Market Risk Analysis: Peak Oil and Investment Real Estate
Synopsis & Recommendation
Energy company officials have estimated that global oil production will start to decline in the near to mid term (“peak oil”), if it has not started already. Experts warn that there is a strict correlation between economic growth and oil supply. Properties currently in design and construction will probably be put in service at or near the time when peak oil is expected to occur. Real estate practitioners must incorporate a more thorough assessment of energy availability and pricing within their transaction underwriting as well as think about shifting their development focus to more resilient properties and investment scenarios.
The (Latest) Download on Peak Oil
Check out Biopact’s very instructive report on the connection between peak oil and economic decline. Not only have energy company executives largely agreed upon peak oil occurring around 2010-2012, experts stress that the prolonged, permanent decline in global oil production can trigger an economic crisis. Moreover, they believe that we will directly suffer from the energy crisis more quickly and a lot worse than from climate change in the same time frame.
“…a new study by Dr Robert L. Hirsh, senior Energy Program Adviser at the Science Applications International Corporation (SAIC) demonstrates the economy-destroying effects of peak oil. His conclusion is that economic growth will decline at a similar rate as oil output, that is, by 2 to 5 percent per year. There is a strict correlation between economic growth and oil supply.”
Remember:
A recession is defined as two quarters of negative growth in GDP.
Landlords & Energy Costs Today: “Just Passin’ Through”
Every real estate practitioner spends a considerable amount of time engrossed in market and economic analysis, to bullet proof their underwriting and make sure that their investments actually perform according to shareholder expectations, if not better. You constantly ask yourself, “what could go wrong?” over the life of your deals. Energy costs have been gradually rising over the past few years and those costs are a key factor in real estate construction, operation and maintenance, not to mention at every point of the business supply chain. So far, the timing and velocity of energy price increases have allowed them to be absorbed by tenants, so investments continue to perform within expectations and we practitioners have not had to radically adjust the structures of our deals or property design and construction.
Time for a New Scenario Analysis
Because we have been able to pass through any increased energy costs to tenants, investment professionals have not had to grapple with the ways in which a permanent change to energy availability and cost would affect the way they do business. The common underwriting practice is the correlate energy price increases with projected inflation, but I have never seen a deal package that analyzed the potential effects of:
- energy prices increasing significantly above the rate of inflation,
- tenants broadly resisting further energy cost increases, meaning that the landlord now “eats” further cost increases,
- widespread reduced petroleum availability, and worse still –
- all of the above occurring at the same time.
If the two to four year timing of peak oil happens as predicted, then most of the properties under construction right now could be put into service in markets facing energy-related economic shocks a short time later. That means that we all could be working on transactions right now that are doomed to go sideways.
Building New Green Buildings Does Not Help
Currently, green building is just beginning to be taken seriously within the investment real estate community. However, even though the gross value of green building activities should nearly double to nearly $12 billion in 2007, most of it represents new construction, albeit with greater energy efficiency over that of non-green buildings. Unfortunately, in the context of an energy crisis, the current green buildings in production today still largely rely on petroleum-based energy – meaning they are “less bad”, but are still unfortunately not “good”. Very few green buildings being put in service actually run 100% on renewable energy. So even though investment professionals are doing the great work of going green, the property construction and performance standard required to adapt to a peak oil economy is still much more sophisticated than the green buildings we will most likely be living and working in when energy conditions deteriorate.
(Re-)Positioning Real Estate Investments for a Peak Oil Economy
While no one can foresee how to navigate the market uncertainty coming from the energy crisis predictions, real estate practitioners can start positioning their businesses and portfolios in such a way that they will have better options to improve their outcome when such events occur by:
- factoring in a larger volatility in energy costs during deal underwriting to account for the growing risk of potentially increased operating expenses.
- investigating switching as much of your properties’ energy sources to renewable energy.
- focusing on adaptive reuse investment plays and renovating existing properties for higher energy efficiency,
- obtaining the maximum rating possible, when going for certification on green buildings, and achieving the maximum amount of energy efficiency points possible for that given rating, no matter what,
- joining forces with those pushing government officials and public utilities for greater overall availability of renewable energy,
- refocusing their investment dollars on urban properties with a smaller, more compact footprint that reduces the need for vehicle travel by occupants and suppliers
- starting to think about sustainable markets: when preparing annual investment plans, redefine your target markets to include regions that have a combination of economic base, mass transit infrastructure and progressive policies to facilitate the above.
Photocredit: Flickr/AZRainman
Warning: Common Sense Lurks Behind Integrated Design
Have you ever been on a project team with or for a commercial real estate owner who had high expectations of their new green building project? Or maybe the better question is, who hasn’t?
Timothy Corbett, President of SmartRisk, recently cautioned an audience at the AIA’s conference on public space and design to carefully manage an owner’s heightened expectations of green buildings. If the finished product doesn’t meet their expectations, ‘then lawsuits and claims could follow”.
No duh.
When I read through Corbett’s examples of green building lawsuits and claims, I began to think that someone on those project teams also drove their car around with hot coffee between their knees.
Corbett is quoted as saying that the best way to manage the exposure to such claims is “direct contact with the client”.
Another duh.
All of the green building professionals that I know continually stress that an integrated design process from the very beginning helps to reduce the risk of misunderstandings about what the green building can and cannot deliver. They contrast that with the tendency of some owners to think of green as an added feature than can be plugged into the project at some later point, creating more costs and the potential for miscommunication.
The article’s title, indicating that ‘risks lurk’ in green building, as well as its appearing on GlobeSt.com, a website targeting real estate investors, unfortunately makes me think that GlobeSt was more interested in getting a few more clicks on their website by playing on investors fears about green building, instead of helping to educate them.
Click here to read the article and decide for yourself.
Photo credit: Flickr/Everydaylifemodern
Transforming Building Markets, or Transforming Marketing?
Bill Walsh’s reprinted article in GreenBiz.com with the same title as above passionately highlights the insidiousness of greenwashing within the building materials sectors, but his thoughts address a similar concern across the entire spectrum of real estate development.
“When Home Depot invited suppliers to submit products for consideration in its Eco-Options program, manufacturers claimed that more than 60,000 of the items currently on the shelves were already “green.” According to the New York Times, “Plastic-handled paint brushes were touted as nature-friendly because they were not made of wood. Wood-handled paint brushes were promoted as better for the planet because they were not made of plastic.”
In these heady days of sustainability’s emergence within the commercial real estate industry, how will we hold each other accountable for true market transformation and not cleverly marketing the status quo?
Click here to read the article in its entirety and share your comments with us.
Labels: Bill Walsh, GreenBiz.com, Greenwashing, market transformation
San Jose’s 50 Million Square Foot Vision
CoStar and others featured San Jose Mayor Chuck Reed’s big ten point vision that will green San Jose in fifteen years by 2022.
Called the Green Vision, this plan artfully concentrates the vision’s outcomes around “10 far-reaching goals that address energy consumption, water use, greenhouse gas emissions, and other environmental impacts“. Sounds nice, but the real estate market underwriter in me still makes me roll my eyes a little because it is intuitively doubtful that such big numbers can be achieved. Plus success will be measured several city administrations into the future leaving me wondering whether realistic accountability can be implemented.
Nevertheless, it was still interesting to do a little fact checking to better assess San Jose’s current real estate and sustainability context. Keeping this type of info in mind helps with future assessment of the Green Vision as it evolves.
What Kind of Impact Will Retrofitting 50 Million Square Feet Have?
The vision calls for retrofitting 50 million square feet in 15 years, or 3.33 million square feet of commercial real estate per year through 2022. Rosen Consulting puts the total size of the metro San Jose commercial real estate market at just under 552 million square feet . So mathematically, the mayor’s retrofit proposal addresses roughly 10% of the current day San Jose commercial real estate market. 90% of the commercial square footage remains untouched for the same fifteen year period, making this objective not as exciting as it appears on the surface. But it may still be tough to meet. Rosen Consulting reports metro new construction amounts to less than 2 million square feet for 2007 with lower levels projected in the immediate years ahead. So somehow, this vision requires existing owners of commercial real estate to immediately begin retrofitting properties at the rate of more than 3 million square feet per year. Hmmm…. How and for how much paid by whom?
Is San Jose a ‘Sustainable City’ in the First Place?
San Jose ranks #23 — between Phoenix and Dallas — in Warren Karlenzig’s How Green is Your City, where SustainLane ranks US Cities according to their sustainability criteria. San Jose gets lots of credit here for adopting far reaching sustainability measures way ahead of many US cities. 62% of all waste is already diverted away from landfills and the mayor’s vision increases that to 100% in 2022. Air quality already ranks #7 in the nation and water is pretty clean at #12. The city’s leadership has proven repeatedly that they get the tight connection between offering a top quality of life for residents and preserving the region’s status as the hub of high tech. That said, room for improvement lies with a severe affordable housing shortage and a widespread allergy to public transportation. Nevertheless, city actions to enforce living wages, incorporating LEED standards into public buildings, and install five new renewable energy systems in 2008 are what make SustainLane praise San Jose as being a city “best situated to promote - and reap the benefits of - a transition to a greener economy.”
So while I’m not a big fan of grand statements, it helps to see a city with a positive track record try to push itself harder to stay competitive.
LEED: Avoid Underwriting Misconceptions
Do you prepare your non-green project budget and then add your “green costs” on top of it? At which LEED-rating do you think you own a distinctive higher value green asset? Think that ‘integrated design’ is only interesting for the architects and engineers? Read on.
I’ve blogged before about Davis Langdon’s update study on LEED-rated project costs and recently saw a talk by one of their architects, Lisa Fay Matthiessen, that went substantially beyond just concluding that LEED projects do not necessarily cost more than non-green buildings. She spoke in depth about the source of misconceptions about LEED project costs and shared a surprise that challenges our current knowledge of LEED-ratings and the associated project costs.
Recap of Davis Langdon’s Findings
In case the study is still sitting on your “weekend reading” stack, here are the Cliff Notes takeaways:
- Many projects are achieving certification within their budgets and in the same cost range as non-LEED projects.
- Construction costs have risen dramatically but projects are still achieving LEED certification.
- The idea of green as an added feature continues to be a problem.
The study conclusions were essentially preaching to the choir. Nothing new for the audience of mainly architects, designers and engineers – many of whom were LEED accredited. But when they drilled down into the ‘why?’ behind these findings, things got pretty interesting.
Why Add Green Components When You Can Integrate Them?
Matthiessen says that the false notion of being able to design and build a green project by adding the desired green components to an already planned non-green project is a deep-seated misconception. Moreover, this sets up the project team for another incorrect evalation approach: comparing the building to itself. When this happens, the project team compares the budgeted construction costs of the building without any green elements to the same budget with estimated costs to achieve the determined level of LEED certification. Naturally, the latter budget is often greater then the former, and individual green components get put on the fiscal “chopping block” instead of the team focusing more on better design and engineering solutions to optimize budget constraints. Matthiessen stressed the need for an evaluation based upon benchmarking costs from a pool of comparable projects, as was done in the study, meaning that the project costs of green buildings were compared with normalized costs for a larger array of similar projects with similar elements and criteria. Also, a heightened awareness about the potential economic benefits, or savings from an integrated design approach will help project teams to achieve their intended goal of the best LEED-rating for their budget.
LEED-Gold Sometimes Costs Less Than LEED-Silver
This was a surprise that was not discussed within the study text and that not many people know about. Davis Langdon’s data included several instances of LEED-Gold projects costing less than LEED-Silver projects, which the audience focused on quite intensely. While Davis Langdon did not study this observation individually, Matthiessen said that the study team concluded that the project teams for those less expensive Gold properties had met the challenge of attaining the required higher level of LEED points by having green elements perform several more functions for the project than normally expected. For example, the roof and building skin might provide more ventilation, heating and cooling assistance than would typically be required of such components. These multi-functional integrated elements not only help the project to qualify for the greater number of points needed for the higher LEED rating, Davis Langdon thinks that the bundling of so many functions within certain components actually saved money. This is good evidence that extending integrated design principles into the project budgeting process can deliver a financially competitive advantage: a project owner could come out with higher performing assets with higher LEED-ratings for less than assumed.
And achieving that level of financial optimization has implications for financiers and capital markets investors. A standard investment underwriting process involves the preparation of linear spreadsheets, so that investors can evaluate project costs and revenue generation potential against their desired payback and return hurdles. Standard operating procedure involves judging specific line items against specific intended paybacks.
But this type of process assumes that every single line item in can be tied to one measurable benefit. And that assumption is at odds with the premise and approach of integrative design. Optimizing your project to the point where you deliver LEED-Gold assets for less than the cost of LEED-Silver will take your financial underwriting to a whole new level. The capital markets are not that familiar with multi-tasking line items that simultaneously deliver multiple and overlapping quantitative benefits. In order to make the best assessment of such a project’s potential investment value , investors – and their lenders – need to implement a holistic financial analysis based upon utilizing these cutting-edge green building best practices.
When is a Green Building Really Better?
This was an interesting side discussion, with Matthiessen relating her opinion that a LEED-certified or LEED-Silver project essentially represented a few good upgrades to a non-green building. However, the elements and engineering required to make a LEED-Gold or Platinum building greatly distinguish the building from its peers, to the point where she considers these properties to truly be several steps ahead in terms of quality and performance. A basic question for the new green investment funds and their partners is “At what point are we building or buying higher value real estate?” This opinion also points to the potential for more differentiation in asset pricing for those higher-rated properties. For example, if that opinion prevail with the current ratings system remaining in effect, speculative development of LEED Core and Shell projects would not be considered as more valuable simply because they are green.
Taken together, Matthiessen’s talk pointed to a needed paradigm shift for investment real estate analysis in order to fully assess and realize the value of green development. Project owners cannot stick with a ‘business as usual’ approach of appending green to the back end of their existing decision making process and expect to successfully compete in the market with green real estate investment strategy. Successful, high value LEED-projects will challenge professionals to employ a deeper, holistic financial evaluation much earlier in the project’s lifespan that goes beyond individual line item measurement.
I tell my friends that, in today’s green age, the deal is done in the architect’s and engineer’s offices, because environmental impact differentiation is the point of value and that’s where it occurs. That shift will continue to challenge our basic assumptions about the way we commercial real estate professionals do business.
