Broker reserves $0.35 a foot on a 1994 MOB. What number do you use?

Question

Walked the mechanical spaces on a 22,000 sf two-story medical building last week. Two original 1994 rooftop units on the north half, both replaced sometime around 2011 by the look of the data plates, four newer splits serving the imaging suite, and a 30 year old boiler that somebody has kept alive with rebuilt pumps. Roof is a mid-life single-ply with ponding on the west bay.

The offering memo reserves $0.35 per square foot per year for replacement reserves. That is a garden apartment number. Medical buildings run their systems hard, the imaging tenant has a dedicated cooling load that never turns off, and every tenant improvement cycle in exam space costs multiples of what a general office refresh costs because of plumbing in interior walls and specialty exhaust.

I'll argue both directions. On one hand, a lot of that capital is either tenant funded or recoverable through operating expense pass-throughs with capital amortized over useful life, so double counting it as a reserve overstates cost. On the other hand, recovery caps and base year structures mean landlord eats a real share, and if you set the reserve too low you're pricing off a NOI that doesn't survive contact with the boiler.

My own gut from the construction side says a building like this needs somewhere between $1.25 and $2 a foot in true annualized capital including tenant improvements and leasing costs, and that if you don't take it out of NOI you should at least take it out of the price. Curious what people who own these actually book.

megan_doyle15 · Answer

Dumb question, is a reserve an actual bank account with money in it or just a line in the spreadsheet? I've seen it both ways in things I've read and I can't tell which people mean here.

diane_kowalski · Answer

@rigging both exist. Lenders often require a funded reserve account they control and you draw from it with receipts. Separately, when you underwrite you subtract a reserve line from NOI whether or not the cash is segregated, because pretending capex doesn't happen makes the cap rate look better than the building is. @solder is arguing about the second kind.

dmitri_v6 · Answer

The number depends on language nobody quotes in an offering memo. Look for whether capital replacements can be included in operating expenses amortized over the useful life of the item, whether the amortization uses an interest factor, and whether there's a cap on controllable expenses that swallows the amortized capital anyway. A base year lease with an uncapped structure and permitted capital amortization pushes most of that boiler onto tenants over ten years. A gross lease with a hard 4% cap on total increases pushes it onto you.

Also check the caps in the specific leases rather than the rent roll summary, because in multi-tenant medical I've read three different recovery structures inside one building. @solder if the imaging tenant is on a full gross deal, your $2 a foot may be low, not high.

hannah_west29 · Answer

Numbers, since nobody's put any up. On 22,000 sf, $0.35 psf is $7,700 a year. One rooftop unit sized for a medical load is going to be well into five figures installed, and a full single-ply roof replacement on that footprint is a low six figure job. So the proforma reserve funds roughly a fraction of one component per year on a building with a boiler older than most of the tenants' equipment.

Separately, the piece that eats people isn't equipment at all. Medical tenant improvements on a re-tenant run several times a general office refresh, and if you assume one 3,000 sf suite rolls to a new tenant every three years at even a moderate allowance, that alone is more than $0.35 psf annualized before a single mechanical failure.

What's wrong with my framing: I'm assuming rollover. If the rent roll is mostly long-term system-affiliated tenants renewing in place with modest refresh allowances, the TI drag drops a lot and $0.75 to $1 might be defensible. So the answer is set by the rent roll, and I'd price the reserve per suite rather than as one building-wide number.

bmoreno23 · Answer

I have no experience with this, and what I'm taking away is that the offering memo number is an opinion, not data. @solder walked the roof and the mechanical room and got a different answer than the spreadsheet. Is walking it yourself the normal expectation on something this size, or do buyers just order the condition report and read it?

Broker reserves $0.35 a foot on a 1994 MOB. What number do you use?

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