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The Performance-Based Pricing Model for Commercial Real Estate

Aug 30, 2017 1:35:34 PM

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Is the commercial real estate industry ready for performance-based pricing models? Will your firm stack up? According to Deloitte's Real Estate and Construction Industry practice, smart building infrastructure will enable the new performance-based model. At present, smart building infrastructure may still be in the "value-added enhancement" category, but it will soon transition into an expectation of commercial tenants.

When people can monitor energy usage and efficiency of each appliance, machine and light in their homes via smartphone apps, they will also demand transparency and control at work.

How Smart Building Infrastructure Enables Performance-Based Pricing

Smart building infrastructure can enhance monitoring, measurement and control capabilities of equipment and indoor environments. With building automation, facility managers can analyze and improve efficiency, energy usage and operational functionality of equipment and staff. For example, how efficient are all faucets in your building? How many gallons are used per sink or toilet use?

You can also monitor and control the quality and price of inputs. For example, what is the current indoor air quality in each space of your building? Are outdoor air conditions currently optimal to exchange higher quality outdoor air for some of your return air? Can equipment in your building be optimized to reduce peak demand energy consumption during the week or weekend?

Monitoring with Internet of Things (IoT) devices allows facility managers to identify inefficiencies, optimize schedules, and repair or replace aging equipment before failures or downtime cause costs to add up and tenants to complain.

IoT technology will eventually be implemented to at least collect and share data from, if not control, every device your staff and tenants use daily. It is beginning with utility submetering, equipment monitoring (HVAC, lighting, boilers, chillers, fans, printers, etc.), occupancy sensors, humidity sensors, air quality sensors, water flow sensors, space temperature sensors, refrigeration monitoring and oven monitoring. You will be able to reduce the human errors involved with monitoring and tracking while improving the efficacy of preventive maintenance, thereby reducing over maintenance costs.

Currently on a 17.2% CAGR, "the IoT market will grow from an installed base of 15.4 billion devices in 2015 to 30.7 billion in 2020 and 75.5 billion in 2025," according to a global IoT applications and services industry analysis by IHS Markit, a global research and information firm.

IoT CAGR (compound annual growth rate) 2015 to 2025 - IHS Markit

IHS Markit states that IoT will fundamentally change and redefine every industry and market as connectivity continues to permeate every environment. The firm relates the transformational power of the "datafication" of society in the 21st century that caused by "electrification" in the 19th and 20th centuries.

So, you have to ask how your firm will compete in an environment where all your competitors will eventually be providing tenants with data on building performance KPIs. Tenants will be translating those metrics into business and workforce productivity KPIs. How will your firm stack up? How will you attract and retain tenants

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Is Performance-Based Pricing Right for Your CRE Firm?

Smart building control dashboard

If you haven't installed smart building monitoring and controls equipment yet, your tenants will soon be asking for it. Once smart building infrastructure is implemented, performance-based pricing will be in demand. Early adopters will be the first to hone their adaptive business models in on opportunities.

Performance-based pricing requires and creates better communication and more transparency between buyers and sellers, and the benefits can be much greater for both parties. Rather than the win-lose relationship inherent in traditional pricing schemes, as each dollar is negotiated, performance-based pricing creates more of a win-win relationship. The goals of buyers and sellers become more closely aligned, as a greater sense of fairness is created during the negotiation of KPIs, incentives and penalties.

When the I-35W bridge collapsed in Minneapolis, Minnesota, on Aug. 1, 2007, the rebuild was designed by FIGG Engineering and built by Flatiron Construction in 11 months (three months early). The winning team, which bid a higher price than other teams, was chosen largely based on design, aesthetics, state-of-the-art smart monitoring technology, public relations goals and other performance factors besides price and schedule. Still, the team finished ahead of schedule with crews working around the clock to complete the project in line with performance-based incentives.

I-35W Bridge Rebuild Construction Flatiron Corp

Source: Flatiron Construction Corp.

Performance-based pricing models are spreading across many industries, including advertising, consulting, trucking, construction and heavy industrial services. In many cases, margins are improving for sellers. According to Morgan Anderson Consulting, from 1983 to 1997, the average profit margins for large advertising agencies climbed from 13% to 19%. During the same timeframe, the number of agencies being compensated based on number of media purchases fell from 71% to 35%.

Benefits and Challenges of the Performance-Based Pricing Model

Three main benefits of performance-based pricing, according to Benson Shapiro, Emeritus Professor of Marketing at Harvard Business School:

  1. It acts as insurance against risk. The seller will not undercharge the buyer because the performance-based arrangement guarantees the seller will be paid more as it provides more. The buyer is also insured against overpaying because more and better services are provided as it pays more.
  2. It enables the buyer to pay only for the products and services that are delivered and measurable.
  3. The disciplined and precise process of discussing limitations, goals and trade-offs between the parties creates transparency and improves trust.

Incentives for better quality products and services are created along with greater potential cost savings and quicker turnaround times. As a result, agreements are more valuable to both parties, and each can reduce costs by removing non-value-add product and service components.

Challenges include:

  1. Performance-based pricing charges for both the quality of performance and quantity of usage. The price is agreed upon after the product or service is delivered and value is clear to the customer.
  2. Price and cost are not established fully before the deal is made, so the seller takes on some additional risk. However, this means the seller is provided more levers to manage spreads between price, cost and customer value.
  3. Payments may be delayed because price is often not determined until product or service delivery, so performance-based pricing could be detrimental to sellers who need short-term cash flow.

With a little more risk come enhanced opportunities for greater reward. Precise measurements made possible through IoT and cloud computing technology help to create insurance for both parties. Sellers are offered the tools to better manage their spreads, and buyers benefit from being able to proactively adapt usage of products and services based on business needs and ability to pay. The performance-based pricing model can aslo be combined with fixed payment schedules, so as not to completely depart from the cost-per-square-foot pricing model that ensures a certain level of cash flow.

Upfront costs of negotiations may be greater, but IoT and cloud computing capabilities reduce the costs of applying the pricing model. Real estate management is an uncertain market. The performance-based pricing model combined with smart building infrastructure may make the costs and margins of tenant attraction and retention more manageable.

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