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Top Site Selection Factors: Occupancy & Construction Costs - Saving a Buck

Real estate typically ranks as the second- or third-largest expense for companies. So it is no surprise that occupancy and construction costs receive scrutiny for that reason alone. Add to that a challenging economic climate, and it is easy to see why companies are under pressure to wring more value out of their real estate.

Beth Mattson-Teig (November 2011)
The Top Site Selection Factor series outlines the factors that ranked high in importance by the executives responding to Area Development's 25th Annual Corporate Survey. Find out why and how these factors should be evaluated in your next move...

Businesses ranging from small mom-and-pop firms to Fortune 500 companies are all looking for ways to capitalize on a soft economy that will ultimately help to boost profitability over the long term. "In today's economy, the number-one objective for companies when it comes to real estate is the bottom line," says Joe Gearen, a senior vice president at Transwestern in Minneapolis. "What am I spending? Where am I spending it? And where can I do better?"

Occupancy and construction costs ranked as the fourth most important site selection factor in Area Development's 2010 Corporate Survey with 89.8 percent of respondents stating that occupancy and construction costs were considered very important or important. That was a 3.1 percent increase in importance compared to the 2009 survey.

"Companies are clearly valuing the cost of their real estate holdings more so than ever as there is absolutely an imperative for companies to reduce operating costs to the maximum extent possible," agrees Dennis Donovan, a principal at Wadley Donovan Gutshaw Consulting in Bridgewater, N.J. Companies that do have an expanding business unit are going to first look within their existing portfolio. "If there is enough space to accommodate a new need, then there is a preference to put it in an existing location if it even comes close to meeting operational requirements," says Donovan.

With real estate occupancy costs at the forefront, businesses are striving to create efficiencies and capitalize on the values that exist in today's real estate market. Certainly, opportunities exist both for discounted rents on the leasing side and reduced purchase prices on existing buildings. Those companies that put a premium on real estate as part of their image are taking advantage of the ability to upgrade real estate at discount prices, while other firms are proceeding with a simple strategy to cut costs.

Focus on Efficiency
Companies are scrutinizing the overall occupancy cost more carefully including the base rent, taxes, and CAM (common area maintenance) charges. "Everybody is really tightening belts on all aspects of real estate from their operating expenses to their rental rate," Gearen says. For example, Gearen is working to lease office/showroom space in a northwest suburb of Minneapolis where the CAM is $4 per square foot - $1.25 to $1.50 higher than in other nearby locations. Even offering tenants an initial base rent that is lower than the competition isn't enough of an incentive. Companies are weighing the total occupancy cost over the life of the lease and the higher CAM costs are a bit of a deterrent, he explains.

Slow economic growth following on the heels of the recession is putting added pressure on firms to utilize real estate efficiently. Instead of looking solely at the cost per square foot to lease or purchase a property, companies are increasingly looking at what is the cost per person or per unit of product that a company is manufacturing or shipping.

"Even if your cost per square foot stays the same and real estate costs remain steady, the cost per person or per unit of production could have changed dramatically because a building is half empty or production has been cut in half," says Gregg Wassmansdorf, a vice president in the Location Advisory and Incentives Practice for Colliers International in Toronto.

For some companies, cutting real estate costs is a matter of survival. For example, a contract manufacturer that produces white label manufacturing or nonbranded products relies on delivering a low-cost product as its main competitive advantage. "Those companies need to be prudent with how each dollar is spent, and they are very motivated to save money in real estate," adds Wassmansdorf.

Construction Costs Remain High
It is cost that is steering many companies to choose existing space over new construction. Although construction costs have declined during the recession, the broader long-term trend is that construction costs have been rising well above the core inflation rate. For example, the Producer Price Indexes (PPIs) for new warehouse construction rose by 8.1 percent in 2006, 4.5 percent in 2007, and 6.3 percent in 2008. The PPI did decline in 2009 to 4.1 percent, but has climbed back into positive territory in recent months. The PPI for the 12 months ending in August reached 2.8 percent, according to the Associated General Contractors of America.

Construction costs do weigh heavily in site selection strategies. For example, Wassmansdorf is representing a Europe-based biomaterials company that is looking for a location for its first U.S. facility. The firm has one capital budget for the whole project that needs to be split between the real estate and the machinery and equipment. That capital budget was cut in the wake of the recession. "They, like pretty much any company, will reduce the real estate portion of the budget before they will reduce the mission critical part of the budget," says Wassmansdorf.

The budget cutback has created major changes in the firm's original site selection strategy. Initially, this was going to be the company's flagship building in the United States. The company was planning to acquire a shell building and build out a nice new space. Now the company has shifted gears to find a less expensive building with as much usable infrastructure in place as possible, such as cleanroom technology. "The majority of companies are trying to preserve capital and reduce costs," Wassmansdorf says.

Among firms that decide that they do need a new location, 60-70 percent of companies prefer to locate in an existing facility as opposed to building new, notes Donovan. Although cost certainly plays a role in that decision, the bigger factor is time, as it can take 50-100 percent longer to assemble the property and construct the building than it does to retrofit an existing building. "Particularly when a company has delayed expansion coming out of a recession, timing is of the essence. It is a matter of getting revenue and profits produced as soon as possible," he explains.

Despite the desire to reduce real estate expenses, it is important to note that most companies are cost conscious - not cost foolish, adds Donovan. Businesses still want to lease, buy, or build a quality facility. Companies have a brand and a reputation to protect. They need to create a good work environment for their employees. Many companies also want modern facilities and are willing to invest in energy efficiency and sustainability technologies. "In the end, they are doing what's right for their business," he concludes.
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