Property service contracts: pricing models for changing portfolios
Property services contracts for portfolios of owned and leased premises are generally contracted out for periods of five years and longer. The general pricing model in the industry is a Lump Sum Price adjusted on an annual basis for changes in CPI only. Although good for static portfolios, the challenge is in accommodating portfolio changes, in size or in profile based on evolving corporate requirements. Changes may be marginal, adding or reducing by a few properties, or may be significant with the new portfolios being added or reduced through mergers, acquisitions or new business strategies.
Pricing portfolio changes
One of the key principles with the Lump Sum Fee is that it should not change whenever one property or lease is added to or removed from the portfolio. Clients seldom want to have to administer ongoing pricing adjustments. This has resulted in the industry approach evolving into the fixed Lump Sum Price linked to the commencement portfolio. This price does not change for portfolio size fluctuates, up or down, unless these changes exceed a predetermined percentage – usually set between five and 10 percent.
On this basis, the managing contractor can implement a stable contract resource structure to service the portfolio requirements. With the known portfolio size and fluctuation parameters, the likely workload can be assessed and the Contract Management Plan prepared accordingly. But how should the pricing change mechanism be structured to accommodate potential large changes in the nature and size of the portfolio?
To start, there needs to be measurement guidelines to determine the size of the commencement portfolio and to measure and administer the portfolio changes. If the property types in the portfolio are fairly generic, the measurement can be defined in fairly simple terms. However, in more complex portfolios, establishing this metric can be more challenging. Portfolios with owned and leased premises, or large and small premises, or with premises located centrally and others located in regional areas, or with simple vacant land while other properties may be complex specialised buildings – for such complex portfolios, what should the measure be?
Considerations may include the net lettable area, or gross building area, or simply the total number of properties, locations or agreements. In many such complex contracts, one of these measures is usually selected and, despite the idiosyncrasies that may exist in the portfolio, is used to determine portfolio size and the changes. But experience has shown that unless the portfolio is fairly generic, none of these measures will reflect the changes in workload requirements and unintended consequences may result.
Recently a measurement concept related to ‘property interests’ has emerged. These may be described as owned properties or leased premises, no matter where these are located, or how big and complex the premises are, all being ‘property interests’ treated as equal. Within this concept, the workload per ‘property interest’ is assumed to be the average across the diversified portfolio. This measurement approach has the advantage of being simple and intuitively pleasing, but it can lead to significant issues during the management of long and complex contracts. For example, consider how the sale and leaseback of a large number of properties will change the required scope of services in becoming less intense as the property ownership and management risk are transferred to the new owner. But, based on the ‘property interests’ measure, this portfolio for the property services contract will not be deemed to have changed, even though the intensity of the service requirements will be significantly less.
Another suggestion to manage portfolio changes has been to treat the owned and leased assets as separate portfolios, and requiring the managing contractor to provide separate Lump Sum Fees for each. Although this can be done, this is seldom how the resource management plans for diverse and geographically dispersed portfolios of properties are structured.
Calculating Lump Sum Fee changes
No matter how the portfolio size is measured, most current contracts have the approach of adjusting the pricing for major changes, either monthly or quarterly as relevant, based on assessing the required changes to the contract resource structure needed to service the new portfolio requirements.
In this approach, a portfolio measurement fluctuation above or below the threshold percentage will trigger a discussion between the parties to agree on the revised resource structure. Despite the best intentions of the parties having ‘agreed to agree’, however, this approach often leads to disputes between the parties that are difficult to resolve.
With the ‘property interest’ approach as described, the Lump Sum Fee is changed above the threshold portfolio level, based on the Unit Rate Fee per ‘property interest’. The assumption is that in large diversified portfolios that changes occur randomly and there will likely be portfolio ‘swings and roundabouts’ that counterbalance each other. Therefore, any increase or decrease greater than the portfolio threshold can be calculated at the Unit Rate Fee per total number of ‘property interests’. The threshold level is then reset to reflect the new portfolio size for the next assessment period.
Although this approach may work for large portfolios in some situations, when there are fundamental changes in portfolio characteristics, this can lead to an inequitable outcome for either of the parties. Consider the implications for an organisation moving from leased properties to owned properties. Will the managing contractor be able to resource the additional requirements to manage the owned properties adequately based on no measured change in the ‘property interests’?
Weighted ‘property interests’
There are alternative metrics, however, that can be used to get a measure of the complexities of a portfolio and to reflect the likely workload increase or decrease, but these are new to the industry. One approach that does recognise the differences is the ‘weighted property interest’ approach. Although more complex than the previously described approaches, this method can be structured to compensate for the more complex nature of managing owned properties versus leased premises, differentiating between small simple and large complex properties, as well as allowing for additional resources related to managing remotely located properties.
The system operates with the client, during the tender period, nominating the weightings related to the different owned and leased properties in commencement portfolio. For example leased premises between 1000 and 2500 square metres may be deemed to be the average ‘property interest’ that is weighted as one, while the same size owned property may be weighted as 2.5. Similarly, leased premises less than 1000 square metres may be weighted as 0.75 and those larger than 1000 square metres at 1.25.
Additional weightings can also be added for different locations in the CBD, metropolitan and regional. The commencement portfolio can be analysed using this approach and the number of ‘weighted property interests’ can be derived as the measure against which any changes in excess the threshold percentage, will be assessed.
A variation to this approach may include requesting the tenderers, during the bidding process, to nominate their estimated ‘weighted property interests’ in the form of matrices per property or lease based on the predetermined measures related to size, tenure, complexity and locational differences in the portfolio. This approach will provide a true reflection of actual allocation of resources across the portfolio that will be more realistic in determining Lump Sum Fee revisions to reflect significant portfolio changes.
This approach is not precise, but it can be structured to take into account the differences in managing diverse properties in terms of size, complexity, tenure and locations. It will provide a more equitable revised Lump Sum Fee to support the changed resource requirements as the size and basic nature of the portfolio changes.
Rodney Timm is the director of Property Beyond.