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Arrakis:
Myths & Facts
about the Cost of Rebuilding
Jan.
2004
There are lots of opinions floating around
about the financial impact of Arrakis, but how many of us
have actually seen the numbers? Frankly, a lot of
people are making assumptions without looking at the
facts. So let's look at some numbers to try to put things
into perspective.
One thing that's important to do is to separate the
cost of Arrakis burning down with the cost of
rebuilding Arrakis. They're completely separate. We
incurred big, big costs whether we rebuilt Arrakis or
not.
Next, for some bizarre reason people seem to be
focusing on the cost of building Arrakis while ignoring
the money that Arrakis brings in. Considering the revenue
we get, Arrakis pretty much pays for itself. Even with
the cost overruns.
Finally, when we speculate about how much we might
have saved by not rebuilding Arrakis, we also have to
look at what we would have given up by not
rebuilding it. The main thing we would have given up is
the ability to dramatically lower room rates in the
future, though there are other things we would have given
up as well.
One note before we get started: I don't use the term
"rent" because since you own the organization you're your
own landlord so you're not really paying "rent". The
money you pay is an investment in the organization you
own. Another way to think of it is "membership dues".
I'll refer to it as "room rates" instead of "rent rates".
And now on with the show....
Summary:
- Room rates went up because
of Arrakis burning whether we rebuild Arrakis or
not. That's because Arrakis didn't
generate any revenue for the three years that it sat
empty, and because the fire made our property insurance
go up for all the houses. This accounts for $26
of monthly rates, whether we rebuilt or not. Fires
are expensive.
- Had we sold Arrakis and
applied the money directly to room rates, they could have
gone down by $10/mo. But applying the money
directly to room rates is fairly irresponsible because
you throw away your asset and then it's all gone. This is
like Bush's tax cuts which give you a small break right
this very minute vs. investing in the future, which gives
an impact that is larger and serves more people. There
are a number of ways to invest that money so you retain
your asset, but most of them benefit future generations,
not the current one. Finally, remember that since the
cost of burning was $26/mo., that means that the cost is
still an increased $16/mo., even if we blew all the money
from selling Arrakis on room rates.
- But wait, you say, rates
didn't go up by $16/mo.! That's right. That's
because we put off most of the pain until the future, in
two ways: (1) We slashed the maintenance budget, and (2)
we refinanced our loan, which lowers our monthly payments
but means we have to make those monthly payments for more
years. In both cases, we're borrowing from the future.
The costs that you're not paying now will be borne by the
next generation of co-opers.
- Arrakis almost entirely pays
for itself, even with the cost overruns. When
people look at how much money we could have made from
selling the charred remains of Arrakis they usually fail
to consider how much money the rebuilt house brings
in. The revenue from Arrakis almost entirely covers
the cost of rebuilding it. Had the project not gone over
budget it actually would have paid for itself and then
some, offering the ability to drive room rates down a
bit. (That was part of the plan.) The fact that it went
over budget was upsetting, but it wasn't so bad that
rebuilding Arrakis suddenly became a mistake. The house
will pretty much pay for itself. And once it's paid off,
it'll wind up saving us around $31/mo. per member.
(By the way our accountant's budget shows that Arrakis
completely pays for itself, even in the short
term, while I say that it mostly pays for itself.
Here's more on why our numbers are
slightly different.)
Now let's look at these issues in more detail.
Member-Months
You can easily figure out how much an item
impacts room rates by using member-months. Here's
how it works: Let's say a charitable foundation is going
to give us $45,000 a year forever, and you want to put it
towards lowering room rates. The first thing you do is to
divide it by the number of members. How many is that?
Well, we have 167 beds in ICC without Arrakis, but we
have only about 90% occupancy over the whole year, so
let's call it 150 members. So dividing our $45,000 by 150
members we get $300 per member.
But that's per year. To figure the cost per month we
divide our $300 by 12 months and we get $25/mo. Now,
since we're always going to be dividing by members and
then dividing by months, we can use a shortcut and divide
by member-months. 150 members x 12 months = 1800.
So in the future we'll divide by 1800 member-months.
On calculations that include Arrakis, we'll use 2000
member-months instead of 1800, because when we have
Arrakis we have more members. (It's actually 2030
member-months, but let's not split hairs.)
Finally, note that this trick only works when you're
talking about annual savings or expenses. In our
example above we assumed we got the $45,000 every year.
But if you get the $45,000 only once then it's different.
If you want to have that windfall lower room rates
over many years rather than just once, then you
have to turn that money into annual income or annual
savings. You could do that in the following ways:
- Divvy up your one-time savings over X number of
years.
- Pay down your debt, saving on your annual interest
expense.
- Loan out the money to another co-op organization,
collecting interest as annual income.
- Invest in more properties, and get revenue from
room rates.
We discuss those methods in more detail in our article
How much can you
lower room rates with $X?
Now that we know about member-months, let's look at
the costs surrounding Arrakis.
Cost of the
fire
We incurred costs from Arrakis burning whether
we rebuilt or not. Those costs are:
Property
insurance. For some reason our insurance
company doubled our rates, just because we had a
second major fire in three years. This would have cost
us another $25k/year if we didn't rebuild, or
$29k/year since we did and now we have another house
to pay insurance on. Either way the cost is about
$14 per member per month. The cost per member
doesn't increase by having Arrakis because Arrakis
gives us more members to divide the cost by. (By the
way, Seneca was the other major fire, in 1997.)
Lost
revenue. Arrakis has been producing
no income for the three years it's been sitting empty,
which is about $108,000. The insurance company paid us
$48,000 for lost revenue so our net loss was $60,000.
Over the last three years, that amounts to around
$12/mo. ($60k / 3 years / 1650 member-months. I'm
using fewer member-months because we didn't have the
14 members from 1910 for almost all of those three
years).
[I figure this by
adding up the revenue that would have been
collected (12 members x 90% occupancy x $544 avg.
rent x 12 months x 3 years = $212k), and minus the
things we would have spent money on had the house
been open: food ($105/mo. x 10.8 x 12 x 3 = $41k),
utilities ($9k/yr. x 3 years = $27k), maintenance
($36k, derived by dividing the total maintenance
budget by 8 houses and multiplying by three years).
The utilities figures are estimated by considering
that in the 2002 budget 20% went to food and 12%
went to utilities. So anyway, $212k income - $41k
food - $27k utilities - $36k maintenance =
$108k.]
So that's costing us $26/mo.
per member. And that cost is the same whether
we rebuilt Arrakis or not.
Now, those who have been around for a while know that
the board didn't immediately raise rates by $26/mo. It
put off the increase by slashing the maintenance budget,
and by refinancing our loans (which lowers our monthly
payment, at the expense of having to make that monthly
payment for many more years). The current generation
hasn't borne all these costs, but future generations
will. That $26/mo. cost is very real whether all of it is
immediately reflected in room rates or not.
Again, Arrakis burning cost
each member $26/mo., whether we rebuilt Arrakis or
not. Think about that the next time your
maintenance officer is concerned because you removed your
smoke detector battery, or you put a whole bunch of
cardboard boxes right next to the heater in the basement,
right where it's marked "FIRE CODE: DO NOT PLACE ITEMS
WITHIN 10 FEET OF THIS EQUIPMENT".
How much is the
rebuild costing?
- Before we look at the numbers, let's get some
perspective. According to Howard, construction costs in
West Campus are about $140 a square foot. ICC's
costs have run closer to $100-$110 a square foot. And
here are those numbers:
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Source of funds
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Total Cost
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Annual Cost**
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Monthly cost per member
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Original reconstruction loan
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$556,000
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$55,807
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$28
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Expansion Fund tapped
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$53,000
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-
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$0*
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Insurance proceeds
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$222,000
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$11,100
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$5.50
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Total before cost overruns
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$33.50
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Overruns paid for by
increasing our construction loan
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$60,000
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$6,111
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$3
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Overruns paid for with
Emergency Fund
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$87,000
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$4,350
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$2
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Overruns paid for with
prior year's surplus
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$22,000
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$1,100
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$0.50
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Overruns paid for with
Expansion Fund
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$25,000
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-
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$0*
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Total after cost overruns
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$39.00
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*Cost of Expansion Fund contribution not
considered to impact monthly rates because our budget
builds the Expansion Fund at a set rate whether we use
those funds or not.
**Amortized over 20 years. Loans
considered at 8% interest. Loan actually starts out at 7%
interest but it's adjustable rate, so I figured 8% over
the life of the loan was a more realistic figure. Amount
from Insurance & Savings figured with no
interest.
A mistake is to look only at how much Arrakis costs us
without also looking at how much it makes us. Let's look
at how much Arrakis will generate:
- Annual Revenue: $114k (20
members x 90% average yearly occupancy x average room
rate of $530 x 12 months)
- Less expenses: Food $23k
($105/mo. x 20 members x 90% x 12
mos.), Utilities $14k
(accountant's estimate),
Maintenance $5k (facilities manager's
estimate)
- Annual Income: $114k - 23k - 14k - $5k =
$72k
By now you know how to take any amount of yearly
income and figure out how much it impacts room rates: we
just divide by the number of member-months:
- Income can lower room
rates by: $36/mo. ($72k divided by
2000 member-months)
The bottom line:
Before the cost overruns we expected Arrakis to cost us
$33.50/mo. per member. After the cost overruns it's going
to wind up costing us $39.00/mo. But that's offset by the
$36/mo. in revenue. So Arrakis costs us only $3/mo.
more than what it generates in revenue. -
- This doesn't mean that rates go up
$3/mo.! The $3/mo. figure is the average
that members pay over 20 years. The way it actually
works out, rates go up by only $1/mo. now. So you're
thinking that means rates have to go up by more than
$3/mo. at some point in the future, but that's not
actually how it works either. Without the overruns we
would have reached the maximum amount we needed to
sock away for savings in four years, and without a
need to save any more rates could go down by $8/mo. at
that point. With the overruns it's actually going to
take nine years for us to max out our savings, not
four. So it's not that rates go up, it's that they
just can't go down as soon as we'd like. Details about
this are in the Appendix, Financing
the Overruns from Savings.
-
- In any event, what we see is that the building
almost entirely pays for itself. Plus, when Arrakis
is paid off we'll no longer have the $31/mo. expense of
the construction loans, and at that point room rates can
go down by $31. It's a clear long-term benefit.
-
But while I say that the project mostly pays for
itself in the short term, your accountant says it
completely pays for itself in the short term.
Who's right? We both are, we're just using different
perspectives. Here's more on the
difference between my figures and your
accountant's.
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- Anyway, even though Arrakis is an excellent long-term
benefit, it's still true that $3/mo. extra on average is
more than zero. In light of this, did ICC leaders make
the right decision in deciding to rebuild? You'll have to
draw your own conclusions about that. Here are my own
feelings:
-
- Your leaders and staff fully
expected the house to pay for itself even in the short
term. The cost overruns were definitely an
unplanned surprise. Your leaders went with the best
information they had at the time, which was all they
could go on. That information squarely pointed towards
rebuilding. I doubt you or I could have done better in
that situation.
- The overruns weren't so
large that the decision to rebuild suddenly became a
mistake. Even with the cost overruns, the
rebuild project is still one of the best long-term
uses of our money. As it turns out, even the $3/mo.
extra isn't devastating, and it's balanced by the fact
that paying this now buys us the ability to lower
rates by ten times that much in the long term
once the house is paid off.
- The way it works out, rates
actually go up only $1/mo. for the next several years,
not $3/mo. The missing $2/mo. is the fact that
we have to wait until 2013 for rates to be able to go
down, instead of 2008. How much extra are you paying
for Arrakis right now and for the next several years?
$1/mo.
- This $3/mo. is a drop in the
bucket compared to the $26/mo. hit we took from
Arrakis burning, whether we rebuilt or not. It
pays to put things into perspective. If you want to be
upset about what could have been, it makes more sense
to be upset about Arrakis burning in the first
place.
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What would have
happened had we not rebuilt?
Let's say that instead of rebuilding we
wanted to sell the lot and put all the money into
lowering room rates. The first thing to consider is
that we were already hit with a cost of $25/mo.
per member just from Arrakis burning in the first place.
Any amount that we were able to reduce room rates would
have only gone towards mitigating that $25/mo. cost. It
wouldn't lower rates from what they were before
Arrakis burned.
With that in mind, let's look at how much we can
mitigate that $25/mo. cost by not rebuilding. To do this
we first add up the sources of revenue we'd have
available by not rebuilding:
And then there's what we'd have to take out:
- Cost of selling. The standard cost for a
realtor for selling a property is 6%, or $11k.
- Lost Revenue. Every year that Arrakis sits
empty costs us $34,000. Let's assume it took us a year
to convince someone to buy our charred lot for $190k.
It could easily have taken longer.
- TOTAL: $45,000
So we'd expect to clear this much from the sale:
Now that we know we're sitting on $367k, how could we
lower room rates with that money? We can't just divide
that $367k by member-months because we're not getting the
$367k every year, we're only getting it once.
There are many ways to use that money to lower room
rates, but each of them has a downside:
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