Leslie Christian’s Sharp Focus on Risk and Flawed Asset Allocation

Leslie Christian’s Essay Series:

Originally published in Reimagine Money -

» Social Finance from an Investor’s Perspective

» Getting Serious about Long Term Investing

» Allocate your Risk Response

So many of us in sustainable finance talk about the need to “finance differently”. However, not many are underwriting or, more importantly here, understanding the green finance problem any differently than before.

As Scott Muldavin points out in his recent work, your intended decision drives the content of and the manner in which you underwrite green real estate investments.  Underwriting green does not have to be done in any “special” way. Your common, hardworking DCF analysis will do the job just fine.

Many governments and NGO’s understand the green finance “problem” as one of raising awareness and delivery logistics. Make consumers aware that a new behavior (like turning off the lights) will save them money and then pay them a few bucks (as an incentive or rebate) to adopt the desired behavior.

For investors perceive the “problem” as one of risk versus reward. They want to earn an appropriate risk-adjusted return for the sustainable property they are purchasing (or lending on). You get the picture.

We’re all in favor of green real estate, just as long as we don’t have to do (too much of) anything differently.

But does any of this address the real problem, or is it all just surface noise?

“It’s the global economy, stupid…”

I imagine that’s what James Carville might say if he read Leslie Christian’s recent essay series that been published in the Reimagining Money blog, over the past few months.

Instead of providing her take on the next couple of short term moves, Christian introduces the idea that we’re all playing the wrong game entirely.

She asks us to consider whether current day approaches are driven by basically faulty assumptions. Her point: limits on ecological resources mean that there are limits to economic growth. Ignoring the role that ecological limits play within our global economy opens us up to other risks (negative and positive) the financial community has never thought about. Risks that are already playing out every day throughout our markets and the world.

Rather than trying to measure the riskiness of a particular asset within the framework of a growth economy that looks a lot like the past century but with more players, perhaps we need to consider the riskiness of the global growth economy itself.

In her first essay, she lays out why “global growth thinking,” as reflected by Modern Portfolio Theory (MPT) and pretty much all of modern finance, is no longer a workable framework (if it ever was). The unquestioned expectation of perpetual growth leads many to analyze a particular asset or risk within a perpetually growing global economy. But they never question if the global growth economy itself is a problem.

Christian does — challenging MPT, then proposing a new risk framework for the 21st century, which positions social investing as a risk mitigant. And all that happens in just the first act.

In the two subsequent essays, she takes it to the next level. By the third essay, she calls you out, naming ostriches and other non-responsive market participants in denial.

The issues she raises are getting attention in financial circles. Pacesetter Vince Siciliano, CEO of New Resource Bank, commented on the second essay:

I welcome the discussion on limits to growth and the very real impact it should have on our lifestyle and investing decisions today. When we define the word “sustainability” we express a concern about future generations without acknowledging the inherent paradox of everyone around the world trying to live an lifestyle. The blunt question is whether we are willing to freeze (or shrink) our current standard of living to make room for others both now and in the future.

On the other hand, Leslie states that we crossed the tipping point on global resource use in the mid-1960s; I wonder how we prove that fact? The use of cradle to cradle thinking and sustainable technologies will enable us collectively to live much better on a global basis and that needs to be figured into the overall calculus.

Are we protecting ourselves with an umbrella in a hurricane?

Vince points out the need for more proof on the connection between ecological and economic limits. Actually, while I think the need for proof is prudent, it is quite plausible that Christian is at least half right. And that spells big trouble because modern finance can’t even address a part of the risks that she point to. So even if she’s partly wrong, there’s still a need for sustainable finance to redefine “financing and underwriting differently”.

So if you thought that any of Christian’s writing could be true, what would you do differently?

If you even partly accept the notion of ecological limits to growth that make the entire global economy riskier than we know:

• how much have you reduced your ‘risk’ by financing and investing in green real estate?
• what is the cost of waiting to implement your strategy?
• how much benefit will you gain by focusing only on “low hanging fruit” during your energy efficiency retrofit?
• are energy efficiency finance programs, such as PACE, really effective or are they too little too late?

Or do you think, as Vince Siciliano comments, that some of today’s new sustainability thinking — like cradle to cradle — can play such a significant role that you’ll be able to to avert the horrible future Christian suggests is waiting not only for the status quo but current day green investing, too?

Take a look at Leslie Christian’s essays, risk framework and recommendations.

Think about some of the markets where you currently seek investments.  Think about your underwriting.  Your network and clients. See any signs of ecological limits taking shape?

We do.

If you work with institutional investors, send the essays along and ask them what they think.

Then, share your experience and their reactions with the rest of us. We’d love to know if and how these ideas cause your conversations and more importantly, your investing, to differ.

Access all three of the essays here:

» Social Finance from an Investor’s Perspective

» Getting Serious about Long Term Investing

» Allocate your Risk Response

Put Fortune 500 Product Innovations to Work for Your Green Initiatives

Now that the economy appears to be improving, we expect billions of dollars of fresh capital to flow into green development and energy efficiency retrofits over the coming years.

However, we also know that many firms are still hesitant to proactively green their portfolios and financial offerings. We think we know why and have new tools to boost their confidence.

These practitioners are saying something that the green building crowd simply can’t ignore. They feel they’re in a Catch-22: they know their companies are at risk if they don’t go green, but they don’t have a clear view of the possible results of committing their capital to green investments at a meaningful level.

Even though researchers have published studies indicating that green properties earn an average 3% higher valuation, or 16% higher net operating income, that still doesn’t mean that you are going to make that on your properties. It doesn’t mean that your particular tenants are going to pay you more rent on a given date. Nor does it mean that you will absolutely realize these results upon sale of your particular green assets.

The truth that leaves these firms skittish is that realizing the value-add of green depends on many variables for which no data exists. Not only must you do the right things, but the sub-market around your asset has to do (enough of) the right things, too, in order for you to be properly rewarded for your sustainability initiatives.

That’s a very hard disclaimer for many investors, lenders and governments to tell their shareholders and voting taxpayers.

So we’re stuck, right?

No, we’re not. There is a much better way.

What Real Estate Can Learn from the Fortune 500

We noticed that leading global players – players like VeriSign, SAP, Genesys, etc. – face similar issues as commercial real estate investors.

They also have the predicament of committing billions of dollars each year to create new or revamp existing products and services in an unclear business environment. The B2B product development gurus who work for these companies told us about the secret sauce of their success – what has made the difference between so-so and blockbuster products, even when the economy is tough.

It turns out that Fortune 500 companies reduce their investment risks within new/revamped product and service initiatives by using sophisticated “voice of the customer research” (VOCR) tools very early in the design process. These tools gather how customers perceive and experience their products and services, which is perhaps the most difficult information to obtain. It is also the most valuable for developing new products and services – particularly the kinds of products and services that are very new to an industry, like green building and energy efficiency.

The B2B product development gurus stressed that these techniques minimize capital at risk because the company obtains key insights up front on what might enhance their product’s success with their customers. Products and services can then be further developed to fit customers’ needs as closely as possible. Often times, these methods reveal data about unspoken or hidden needs customers have never clearly expressed, leading to innovative product breakthroughs.

Galley Eco Capital has carefully adapted VOCR tools to work specifically for the real estate finance and investment sector as well as municipalities engaged in energy efficiency and green building programs. They are available within a branch of special services called Real Estate Innovation Advisory®. REIA now offers special collaborative forums that power green initiatives by enabling investors, lenders and governments to collaborate with their customers on their green space, investments, and service offerings.

Join an upcoming Mini-forum at Competitive Edge Workshop #3

If you are attending Competitive Edge Workshop #3 on June 24, you’ll participate in a mini-version of an interactive Real Estate Innovation forum titled, What Real Estate Investors Think about Your Products & Services (And How You Can Communicate Their Value).

Whether you are a real estate practitioner, investor, service provider or government employee, you will have hands-on involvement in learning how owners perceive green building products and services. You will take away insights about interactive forums as well as specific content that is immediately applicable for your own business.

Understand Your Customers, Minimize Investment Risk and Boost Investment Value

If you don’t have the voice of your tenants, borrowers, partners and customers influencing the development of your green building space, products, services and offerings, then you are missing an incredible opportunity to bring more certainty to your capital programs. You could also miss the chance to find more breakthrough ways to do smarter green initiatives.

Call me today to talk about how Real Estate Innovation Advisory® Services can help you gain clarity about enhancing your existing products and services or get customer input on new ones.

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.

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.

How Green Multifamily Helps Bank CRA Ratings

(that’s “New Orleans” for  non-Southerners).

I am conducting workshops on Underwriting Green Multifamily Development this week at the 2010 National Community Development Lending School (”NCDLS”), hosted by the San Francisco Federal Reserve Bank.

NCDLS takes place within the National Interagency Community Reinvestment Conference, a big national event for community development professionals, Community Reinvestment Act (CRA) officers, lenders, investors, non-profits and intermediaries.

This is the first time that the topic of underwriting green multifamily developments is part of the NCDLS curriculum. We’ll share more tips from the course for you in Tuesday’s Pacesetter (subscribed, yet?)

A main point we are stressing in workshops is that green multifamily investments fulfill a far larger set of objectives than just better quality housing (which, of course, is a great start). We’ll be educating colleagues on how sustainably-designed apartments help regulated financial institutions to go beyond simply fulfilling CRA requirements. Done right, green apartments can materially improve bank CRA examination outcomes, which satisfies the institution’s broader business objectives.

But first, a short background: The Community Reinvestment Act of 1977 was established to ensure that regulated financial institutions would have an obligation to help meet the credit needs of local communities in which they were chartered. Briefly, financial institutions demonstrate compliance with these laws by providing “qualified community development loans, investments and services.”

The actual performance requirements needed to comply with the CRA vary by institution size and charter, however, it’s enough to know here that regulators use CRA examinations to verify an institution’s compliance with these laws. Those examination results are considered whenever a financial institution applies to open a branch, merge with another institution or become a financial holding company, which are the key moves bank need to make in order to grow and survive.

The CRA examination can result in four possible ratings: “outstanding,” “satisfactory,” “needs to improve” and “substantial non-compliance.” In work and conversations with CRA officers and other professionals, we learned that many banks typically receive “satisfactory” ratings, but it is very hard to improve an examination rating from “satisfactory” to “outstanding.” If you take a look at the Cliff Notes version of CRA requirements here, especially those for large banks (assets > $1billion), receiving an “outstanding” across examination categories is not a matter of simply being “very good” at a few things, the institution has to be “excellent” at many requirements, which can be very challenging, particularly during a tough economy.

One of the toughest requirements to fulfill-let alone demonstrate excellence at-is in the “Product Innovation” category, where the large bank has to “make EXTENSIVE USE of  innovative and/or flexible lending practices in serving [assessment area] credit needs.” And this is where green multifamily investments help greatly.

» SF Federal Reserve Bank’s CRA page
» CRA page at Cornell Law School’s Legal Information Institute

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