Aligning your Capital Works Plan with the building’s future valuation
A partial case study for an Inter-War Flat building
A Capital Works Plan (CWP) can often become a blunt instrument that creates more harm than good in old buildings. Property valuations are a key motivator for improvements and old buildings with valuations just above land value growth ring alarm bells in terms of how money should be allocated for building maintenance and improvement in a CWP.
Valuation is partly real and partly perceived and aligning your CWP with a building’s future valuation means asking some fairly subtle questions, such as:
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Does the CWP fit with the building’s specification?
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Is the CWP complete?
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What fixed costs are hidden in the CWP?
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What are the assumptions around risk?
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How is strata supporting the CWP?
Does the CWP fit with the building’s specification?
The building’s specification is critical to understanding whether your funds are simply rearranging the deck chairs on the titanic.
My case study focuses on a 1929 building constructed during the Arts & Craft design period when the pre-Raphaelite movement led by William Morris and others feared the rapid modernisation of industry through the Industrial Revolutions. This design movement rejected modern materials created through chemistry and advocated a return to traditional building materials and techniques.
This means that my case study building has no concrete in it. There are no concrete foundations or concrete floors. There is no cement used between bricks. The original lintels are made of timber or compacted clinker, and replacement lintels using pre-stressed concrete often fail early due to the type of movement. Likewise, all roofing timbers use iron square head nails and there are no bolts or plates. The building is always moving and the lime mortar, emulsified with whale oil, accommodates this movement. But lime is caustic and oxidises certain metals in modern building materials, and also has little resistance to water flow. A $3,000 crack repair in the sea shell roughcast can quickly become a $30,000 repair because rainwater has washed away the lime between the bricks and caused major structural movement.
If repair materials are not compatible or if seemingly insignificant defects go unchecked, the maintenance cash-burn rate can spike. Any building has a finite life and at some stage the analysis of the CWP needs to adopt a surgical process in defining its contribution to the building’s real value, and this means that certain upgrades are simply too risky for owners corporation funds. More on this topic later.
Typical erosion of lime mortar hidden behind the roughcast which is caused when a minor crack is not repaired and the rainwater is able to flush away the lime between the bricks. The repair is not difficult but does require access via a scaffold or scissor lift. The membrane on the walls requires inspection every 10 to 15 years to ensure that rainwater infiltration is minimised, and this means that the owners have to budget for scaffolding every 10 years.
Is the CWP complete?
The issue of completeness, a term favoured by the accounting profession, is really about whether the right items are included and the wrong items excluded. Wrong items include upgrades to the property that go beyond the repair and maintenance obligations in the Strata Schemes Management Act. For example:
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upgrades required to meet current BCA requirements as part of a Development Application should not appear in the CWP (e.g. fire, termite management, drainage, electrical, geotechnical, structural and other upgrades).
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upgrades that could overlap with repair and maintenance obligations should not appear in the CWP (e.g. upgrading window performance with acoustic glass, acoustic seals and secondary glazing when the obligation is only to repair and maintain sash cords, beadings, painting and other timber works).
Inclusion of upgrades which are not strategic will over-inflate the CWP and make it appear too costly and cumbersome for any new owner resulting in reduced valuation. It also makes it harder for existing owners to claw back their investment.
Of course, this does not prevent owners from doing upgrades but the costings and provisions for the upgrade should be at arms-length and appear in separate documentation to the CWP. This is usually a Special By-Law that provides common property rights to some or all owners, and also provides owners with much more freedom in design and specification.
Likewise, not including the “right” items or including them in a manner that does not deliver clarity, is also value destroying. This is very subjective but if the goal is to build value then owners need to put themselves in the shoes of the professional people who might scrutinise their building. In this regard, the use of engineers, neighbours, tradespeople and real estate agents should always come before the quantity surveyor (a typical author of the CWP) as surveyors rely on quality inputs to deliver meaningful outputs.
What fixed costs are hidden in the CWP?
Fixed costs play a big role in sorting the good from the bad. A good CWP will have adopted a process where major fixed costs are clearly itemised in the CWP and the scope of other works is built around them. Scaffolding is a good example.
In my case study building there is a need to check and repair the membrane every 10 years or so. The membrane is acrylic and flexible but becomes brittle with age. Since the building is constantly moving as it has no concrete foundations, and the bricks rely on lime mortar for their integrity, a superficial crack can quickly hide structural issues. At the same time the owners want to upgrade windows, which also requires scaffolding.
Now, as already discussed, window upgrades are the owner’s responsibility and should not appear on the CWP. The scaffolding costs for membrane repairs should be kept at arms-length to the scaffolding costs that owners incur for window upgrades.
However, let’s assume that a majority of owners want to upgrade their windows and they see the use of scaffolding for membrane repairs as an opportunity to reduce their own costs. This can start to create conflict as most owners in shared schemes do not apply any governance to their decision making. They struggle to distinguish between the rights of an owner’s air space and their obligations through a separate legal entity for the external structure and common property. The line between owner and shareholder is blurred. It starts to create a cocktail of outrage that can become very time consuming to resolve and compromise is often the better approach, but that is a topic for another day.
To accommodate multiple tasks or work events through a single fixed cost item, and therefore make the CWP as efficient as possible, the owners will need to ensure that the fixed cost item (e.g. scaffolding at $50,000):
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has its own line item
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has its own contract and the specification defines the multiple tasks that need to be done with any phasing across different facades (e.g. scaffolding each façade at $15,000 per year for windows and membrane works)
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has been phased according to the risks (e.g. the 10-year painting cycle and window upgrade process has been phased so that the eastern facade taking the brunt of the weather and street noise gets completed in year one, followed by other facades in 12-month cycles)
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has been excluded from other work items in the CWP that rely on the fixed cost item and this is clearly stated (i.e. there is no double-counting of cost estimates).
Over-capitalising when renovating. In my case study building a unit was bought in 2001 for $560k and almost $200k was spent on renovations. It then sold for $800k in 2010. Over the 9 years the property grew $240k in value, as a combination of land and asset value, but was sold $48k below the trend value. Over the same period asset costs were averaging $5k per year. The total net growth in the property over 9 years was close to zero.
The growth in value of a unit in my case study building has increased on average by $32,000 per year between 1994 and 2018. However, land values have grown by $23,000 per year and so asset growth has only been $9,000 per year. For the same period, a total of $790,000 in common property levies has been raised to maintain the asset, which is an average of $8,800 per year for each owner. This annual expenditure is just covered by the asset growth per year, but anything beyond the $9,000 trend growth is likely to be dead money and owners will have over-capitalised at the expense of their highly efficient land growth.
What are the assumptions around risk?
Risk analysis is a standard tool but communicating the underlying assumptions in a way that people understand and accept is verging on a black art for some topics. But its use is important as it impacts the timing of money and can spread the cost burden. Numbers help to build scale and relativity (i.e. quantifying risk) but the main challenge is building a narrative or story around the connection of events and assumptions. People usually warm to story-telling.
In my case study building there has been a long history of using a CWP to prioritise works and this has usually raised 2 types of enquiry:
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Why is the line item in the CWP (i.e. do we really need to do this)?
A work item in a CWP is sometimes enforced (e.g. through a fire order) but mostly volunteered by an owner or recommended by an engineer or tradesperson. One critical issue with volunteered or recommended information is managing the conflict of interest (i.e. the recommendation is motivated through financial gain). Obtaining second, and even third opinions in writing from professionals is critical to managing this.
A mistake made all too often by owners is agreeing to works that inadvertently add to the building’s contingent liabilities. For example, changing fire doors because they are filled with asbestos, but not converting the fire door to an outward opening operation to support its path of egress requirements stipulated by Council. This is because the decision-makers often lack the knowledge to assess these scenarios, and because the communication tools fail to build confidence in owners around the future performance of the building to support a growing valuation. Defining the scope of work and specification (the story) is the single most powerful communication tool for building solidarity in the purpose of each line item in the CWP.
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Why is it a priority now (i.e. surely it can wait another 5 or 10 years)?
This is where the narrative is crucial in order for those funding the work to understand their exposure. Owners sometimes want work done earlier than planned because the perceived risk triggers outrage (e.g. the replacement of fire doors filled with asbestos), but in most cases owners want the cost delayed because they do not see it as a current priority when weighed against other items on the list (e.g. delaying the 10-year check on the façade membrane because it looks OK from the footpath). However, shifting the priority needs to be technically grounded and fully understood by owners.
In our case study building there are 4 units that still use the old 1929 electrical lighting circuit with metal conduit. As these circuits age they can present a hazard especially if the conduit earth is not intact. However, they can also remain in perfect hidden condition and replacing these circuits is extremely invasive for owners as it involves holes in ceilings, chasing out walls for bigger conduit and even installing noggins between joists for new fittings. Lime dust is caustic and very fine. In this scenario the priority can be shifted by using safety switches which are installed on all circuits and these trip with the smallest electrical leakage to protect occupants. This measure changes the risk profile and gives the owners more time to plan the long-term improvement which, in this case, includes the installation of a new 10mm power feed into each unit with their own distribution board.
How is strata supporting the CWP?
The role of strata is very limited in how the CWP can support a building’s future valuation. The Strata Schemes Management Act 2015 makes reference to a CWP in Section 80 (Part 5, Division 2) and its clauses define the minimum requirements. The Act provides a lowest common denominator for owners and does not define any performance parameters. The role of owners, on the other hand, is more about a mindset as their duty is as a shareholder.
For these shareholders, if the focus of the CWP is not strategic in lifting or maintaining the valuation of the asset then the risk of over-capitalising is very real. Allocating funds through the CWP to play catch-up with contemporary performance standards can easily become dead money. For example, spending $250,000 to “repair” 90-year old timber windows that will always fail to meet contemporary performance standards is unlikely to ever be recovered in the sale, and the owner will simply have to depreciate the cost over their time of ownership. The market rarely rewards these types of works as they are the norm in more modern buildings and cheaper.
By way of further example, if my case study building was planning to raise $1.2 million over 10 years in a CWP then it is highly probable (with 90% confidence) that each owner would only recover $90,000 of their $200,000 share of the cost, ignoring NPV and depreciation, and $110,000 would be dead money. Their 10-year net growth position, recognising that land value on their unit will most probably increase by $230,000 over the 10-year period, could be as low as $120,000.
However, some upgrades through the strata scheme can be very strategic if all owners agree. For example, the addition of a mechanical lift or the sale and conversion of redundant common property airspace to benefit each Lot can significantly lift valuations for a specific target market (e.g. baby boomers).
A future Royal Commission? If asset growth is only $9,000 per year for each unit, how much should an owner (as a shareholder) be paying in administration costs to achieve this growth? Is it 10% or 20%? This question ignores land value growth as this will occur regardless of any asset being present, and is no different to asking the same question about the fees in a managed fund investment, life insurance plan or aged care plan. In my case study building about 35% of the $9,000 asset growth is used to administer this growth annually.
Owners will always have far more diversity in their Lot air space to facilitate upgrades than the owners corporation, since the obligations of the owners corporation are only to repair and maintain the asset and owners can now more easily access permission to modify many aspects of the asset that they come into contact with. The ability for owners to spread the risk of over-capitalising is far greater than anything available to an owners corporation because they can build scale which allows them to descend the cost curve. A levy of $35,000 for a window upgrade contract is only likely to cost the owner $20,000 when it is part of a $100,000 renovation. The owner saves $15,000 by using a Special By-Law and builds their margin for a future sale, which can be crucial if the property value is only going up by $32,000 per year or $9,000 if you exclude the land value growth.
To better understand these risks and options, the owners corporation for my case study building resolved to opt into a collective sale process in 2017. The economic driver for this is the land value at 50% of the property value and based on contemporary standards the land can comfortably support 8 new units with a valuation of between $2.5 million and $3 million each.
The principal author has no commercial interest in any of the properties referred to in this article.