact, the asset must be replaced. Assets will not be replaced automatically just because they are at the end of their documented useful lives. On the other hand, the replacement schedule may be accelerated by changes in the company's business environment. For example, if a building is required to operate on a prolonged schedule (longer than the current 12 hours per day), certain assets in that building will most likely be replaced sooner than planned.

At the beginning of each annual budget cycle, representatives from each business unit participate in a yearly update and evaluation of the asset lifecycle matrix. At the time of the yearly updates, business units add new assets to the matrix, delete retired assets, and look for cross-impacts between groups.
 

Exclusions

 
Freddie Mac's replacement plan addresses mainly replacement for functional purposes, and it excludes replacements for transformational or technological purposes. For example, asset replacement costs not addressed by the Freddie Mac matrix include assets that will become obsolete and be retired at undetermined times due to technological advances. Fax machines, copiers, and leased vehicles fall into this category and were not given definitive life cycles in the matrix. The Freddie Mac matrix also does not address future outlays that could be justified by the new technological improvements, such as retrofitting to take advantage of more energy efficient lighting technology, nor does it address asset replacements that would occur as the result of major business process changes.
 

Freddie Mac's 30-Year Plan for Asset Replacement Outlays

 
Freddie Mac's lifecycle costing project for facilities assets has been developed to span 30 years of operations. As shown in Figure 2, there are years of high peak expenditures and years of little or no expenditures. In reality, they will work to smooth the curve by physically examining assets to see if they can either postpone or accelerate replacements to have them occur in years when forecasted expenditures are low. Nevertheless, this graph provides the company with a guide to planning and budgeting which signals "seasons" of heavy capital outlays for subsystem replacements. The numbers shown in Figure 2 reflect 1998 dollars and will need to be adjusted during the actual budget years that assets are scheduled for replacement.

The calculated spike in recapitalization outlays that occurs in 2000 includes replacement of HVAC rooftop units, roofs, carpets, chairs, and executive furniture. In 2005, heavy outlays are calculated for an uninterruptible power supply system, more roofs, wall fabrics, chairs, and executive furniture. In 2010, the list includes generators, more HVAC units, UPS batteries, another UPS, more carpeting, and cafeteria equipment.

Over the 30-year period, Freddie Mac's total recapitalization budget in 1998 dollars totals $30 million. If you take the current replacement cost of 2.3 million gross square feet of office space in McLean, Va., (Freddie Mac's location) to be $100 per square foot, that would result in a 30-year average recapitalization budget of less than one half of one percent of the calculated replacement value. In the three peak expenditure times that are calculated to occur in 2000, 2005, and 2010, however, recapitalization expenditures for Freddie Mac are calculated to be 1.8 percent, 3.6 percent and 2.5 percent of replacement costs, or as much as four to nine times the 30-year average.
 

IBM's Approach to Recapitalization

 
In 1998, IBM was the recipient of IDRC's Best Practice award for a program adopted by IBM in 1996 called Real Estate Value Management (REVM). IDRC Communicator, IDRC, October, 1998) REVM is in essence an asset replacement planning and management program.

In the late 1980s, IBM found itself faced with rising costs of asset ownership coupled with an increasing expense-to-revenue ratio. During these years, many of the company's capital spending decisions resulted from "put-out-the-fire" criteria.

By the early 1990s, studies showed premature deterioration and failure in building systems due to a lack of investment in fixed assets. At the time, an assessment of IBM's real estate portfolio indicated that more than 50 percent of the portfolio was more than 25 years old, and more than 50 percent of the major equipment had passed the 70 percent life-cycle point.

To address these issues the IBM Real Estate and Site Operations (RESO) organization developed and implemented REVM.

REVM is a global business process that:

  • provides a common methodology or criteria for evaluating the condition and performance of IBM's real estate assets.
  • provides a capital allocation system.
  • supports business plans.
  • focuses on portfolio value management.
  • balances business affordability and real estate risk.

The REVM program process involves these elements:

  • Identify, inventory, and profile the real estate portfolio at the site/building level.
  • Assess the physical state of assets, at the system and subsystem level.
  • Develop feasible alternatives, identifying cost and timing as well as maintainability, functionality, reliability, flexibility, and regulatory issues.
  • Integrate business strategy factors to develop a weighted rank-order based on risk (regulatory, productivity, preservation, deferral, and strategic risk).
  • Identify the appropriate affordability/risk levels of all ranked programs.
  • Secure funding and implement programs.
  • Measure benchmark results.

The net impact of the REVM program is that IBM's capital real estate value management system has transitioned from a transaction-based program to a stable, process-based program. IBM sources report that the REVM program has contributed to increased customer satisfaction at a lower overall cost and improved expense-to-revenue ratio.
 

DuPont Findings Confirm the "Waves of Expiring Assets" Phenomenon

 
DuPont reports that the company has neglected the recapitalization needs of its lab and office facilities to the point that maintenance demands are rising to unacceptable levels. They report that maintenance costs and service calls have rapidly increased during the past three years, and that the facilities department lacks the people-resources to keep up.

DuPont had been following an historical policy of spending one percent of replacement value every year for recapitalization projects. For the past few years they've raised that to the 1.5 percent to two percent level and are still finding it is not enough to catch up. Currently they are trying to raise that figure to more than 2.5 percent. For one particular group of office buildings that were built 20 years ago, they are finding that maintenance costs are suddenly beginning to escalate at a high rate, so that even the 2.5 percent number is proving to be too low.

A recent employee survey on how building occupants feel about their workspace gave senior management a clear message that employees were very displeased with the condition of the facilities. That feedback is helping DuPont facilities groups to compete more favorably for capital funds during the next few years.

Currently DuPont is attempting to develop recapitalization percentage rates (percent of replacement cost per year) based on building types. For low-rise office buildings built inexpensively for a life span of 20 to 25 years, they would propose an annual recapitalization budget of four percent of the replacement cost based on the short life-span and low construction quality of these facilities. For laboratory buildings they see the need to recapitalize on a 25-year cycle partly because of deterioration of these kinds of facilities, but more due to technological obsolescence factors. That also translates to a recapitalization rate of four percent of replacement value per year. DuPont is currently benchmarking with several other companies with R&D facilities to try and determine a best practice recapitalization rate for their laboratories.

In practice, the Dupont facilities group is not allocated adequate capital to recapitalize its facilities, particularly its low-rise office portfolio. This has two consequences. The first is that maintenance costs and work disruptions are rising, and are expected to continue to rise, rapidly. The second is that physical inspection of major systems is playing a crucial part in allocating scarce funds to the most urgent problems.

In contrast with the subsystem planning approach illustrated by Freddie Mac, Dupont's model is a flat percentage rate that should be adjust upward as building systems age, but which in fact isn't being adjust upward because of capital spending limits.

For more information on the above report, please contact the Tradeline Editor

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