Net of Utilities: A Savings Model for VA Clinic Operations
Mark Ritchie, Principal, Gantry

Oh, I miss the days when the Department of Veterans Affairs, or the VA’s, Solicitation for Offers (now Request for Lease Proposals or RLP) were “net of utilities” meaning the VA paid actual incurred utility costs and, more importantly, could exercise some control over these expenses. Today’s RLP is written to include utilities as a fully serviced expense provided by the Lessor. 

As a financier for many VA medical facilities (including HCCs, MS CBOCs and CBOCs – Clinics), I am amazed how onerous it is to properly put together operational pro-forma’s for our clients building and leasing these Clinics to the VA.  For utilities, if a potential owner bids too low, then any cash flow is wiped out upon lease commencement. Bid too high, then the VA is paying much more than it should for this line item in its rent. 

Now environmental concerns, including energy usage and conservation, have moved to a front and center position in both public and private sector projects.  Additionally, the U.S. Government is requiring that all leasing of federal projects be in buildings with “net zero emissions” beginning in 2030.  How do we get there?

For recently awarded VA leased projects, a base utility guestimate is included in a serviced rent calculation. Though the Clinic facility owner has no control over utility usage, they are fully responsible for significant changes or swings in utility costs. Since the VA doesn’t see these expenses, there is little incentive to manage utility costs.  

These issues were raised in a recent virtual industry event between the NFDA and senior leasing and construction executives at the VA.  The VA is aware of industry concerns with the current utilities rent structure. As the “net zero emissions” lease is a recent development, the VA (like other agencies) is just getting its arms around this as investments in energy efficiency for both real estate owners and VA operators will be a required outcome of this mandate.

Some of the factors impacting utilities that should be considered in pursuing an equitable balance in future VA leasing agreements with the owners and operators of Clinics and facilities include: 

By under-bidding utilities expenses in the RLP, the asset’s operations could be underwater financially, from the day it opens.
  • Current practice in bidding on Clinics is to err on the side of caution when incorporating utilities expenses. So, in many instances, the VA is paying more for rent (inclusive of utilities) than the VA should with utilities netted out.  As my company consults with prospective owners of these Clinics, we can confirm that this line item for developing a pro-forma budget is among the most vexing issues in trying to accurately develop rental models. 
  • Private sector single-tenant medical projects pay utilities directly, so relevant information is very difficult to obtain from the appraisal industry when constructing VA Clinic pro-formas.
  • Though many Clinics offer redundant services, some are more energy-intensive than others.  
  • Control is critical. Though the real estate industry has come a long way with developing energy-efficient buildings, as documented through Green Globe, LEED, Energy Star and other energy conservation programs, even the most efficient Clinic is still under control of the users of the Clinic and the staff managing that Clinic. Put another way, utility usage is completely out of control of the asset manager and in the control of the Clinic users. 
  • As the loan servicer for a significant number of GSA and VA facilities across the country, we studied utility usage and determined the factors going into utility costs made it extremely difficult to extrapolate between different facilities, different locations, different uses, and different climates to project utility usage for the next facility. Lastly, these leases are of multi-year terms and predicting future energy costs, which have proven to be volatile is simply impossible.

Potential fixes to the current system, which should pave the way for the VA to fully embrace “net zero emissions” in its leases well before 2030.

  • Turn the lease into “Net of Utilities,” as there is history for the VA utilizing this approach for its Clinics. By “Net of Utilities”, the VA will ultimately be responsible, either directly or indirectly for payment of utilities. Concern expressed by VA executives is that the VA is not necessarily staffed to pay these bills directly to the utility providing this service. All Clinic owners employ property management and there is no reason why a property manager cannot pay the bills and the VA reimburse this expense. This reimbursement can be made on a monthly, quarterly or on an annual basis. This will also serve to allow the VA to assume more control of its utilities. The ultimate short-term benefit to the VA is that the VA’s Lessor should be more competitive on its rent, knowing they do not have to raise rent otherwise to offset the guessing game of including all utilities.
  • Pre-award, the VA and it’s consulting teams (including the VA’s Broker) can do an in-depth study of utilities costs and include that amount in the serviced rent in the RLP for all bidders. Similar to property taxes in certain jurisdictions, utilities costs above a base number are reimbursed. Of course, a true-up would also occur if utilities costs run below this base amount, which would save the VA’s resources. 

Depending on jurisdiction, utility expenses are among the top three expenses in managing commercial properties including Clinics (generally behind property taxes and roughly the same as janitorial and labor expenses).  This reality makes getting utilities costs right in an RLP response critical to the success of a real estate operator’s business model, encouraging high side estimates to mitigate potential downside outcomes over the life of a lease. 

For VA Facilities Management officials, this area is also a compelling target for overall cost savings and operational efficiency across a growing portfolio of Clinic facilities nationwide through its ability to reduce rents across its portfolio. By shifting from a high side estimate to an actual net of utilities model, both parties in future lease agreements will be better served in the long run and encouraged to invest in meeting energy efficiency goals and related mandates. 

*The NFDA Board of Directors has reviewed and published this article, and endorses the opinion and position advocated therein for consideration and possible adoption by the Department of Veterans Affairs.

About the Author:
Mark Ritchie has over 30 years of experience in commercial real estate finance. Based in Los Angeles, he is a principal of Gantry, which is the largest independent mortgage banking firm in the US.

As a member of The Urban Land Institute and International Council of Shopping Centers, Mark has spoken on various real estate finance topics for these organizations. He is past President and Co-founder of the UCLA Real Estate Alumni Group, a Ziman Associate at the UCLA Ziman Center For Real Estate, and has been a guest lecturer at the UCLA Anderson School of Management.

Mark is on the Board of Governors of the Commercial Real Estate Finance Council and is a Board Member of the National Federal Development Association.