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.