Heard at ULI Boston: Four Forces Shaping Green CRE

There was fresh energy among folks recently at ULI’s 2010 Spring Council Forum in Boston — market opportunities are slowly coming back, but it would be a mistake for your firm to simply repeat all your old moves from the last cycle.

I heard four comments that represent the mood and actions of investors on green real estate now:

Here’s a synopsis of the forces I see those comments representing:

“The other shoe’s dropped, but no one heard it.”

Your plan → Get going on your green portfolio strategies, you’re already behind.

Professionals finally acknowledged that a) rumors of 30%-40% loss of value in commercial real estate are, for the most part, overstated and b) there is currently too much capital in the market chasing too few deals. The latter point has been creating the paradox of deals trading at aggressive cap rates amid a recession.

In the opening session, Equity Office Chairman Sam Zell explained the paradox. When real estate markets tumbled, investors had expected banks to dump lots of deeply discounted properties into the markets, which investors would snap up at rock bottom prices.

Wrong assumption. Instead, banks have focused on working out troubled loans and strategically offloading REO assets one-at-a-time, and as a last resort. That has given the market time to gradually readjust pricing, preventing fire sales.

Reality: on-going one-off REO sales cushioned the velocity and depth of property value loss. The practice has also frustrated distressed players, forcing them to compete for REO deals against high net worth individuals and other sources with more patient capital, willing to pay more. This way has helped the banks to achieve better than predicted pricing on their sold assets and the market again saw no drastic fall in commercial real estate pricing.

In response to the question of why so many investors still talk about doing distressed deals, in the face of this very different reality, one panelist replied “the other shoe has already dropped, but no one heard it”.

Lots of investors have been delaying their investments in green initiatives, n waiting for the market to return to health. The good news is that the market is now not as bad as everyone thought. That’s also the bad news — all the players with dough have already gotten started, so you need to keep up.

“Every day, 1MM square feet of real estate is being LEED-certified.”

Your plan → The shift to green is happening much faster than you might think. You need to speed up your firm’s own shift to keep up.

Doug Gatlin, of the US Green Building Council spoke at our Responsible Property Investing Council Meeting, about the current stats on LEED. Here’s one: LEED certifications are running at 1,000,000 sf/day, even during an economic downturn. One council colleague, calculating a corresponding value of several hundred million dollars per day, said this fact would definitely influence his market conversations in favor of green building.

There’s still quite a way to go before we can say that market transformation from LEED has really happened. One main premise behind Architecture 2030 goals is that the US either renovates or builds new a net 10 billion square feet of real estate each year. The 365 million square feet annualized velocity currently being LEED-certified represents 3.65% of the estimated 10B in annual square footage built or renovated in the US — so there’s much progress to be made.

Theory: For green building to influence leasing and investment activity in a market, the “tipping point”, “competitive mix” and “OS” factors have to all be balancing and reinforcing each other in healthy levels. A sufficient concentration of LEED-certified square footage in a sector can be enough to influence investment activity in that sector towards green buildings (tipping point). Note that “sufficient” needn’t be that much in absolute numbers.

That, plus LEED maintaining its relevance and dominance as a green building rating standard (competitive mix) and regulatory support on federal, state and local levels (operating system or “OS”) are the keys to further increasing green building volume. The lack of competitive mix and OS in a market or for a real estate asset class will result in no tipping point being achieved in the area being studied.

The tipping point and OS factors are already a particular force on investment real estate in some gateway metros. For example in San Francisco, brokers have been publishing their own reports showing higher occupancies in LEED-certified buildings. There are already whole classes of global investors who publicly refuse to buy inefficient buildings. So this force is already at work, even with a small proportion of US real estate earning LEED certification to date.

“Operators need the track record to execute on both traditional real estate and sustainability strategies.”

This was a fund manager’s answer to my question about what made her choose to invest with a certain real estate operator, who had brought her a deal with an extensive energy retrofit including adding renewable energy in the business plan.

With capital markets slowly thawing and the velocity of green building certifications growing, it’s time to ask yourself if you’re company will attract capital with a mandate for sustainable real estate. Fund managers are now speaking out about needing to work with partners who can execute on a sustainability plan.

Additionally, you’ll need to assist the equity partner with understanding the value-add from green strategies being pursued, that will come from your local expertise.  The good news is that right now the market is wide open. Most of the US investment real estate firms who have achieved any progress on greening buildings have done so with a few buildings and many are still just focusing on low hanging fruit.

With the projected high increases in energy and water costs, nimble regional operators have a great chance at building a great track record on greening buildings that can get them hired over larger competitors. Plus, its a big market, anyway, with lots of room for more players. Remember what I said above, about 10B sf real estate being built and renovated in the US each year plus all the money out there chasing too few deals?

“We’re serious about being green, but we’re skipping commissioning on all our buildings.”

Your plan → Ignore free lunches. Compete via consistently delivering the best building performance possible.

This was said by an owner’s rep of an institution presenting their multi-billion dollar portfolio of institutional assets. He added:

“We are making our space LEED certifiable. We’re doing many things according to LEED for existing buildings, like green cleaning and updating the systems in our buildings, but we’re saving a couple hundred thousand dollars by skipping commissioning.”

“Pennywise and pound foolish” - even tired clichés are still true. If you attended our recent Competitive Edge workshop, Financial Considerations for Energy Efficiency Retrofits, you learned that Lawrence Berkeley National Labs (LBNL) research shows that on median costs of just $0.30/sf, commissioning alone achieved energy savings of 16%, with a 1.1 year payback and 91% ROI.

This means that our investor friend’s portfolio could probably deliver many more dollars in performance, which will literally go to waste via a) the properties remaining exposed to more energy price risk (current price plus escalations) than is warranted, b) not achieving the level of upfront energy savings that might have been possible, c) being in for longer-term, higher capital expenditures on their major systems since their performance was never audited to a commissioning standard.

Why is this unfortunate mindset a force on green building investing?  Actually — it’s pervasive to the point of being an archetype. You’ll find a similar mindset in a certain percentage of companies in every industry and at every point in the economic cycle. As the market matures, the economic downside of their inaction will become more apparent

Those of us who know better have to consistently incorporate building performance data into underwriting and valuation, and adjust prices accordingly. When a certain percentage of investors find themselves taking discounts at sale and losing enough tenants, then they’ll change their minds, improve their O&M - and even save themselves a few more bucks the process.

Study: energy efficiency spending is up, incentives less important

Johnson Controls and IFMA are out with their latest survey on the 2010 energy efficiency spending outlook for North America, based on their survey of executives with direct oversight and control of energy budgets.

Aside from the larger conclusion that survey respondents intend to spend more in 2010 on energy efficiency than in prior years, comes a “sub-conclusion” that incentives were not as high a priority among executives as  most of us would think.

Specifically, the answer to the of ‘ how influential are government/utility incentives in the organization’s energy efficiency decisions’ was ranked as “somewhat, very, or extremely” significant by a lower percentage of respondents in the 2010 study than in prior years.

When asked about the ‘significance of greenhouse gas emission reductions on their organization’s energy efficiency decisions’, a greater number indicated that GHG emission reductions were “somewhat, very, or extremely” significant than in 2009.

From there, Johnson Controls and IFMA conclude that incentives have dropped in importance.

There are a couple of related items of note, that remain unexplained by the summary presentation notes.

- in a subsequent question of “which options will  your organization consider to pay for energy efficiency and renewable energy projects over the next 12 months“, the option of grants or tax credits were chosen by 20% answering. It was the number two most selected option. Number one, with 52% answering, was capital budgets.

- large and public organizations (read: those with more cash these days) answered as being most likely to invest in energy efficiency. The retail sector was noted as lagging in this category.

- they note that respondents’ investment criteria, 44% of which answered as being a 3.2 year payback, remains unchanged.

To be sure, this study is definitely not one in advocacy, as the unchanged 3.2 year payback represents a 31.25% return on investment, which is well beyond the returns most investments can deliver.

Also, it appears that most of the respondents were not from the investment real estate community, but mainly the corporate community. So, while its great to hear that more money will be spent on building energy efficiency, one can also see that there is still an intense  focus on the low-hanging fruit.

Even though it appears that the study was directed more towards exciting the Johnson Control customer base, it nonetheless provided some insights into current thinking on investing in energy efficiency in the corporate world. From that standpoint, it is worth a read.

For more fun — and insight, these exact questions should have been asked of institutional real estate investors and managers in a separate group, so that we could compare their answers with those responding to Johnson Controls here. I suspect that there would be quite a divergence in opinion on some of the questions.

For even more perspective, they should also be asked of lenders separately, too, about the projected spending of their borrower clients and loan portfolios on energy efficiency.

Perhaps, next year.

Happy reading!

Galley Eco Capital Wins CALED Mandate

Financing and Business Model Challenges

Lisa Michelle Galley, Galley Eco Capital’s Managing Principal, has had a long career as a financial services executive and is a nationally-recognized green finance specialist. She spoke about the challenges encountered by groups such as CALED that decide to explore new financing models and products:

“Our experience with regional finance programs and products has shown some typical problems organizations encounter when they troubleshoot their initiatives, so we bring a  unique toolbox and skill set to help them identify the problems and create sustainable finance models.”

Identifying Root Causes

First, many organizations will decide that they have financing problems without knowing the root causes of why money is not flowing through their markets in the way they expect. Without identifying the root causes of the problem, they never know the true minimum requirements that any solution should deliver. As a result, fresh funding might not flow efficiently enough to resolve their financial problems. Galley Eco Capital uses performance technology tools and techniques to identify root causes to finance problems.

Systems Analysis Defines Problems Better

Then the problems should be analyzed within a dynamic system of behavior and interactions. For example, the power dynamics between price makers and price takers within a market has to be understood as part of defining the problem.

Price makers are firms from industries that have pricing dominance — they have the power to obtain their desired pricing within transactions. Healthcare companies are a great example. The markets dictate pricing to price takers, making them weaker actors in any business system. Many hotels and manufacturers find themselves in this group. To create successful regional finance initiatives, organizations have to identify the power dynamics between these groups and make sure mechanisms are in place, which will keep them in balance over time.

Galley Eco Capital applies concepts from system dynamics, analyzing business models within whole financial systems, in order to obtain deeper insights about how these issues might be brought into balance.

In the case of regional economic development, EDC’s may want to simply recruit a successful businesses from another region into their own. Without knowing the dynamics between the new firm and existing firms in their region, EDC’s may inadvertently encourage too many price takers, weakening their region with high unemployment –  price takers usually have no choice except to control profitability through firing personnel. Conversely, having too many price makers may dampen a region’s economic growth — these firms may maximize their profitability unrestrained while externalizing the social costs their actions create.

A sustainable business model will consider the dynamics and interactions between customers and transactions over time, in order to design financial programs and services that truly deliver the economic, social and environmental stability they promise.

New Tools for Financing Program and Product Development

Galley Eco Capital applies decades of experience in financial services, program and product development for investors, government agencies and lenders to assist its network of investors and collaborators. What’s unique about the consultancy and new to green finance is that the firm brings new tools for complex problem-solving and financial program development, such as systems dynamics, performance technology and innovation games to financing problems.

These kinds of tools render deeper insights into problems much more quickly, and help collaborate with clients to develop sustainable finance programs, new business models and other solutions that are better tailored to unique challenges.

For questions or comments about this story, please call Galley Eco Capital at (415) 655-6668 or email lisa@galleyecocapital.com.

PACE inside baseball: Private-label securities to the rescue?

GSE’s bench PACE

If you follow the PACE saga — which we covered in February’s Pacesetter as well as in numerous posts before, you know that it’s attracted enough interest to keep us all hopeful about the prospects for a liquid secondary market for energy efficiency loans.

But, like any saga, there are always curveballs and intrigue to keep us wondering.

GSE’s (government-sponsored entities) Fannie Mae and Freddie Mac supplied the  action in this latest edition of PACEwatch.

They recently sent PACE financing back to the dugout, by declining the purchase of tax-lien secured energy efficiency loans on residential properties, citing concerns with repayment risk associated with the priority of the tax-lien over the senior mortgages.

No, folks,  the tax-lien-priority issue will not just get up and walk away on it’s own.  Market watchers quoted in the article point out that pricing in the theoretical risk and/or clearer underwriting to clarify the value improvements to the retrofitted properties could help the GSE’s and others buy into PACE-related debt.

IMHO, it’s going to take a solid mix of both approaches to get the secondary market comfortable with fund PACE paper.  Altering a senior mortgage’s status makes it tougher for the lender to price and re-sell their loans, even if retrofits improve property valuation. They’ll want compensation for what could be an important change to their contractual structure. It’s always been that way with modifications and I don’t think there’s anything wrong with a lender expecting to be paid a market return for agreeing to re-do a deal.

Additionally, requests to see, touch and feel (and standardize) the control of the retrofit value-creation process, beyond the theoretical math of energy savings is reasonable. Programs that dole out tax payer dollars without robust underwriting and performance measurement are setting themselves up for failure.  No matter how smart we become every economic cycle, a certain percentage of loans typically fail for the same old reasons.  “Failure to properly monitor” loans is one of the oldest, and most typical paths to default.

So, while I greatly wish to see lots more capital flowing towards PACE financing, I still think it’s prudent for any lender to request clarity on the loans they buy and to be paid the right price for the risk and underwriting.

Inside baseball: private-label securitizations to the rescue?

That being said, I suggest we keep our collective eyes on the private-label securities market as an alternative funding source.  Yeah, I know it’s been dead since the economic downturn, but that would be the alternative for PACE to build up a liquid secondary market as long as the GSE’s aren’t stepping up to buy energy loans.

And the idea’s not so far-fetched since the private-label market is now starting to show signs of life.  While the GSE’s are definitely big players in the residential mortgage secondary market, which reached $2 trillion at it’s height in 2006, private-label securities were responsible for as much as 56% of home mortgage securitizations during the same time frame.

Today’s WSJ details how Redwood Trust is taking a shot at offering ~$200 million in jumbo residential mortgages in a private-label sale. This will be the first sale of private-label mortgages in two years. Market watchers say that the timing seems good for private-label securitizations to make a comeback, now that the homeowner default surge that killed the market a couple of years ago has receded. Add to that, the currently tight underwriting guidelines in effect, which strengthens the credit quality of these loans, making them attractive to secondary market investors.

Note that this particular transaction is not a done deal yet, and Redwood may have to postpone the transaction if they can’t generate sufficient interest in the offering.

For us PACE fans, however, this is bit of side action is worth tracking. The private-label securitization market is another potential source of secondary market liquidity, if the GSE’s continue to reject energy efficiency finance.

I’m willing to bet, however, that private-label market will be just as tough on conforming documentation and tight underwriting guidelines. If investors are now able to buy into residential mortgage paper structured  with tight underwriting and and high credit quality, what will compel them to give that up for PACE-paper?

Nothing, I think.

Nonetheless, the game is not over and we’ve still got several more innings to go.