Get the Best Valuation for Your Green Real Estate Project
The appraisal industry is just starting to incorporate sustainable design considerations into the valuation practice. So how can you navigate your green project towards its maximum appraised value?
We recently heard Wells Fargo’s appraiser James Finlay’s personal perspectives on how the appraisal industry is working to adapt valuation standards to sustainable real estate. Here’s a short summary of his comments:
Green Project Valuation Road Bumps
- On-site distributed energy systems: The real estate appraisal might overlook the value of these components. A lot of these systems would best be appraised by an M&E (mechanical and electrical) appraiser. Additionally, systems like geothermal heat pumps may also require the services of an M&E appraiser.
- Appraisers can’t base their operating expense assumptions on your energy savings projections alone. Claiming that your asset is designed to use 30% less energy than conventional product is not evidence enough- what happens when the performance is suboptimal? If you don’t support your case for the lower operating expense projections, don’t expect the appraiser to go out on a limb for you- it’s their job to be conservative.
- Appraisers are unlikely to value incentives. Simply stated, banks won’t lend on property tax credits or any other green incentives that would flow through the asset’s revenue stream, so don’t expect your appraiser to value them. Expect them to be reversed out so that the appraisal is based upon the assets true economic performance. (Our note: we’ve seen cases of owners negotiating large incentive packages –and their lenders ignoring the fact that some of these incentive benefits could also be additional collateral that secures loan repayment).
Preparing for a Good Appraisal
Finlay provided the audience with key suggestions on how to manage the appraisal process in order to maximize the appraised value of high-performance assets:
- Hire an appraiser with green experience. Look for a local appraisal expert with some green experience, who is eager to learn more about green building systems. If a perspective lender has a go-to appraiser, find out in advance of agreeing to terms whether they have any green experience. If not, offer up an experienced, alternative appraiser.
- Proactively provide your appraiser with as much relevant and organized information as you possibly can. Don’t just assume that an appraiser will be able to value your advanced building systems- provide them with the data and evidence they need to do so. It’s your responsibility to build the case for higher than market value.
Most importantly:
- If you are not monitoring and tracking the performance of your green buildings, you are not maximizing appraisal value. Want an appraisal to accurately reflect the superior energy performance of your asset? You need to track your data. Additionally, utilizing building management systems and commissioning (or retrocommisioning) are great ways to show an appraiser that the asset will continue to outperform market assumptions.
By the way, there will be great case studies and valuation discussions at the upcoming Green Building Finance and Investment Forum, which will be held here in San Francisco next week on March 2-4, 2009.
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Can Debt Yield Covenants Help Finance Green Real Estate?
Can the debt market’s use of debt yield covenants help green real estate investors qualify for greater loan proceeds?
In my upcoming article, “Present Your Green Property to Lenders“, I explain how you can structure your commercial real estate loan applications in a way that helps lenders to evaluate the value that green features bring to their sustainable commercial property.
Naturally, investors also want to ensure that all the other ‘usual’ parts of your loan application package answer your lender’s typical credit concerns, as well — particularly how lenders are handling the current problem of unreliable property valuations.
Today’s post on The Ground Floor highlights the “emergence” of the debt yield as a lender’s preferred measure of the NOI cushion available to pay debt service. Their quote:
In fact, debt yield, which measures net operating income as a percentage of the loan amount, is emerging as the main tool because it is viewed as the most direct method for calculating risk. The higher the debt yield, the more attractive the mortgage is to the lender. When the market was hot and properties were trading actively, the loan-to-value ratio was the go-to benchmark for lenders, and negotiations with borrowers typically hinged on the degree of leverage that would be employed. But now, the sales-market freeze is making it hard to pinpoint how far property values have fallen. What’s more, there’s no sign that property values have hit bottom yet. Against that backdrop, lenders are turning to the debt yield.
I chuckled about the use of the term “emerging”. In my prior life as a portfolio lender through several economic cycles, debt yield covenants have always been around and most of the loans that I funded contained a two-pronged loan-to-value and debt yield test. In the heady days of the market boom, many lenders simply manipulated their debt yield calculations to win business or just dropped them altogether in favor of more lenient loan-to-values. So I wouldn’t describe the current trend as “emerging”. It’s always been around.
In any event, we can confirm the current trend of lenders applying a strong debt yield based upon trending existing rents forward (no increases of current rental rates allowed) as an essential part of any successfully funded debt deal these days. And there is nothing about a property’s sustainability that will exclude it from this evaluation.
But think about this –> one of the longstanding problems that investors face with financing green properties is that of getting appraisers to recognize economic value contributed by green design and specific property features. In a way, this has left some investors grumbling that the appraisal process can actually be more detrimental for the green property than the brown. However, in this particular lending environment of focusing on NOI over valuation via using debt yield tests, green property developers and investors who can prove how their sustainability strategies improve their asset’s NOI should have an easier time working with the lender on the desired loan amount.
Water Supply and Price Risk Flows to Investment Underwriting
Are you underwriting a green and/or retrofitted property in Los Angeles? Well, your business case might have improved (unfortunately).
The Los Angeles Department of Water and Power (LADWP), the largest municipal utility in the United States, has voted to adopt a water rationing plan in principle. The Water Department board will formally vote on the plan next month, in response to a drought now in its third year. The plan hopes to cut water usage in the City of Los Angeles by 25 percent.
If enacted, penalties(!) will be levied on homes and commercial properties with water usage exceeding a set threshhold. What is not discussed is the silent cousin, which we always see trailing water rationing actions and penalties — regular usage rate increases that are significantly above the rate of inflation (remember this advice from the late George Carlin –> “you gotta watch the quiet ones!”).
Asset Value and Underwriting Implications
If this measure passes, “brown” or unretrofitted buildings will be much more affected by lower NOI via higher water costs than their higher performance peers. Sooner rather than later. All owners are already dealing with properties being devalued by a weaker real estate market, however these “brown” building owners will have the additional challenge of the real erosion of net operating income that further depresses property value.
Apartment owners need to factor in the fact that water price and supply risk triggers food price increases. Even those renting submetered units should bear in mind that a larger portion of their tenant’s incomes will be allocated to food prices, putting further pressure on a resident’s ability to pay rent. Most apartment owners we talk with do not really know the total cost burden that water, fuel and electricity price risk pose for residential tenants.
Perversely, higher water rates improves the lifecycle costs and payback analysis and thus, the business case on any water related retrofit projects you may be considering. The element of risk that is not properly captured within this type of analysis are any of the insurance and business risks tied to insufficient water supply for certain types of businesses or an abrupt stoppage. That hasn’t happened in Los Angeles, yet but the article details that Los Angeles will be facing serious problems for years into the future even when the drought is over.
And if you are running an equity fund with Los Angeles as part of your investment footprint, then you will want to make sure you are properly underwriting your property’s water costs in Los Angeles — an essential part of the integrated finance strategy.
ShoreBank Leads with Green Building Loan Platform
Click to enlarge.
In our Green Real Estate workshops, you will see an outline similar to the one here with our explanation:
Real “green” loans are backed by appropriate underwriting and evaluation, and/or earmarked capital from the lender.
(See also “What Makes a Real Estate Loan Green”).
There are certainly institutions that may fund green buildings, but we observe that their lack of appropriate underwriting and evaluation procedures means that they are not really capturing the complete range of opportunities that green buildings present, nor assessing the true collateral risks — both issues of intense interest to their shareholders. Their green developer and investor clients may also suffer because if issues occur during the life of the loan, they lack the history and infrastructure to constructively contribute to the most appropriate solutions.
But here’s new evidence that perhaps the financial community is about to catch up on these issues –> from one of the ‘usual suspects’ in the green real estate finance space.
Industry pacesetter ShoreBank Pacific announced that they have formally launched a green building loan program, while many other financial institutions are retreating from real estate. Go ShoreBank Pacific!
But wait there’s more…
ShoreBank’s announcement is particularly interesting because CEO Dave Williams is a keynote speaker at the upcoming Green Building Finance & Investment Forum, this 2-4 March. Attendees will be able to get the details from him live (and perhaps even personally hand him a loan application…ha!)
In any event, good news for green finance and we hope to report similar news from other banks.
Benchmarking Anchors Energy Efficiency Retrofit Finance…and Returns
For us, 2009 is already shaping up to be “The Year of Energy Efficiency Retrofits”. Constrained credit markets mean that growing organic cash flow within the existing building portfolio is a real estate investor’s top priority.
So we now spend more time with owners applying an integrated finance approach that structures the right deployment of capital to pay for retrofits while creating the best combination of environmental and economic returns.
Great green finance for existing buildings actually begins with a solid benchmarking process, in order to establish where the opportunities for energy, water and operational improvement exist within the portfolio. This is necessary since operating cost reductions can be a key source of repayment for retrofit costs.
Benchmark Like a Pro
So what critical areas you should be looking at when thinking about your company’s own benchmarking practices? We have our own experience, and also want to share recent comments from Nick Stolatis, of industry pacesetter TIAA-CREF, that really bring the message home. Nick dispensed hard-won benchmarking wisdom at a forum we sponsored last fall, experience gained while benchmarking their 200 building, 44 million square foot existing office portfolio:
- Tap the experts. The knowledge and guidance of benchmarking experts will help you avoid potential pitfalls. The first time that TIAA-CREF benchmarked their portfolio performance via the Energy Star Portfolio Manager tool, they realized that more than 50% of their properties were not being benchmarked correctly, if at all. This cost them valuable time and money. With the help of third party consultants, they re-launched their benchmarking efforts. The consulting team, which had developed the Portfolio Manager tool, helped TIAA-CREF establish reporting protocols and additional tools to identify under-performing assets. The re-launched effort resulted in 100% program implementation.
- Benchmarking is forever. Your asset managers and property managers (and all of their staff) need to understand that benchmarking is an ongoing weekly (if not daily) activity. As a portfolio manager, you need to make sure that they have the right tools and knowledge to consistently and accurately track building performance data.
- Training is crucial. All asset managers and property management staff need to have adequate training in performing benchmarking tasks. TIAA-CREF, with the help and guidance of their consultants, set up a complete training program for staff, featuring periodic webinar tutorials.
- Establish expectations. In addition to adequate training, staff needs to understand that these activities are a requirement of their position, not an optional task.
- Don’t overlook the low-hanging fruit. Benchmarking can take months, even years, to provide an accurate picture of your portfolio’s energy and water performance. In the meantime, there are a number of low-cost/no-cost measures that can be implemented across all property types. For TIAA-CREF, replacing any existing T-12 bulbs with T-8 (only high efficiency) or T-5 bulbs was an easy way to reduce energy use by 30% per bulb, at no additional cost.
Learn About Benchmarking and more from Energy Efficiency Retrofit Specialists
Finally, if you are working to retrofit your existing portfolio, you should attend the Financing Energy Efficiency Retrofits workshop at the upcoming Green Building Finance and Investment Forum – West. During this workshop, top industry leaders will be presenting the newest best practices on financing mechanisms, case studies of successful building retrofits, the nuts and bolts of LEED-EBOM certification and new regulatory initiatives that make sharing building energy information more transparent. Here is the link to the agenda and registration information.
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