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.

RFP Magazine Article: Green finance breaks barriers for global real estate

 

The following article, written by Lisa Michelle Galley, was published in RFP Magazine, on 3 March 2010. RFP stands for “Real Estate, Facilities, Projects”.

RFP Magazine focuses on investment real estate across Asia.

The article published under the title “The Financial Barriers to Real Estate Can Be Overcome, Explains Lisa Michelle Galley”.

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Community officials, property owners and citizens are changing the world – working hard to extend regional social, environmental and commercial vitality. This is driving exponential growth in energy efficient and environmentally-certified (collectively called “green”) buildings, since some people realize that green buildings are clearly better performing investments that release funds trapped in wasted resources back into the pockets of workers and local economies.

Yet, green building opportunities present major challenges for today’s financial sector. In Living Cities (2009), a collaborative of 21 global financial institutions, cities named a lack of funding as their number one challenge for developing large-scale green building programs. Commercial banks have difficulty with pricing energy savings as an asset. Investors are still getting comfortable with factoring water and energy performance into property pricing decisions.

To address these barriers, governments and private investors are combining green financial products with traditional ones, into systems of finance products and mechanisms, to introduce transparency about building performance into markets, and direct capital into and from green buildings.

These new financial solutions, organized at the district or community level, are implemented via public-private collaborations. Implementing these programs requires moving through a series of nested considerations from determining the interests of diverse stakeholders to structuring the right finance mechanisms for communities and investors as well as for reducing greenhouse gas emissions through day-to-day activities.

Understand the Interests of Stakeholders and their Markets

Financing green starts with understanding the real, often unspoken expectations of each stakeholder. Property investors need clear green investment cases. Home buyers seek to reduce their energy costs and ensure safe air quality for their children. City officials want to limit resource expenditure on public infrastructure.

Incorporating these expectations into any green finance assessment promises crucial insights.  Participants can increase the impact of initiatives, since finance options are simultaneously compared to everyone’s interests and available opportunities. They also provide an early warning system about potential roadblocks, saving the time and money associated with creating financial solutions which were doomed from the start.

New Tools for Green Finance

Accelerating green buildings requires that communities and investors obtain capital for their projects. Below are a few new, popular and innovative green finance products that assist with both individual projects and large-scale transformation.

Green bonds: Socially responsible and ethical investors are a potent source of capital, but have traditionally shied away from investing in real estate, since it does not clearly align with their mission requirements. However, as a US$2.71 trillion market “on a mission”, socially responsible investors (SRI) are increasingly stepping up to partner with communities by buying green bonds issued by local governments that fund large-scale retrofitting of low income housing or regeneration of blighted urban areas. Recent examples include the EU-issued EUR1 billion in “Climate Awareness Bonds” in 2007. In the United States, bonds for ‘tax-lien’ financing, such as those issued by Sonoma County in spring 2009 and the upcoming GreenFinanceSF are growing in popularity, with more than 95 Californian cities either operating or in the process of establishing similar programs.

Commercial bank green loans and investment products: When a municipality implements sustainability initiatives, the continued access of businesses and consumers to credit services is often taken for granted. However, this as well as an adaptation of those products to better fit with the municipality’s sustainability objectives for buildings, is a critical area of analysis which often goes overlooked. As a result, many communities watch as sustainability initiatives falter, since they do not see sufficient private market credit and investment taking place. Often times, they fail to understand exactly how much credit for buildings actually comes from local banks.

When the South Korean government announced a national “low carbon, green growth initiative”, several of the nation’s largest lenders, including Kookmin Bank, also announced their roll-out of many types of green financial services and products. The products not only cover residential and commercial green building loans, but also extend to industry with asset management, project finance and insurance.

Climate Benefiting Finance: Some communities and investors are even requesting green finance solutions that are sophisticated and scalable enough to transform the national economy. Introduced in June 2009 by the winning ‘c_life’ team in Sitra’s Low2No competition in Helsinki, Finland, climate benefiting finance is a replicable set of economic frameworks that will help to assure a private finance market that values green buildings. The frameworks consist of many interrelated systems of green financing mechanisms, all designed to price and deliver finance in a way that rewards carbon savings within businesses, real estate projects and the carbon-related behavior of private individuals. Here, the goal is to use finance to ignite profound change and diffuse new ways of thinking about sustainability.

Designing Green Finance Mechanisms for Impact

Molding green and traditional finance products together into a customized program sets the stage for finance that is truly aligned with driving sustainability.

First, stakeholders jointly analyze their situations and cross-educate each other about their individual risks of continuing business-as-usual. Second, the government will comprehensively assess the availability of incentives available to the building owner, to understand which ones most closely complement their objectives and those that conflict. Third, the initiatives’ attractiveness to private sector capital sources will be researched. Fourth, they will focus on needed partnerships with private financial institutions to assist the development of the loan products, that work best with program funds that public agencies may provide for green buildings.

From those evaluations, officials, investors, financial institutions and citizens can obtain a common understanding not only of their individual green business case, but also of the interrelationship of their success within the green initiative and the success of others.

Market-tailored tools such as investment and credit underwriting protocols for green buildings, benchmarking and metrics to measure property performance, as well as new monitoring and reporting regimes to assure feedback, will strengthen the initiatives’ success.

The gains of incorporating green finance mechanisms into sustainability initiatives are transparency and clarity. When everyone at the table is able to actively benefit, barriers fall and the complex dialogue becomes much clearer and simpler.

What I Learned at the Competitive Edge Workshop #1

 

“Teaching is half learning.”

That’s a Japanese proverb, originally from the Chinese Book of Documents.  After teaching the first Competitive Edge workshop last week, we definitely believe that’s true — teaching involves a great deal of learning.

In addition to a personally amazing experience with a fantastic group of high-caliber professionals, we found ourselves reflecting deeply on how much we learned from them.

If you’ve been following previous posts on this blog or getting Pacesetter, Investment Analysis of Green Buildings, sponsored by the US Green Building Council - Northern California Chapter and law firm Hanson Bridgett was held last week, we taught to a nearly sold out room.  On top of that, the course was granted CEU-status by USGBC national, a first for the Northern California Chapter — and for green finance anywhere, to the best of our knowledge.

Here is what we learned from listening to and working with the workshop attendees:

#1: Green finance is important to a much larger group of professionals than you might think.

While we deeply believe that green finance can change the world, we had still oriented much of this course’s material to real estate finance and investment professionals. And, we had a full house of folks from some of investment real estate’s household names, which was flattering.  In addition, however, there were also professionals from the building technology,  construction, corporate real estate, affordable housing and legal sectors. In our conversations, we asked attendees about why they attended the course. The answer we received repeatedly was that professionals were finding it critical to understand the perspective of the property owners that they worked with and they believed that updating their knowledge of financing sustainable properties would be a good way to do that.

Real estate professionals in the room were leading change within their firms or they saw the workshop as a good way to help themselves transition within real estate by upping their knowledge and skill of financing green  real estate.

#2: Attendees most liked learning a simple, cohesive underwriting approach, how to apply LEED to finance decisionmaking, metrics and taking away a rich set of resources

We had definitely focused on creating actionable content, and when we reviewed the feedback, the following  topics were voted as being most significant time and time again:

• the GAPS approach simplified underwriting: We had really focused on reducing the complexity associated with underwriting and received strong, positive feedback on this. The participants gave high marks to our own system for green real estate underwriting, which we use to help decisionmakers quickly to define, evaluate and communicate the value-add of green real estate. It was interesting that folks from many non-finance sectors found this approach quite useful, too, in their structuring of their own work with property owners. (Don’t know about GAPS, yet? You should check it out at the next Competitive Edge, Financial Considerations of Energy Efficiency Retrofits, on 7 April; sign up here.)

• Learning how to connect LEED credits with the project operating cash flow: This particular need, a core requirement of our work here, got high marks as well. Most of the feedback was along the lines of participants feeling much more comfortable in conversations at work and with clients, now that they could point to very concrete areas within the LEED-NC system, which were prioritized according to cash flow impact.
  

• More metrics, please!: Green Journey readers know of our papers and posts about metrics for responsible property investing. This topic came at the end of the day, when people are typically a little tired. However, the participant feedback revealed that the topic of metrics was considered very important, telling us that professionals assign a value to incorporating both double and triple bottom line metrics within their practice.

• In-depth resources for self-study: Getting a packet of distilled, vetted sources of the latest green finance research plus tools and tips for further learning and takeaway was voted as very valuable by the attendees. While we taught course materials from  powerpoint slides and handouts, we had originally thought it would be helpful if people received an extra resource book compiling the research, tools and tips on real estate underwriting and sustainable finance that we’ve come to rely on here. So we prepared an 87-page resource book, to support the underwriting of new green construction, which expanded upon the information being taught in the course. We really focused on the green building, finance data and information that we most like to geek-out on. We were pleasantly surprised at how many attendees stated that this information was very valuable. Just this evening, I received a note from a participant saying, “I wanted to thank you for your great insight and the wealth of information that you shared”.

It was really gratifying to be able to share our knowledge and passion with a sharp group of professionals. Their feedback about the topics and resources that were most valuable to them opened our eyes also . This will definitely help us in the upcoming Competitive Edge events.

P.S. → The next Competitive Edge workshop, Financial Considerations for Existing Building Retrofits, takes place on 7 April 2010. We are excited about the fact that the City of San Francisco and PG&E will also be taking part with great information that will help properties to better finance existing building retrofits. Sign up and join us in an exciting day! Seating is limited and several of Workshop #1 attendees have indicated that they’ll be attending again, so register sooner than later. On top of that, early bird pricing runs through 24 March 2010.

Norwegian fund putting $16 billion into socially-responsible real estate

 

The juggernaut Norwegian Global Pension Fund has just announced that it intends to significantly expand its real estate holdings globally.

According to the report in Responsible Investor, “Environmental, social and governance (ESG) factors including energy efficiency and water consumption are to be key planks“ within the criteria for new property investments.

The $16 billion investment amount represents 5% of the fund’s overall value and its manager, Norges Bank Investment Management (NBIM), indicates that the fund will need a few years to actually invest in ESG-screened real estate to achieve that level, as the allocation comes from portfolio shift created by cutting the fund’s bond portfolio.

How will they actually invest responsibly?

This is interesting, as there is no real consensus about reporting standards and measurements that constitute responsible investing in the institutional real estate field (see our previous posts and papers about Metrics for Responsible Property Investing, for more details).

NBIM will be required by the government to produce an annual report of the portfolio, including an “assessment of how it conforms to responsible management and the exercise of ownership rights. The bank will be allowed to hire external managers and outsource operational functions, with returns benchmarked against a customised version of the Investment Property Databank’s Global Property Benchmark.”

Overall, we are noticing increasing interest by foreign investors in US markets, as they believe that property values have nearly bottomed out. That, plus the growing requirement for green and socially-responsible properties can possibly spur a near to mid-term shortage in green real estate, even as property markets generally are expected to be in a slow recovery.

As we have seen in previous cycles, lots of capital seeking an asset in short supply can always create some interesting market action. From my point of view, the Norwegian Global Pension Fund is not alone in the direction they are taking. Expect to hear more on this point in the near future, as others get in on the action.

The little clause that killed a green building sale

 

Here’s a live action green building underwriting story.

Basically, it underscores the need for property owners and lenders to make sure their underwriting processes are tailored to certified green and/or Energy Star qualified buildings.

Tonight I received a note from a rather overworked, but sharp-eyed investment analyst, under the gun to underwrite his firm’s purchase of an office building under a very tough deadline.

He was not only frazzled, but also frustrated — prompting his note. You see, earlier in the deal, he had been excited about helping his firm to buy a LEED-certified building. Working on this acquisition gave him the hands-on chance to participate in directing more environmentally responsible investment choices — what he really wants to do more of in his career.

The excitement turned to frustration, however, as he came across the following phrase in the anchor tenant’s lease:

“Landlord shall not be required to impose on Tenant or any other tenant of the Building, requirements for Tenant or other tenants to comply with any certification requirements under the USGBC’s Green Building Rating System or other green or sustainable design elements.”

Long story short: his firm interprets this clause to mean that the landlord is blocked from employing any O&M practices, which would help the building to perform to the level expected from it’s LEED certification. To them, the language allows the tenant to object to any measures employed by the landlord that can potentially affect their costs in any way, no matter if those measures even benefit them down the road.

The building is LEED-NC certified and now the property buyer is faced with the reality that — if they wanted to get a LEED-EBOM certification or even just an Energy Star qualification — which, in their view, helps preserve value over the holding period, absolutely every tenant in the building is explicitly not obligated to cooperate with any measures the Landlord would introduce to achieve those certifications.

Moreover, they also worry that investing in the asset marketed as LEED-certified, with the full knowledge that achieving environmental performance is effectively impossible, leaves them open to being thought of as greenwashers.

As a result, our colleague and now his superiors have adopted the opinion that the LEED certification on this building is essentially worthless. Moreover, they don’t see any way to proceed with the acquisition because they will have to wait nearly ten years until the anchor tenant’s lease expires in order to change this clause, which prevents them from working with every single tenant in the building on this matter.

The investment is fundamentally flawed, doomed to a lifetime of discounted rents and sales prices any time other tenants and future buyers figure this out — or until that lease clause is changed. It could be completely non-competitive on energy performance within its submarket by then as all the other landlords will have been able to easily write leases which assure the landlord the ability to institute O&M expected of green buildings, making this asset the market laggard and — relatively devalued at disposition.

Ironically, any appraiser would typically ignore this in their valuation of the project since absolutely none of these issues would hit their traditional underwriting radar. They would have to be sensitized to the connections between sustainable design, O&M, building performance and related contractual lease obligations to figure out the true negative impact of this clause.

So the seller, after spending so much time marketing the building as a high quality, LEED-certified asset now must move on and find a buyer, who is not as sensitized to the de facto devaluation of the building, and willing to pay his sales price.

Kudos to this investment analyst and his firm for doing the right thing, both financially and environmentally. Green buildings made brown by bad lease language shouldn’t be rewarded with top dollar purchase prices.

In the meantime, please take this as a cautionary story about actual underwriting issues that can come up with green building investments in today’s market.