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.

Green building investment an ‘affordable truth’

Did you catch Paul Krugman’s op-ed in the NY Times this past Sunday?

Essentially, he says that going green is more affordable than certain folks would like for us to realize. Moreover, he thinks that the investment that would be required by buildings to go green would provide a great “organic” stimulus for economy (excuse the pun).

Consider, for example, the case of investment in office buildings. Right now, with vacancy rates soaring and rents plunging, there’s not much reason to start new buildings. But suppose that a corporation that already owns buildings learns that over the next few years there will be growing incentives to make those buildings more energy-efficient. Then it might well decide to start the retrofitting now, when construction workers are easy to find and material prices are low.

The same logic would apply to many parts of the economy, so that climate change legislation would probably mean more investment over all. And more investment spending is exactly what the economy needs.

Big Landlord’s: “It’s LEED or bleed”

Thanks to Greg Porter, of MP Commercial Partners, for sending along the WSJ “adver-journalism” piece featuring several large landlords and the USGBC. It contains a good lineup of industry pacesetters who build and/or retrofit green and have seen a boost to the bottom line from operating environmentally friendly buildings. Essentially, it was a “get on the bus” writeup, encouraging environmental certification of buildings.

Remember that I asked in yesterday’s post, about whether Bloomberg’s pullback on mandating green retrofit mattered for large landlord crowd? My take: the horse is out of the barn on greening buildings and they were under pressure to keep up with the Jones’.

Read what the landlords in this article have to say — even though they’ll continue to push for more incentives at every government level — since their reports of overwhelming tenant and resident preference for green and energy efficiency buildings basically mean that a LEED or Energy Star certification is just the price of entry into the big ticket game.

Then and now

A few years ago I was on a panel that was moderated by an industry icon. Cap rate compression was still the hot thing and sustainability was pretty much ignored in real estate circles.  The moderator asked me (then a lender) if I thought green buildings would ever be worth more than conventionally-built assets. I told him that conventionally-built assets would probably start trading at a discount once enough green buildings were up and running. I’ll never forget him looking at me as if I had two heads.

Today’s WSJ article contains the following quote by Dave Pogue, of CBRE:

“This is a growing movement,” he concludes. “If you don’t improve your buildings to a good standard, there will be a market penalty. We’re already at a point where sustainability gives you an edge.”

Good to see that I probably won’t have to endure panels like that one any more.

Mandatory NY green retrofits R.I.P, but does it really matter?

Blowback from NY building owners forces Bloomberg to drop mandatory retrofit proposals.

But, does this really matter for green building?

Mayor Bloomberg had to scale back his announced plans to require New York building owners to obtain energy audits and, based upon the results, require the owners to perform the upgrades suggested in those reports.

(Note: This particular item has been sent to me from several sources, so I’m compiling and can’t link back to any specific source).

Fact pattern:

• Mayor’s plan would have affected some 22,000 buildings in the city; reportedly creating 19,000 construction jobs
• Above statistic vigorously disputed –> “I’d be shocked if 5,000 of those jobs were created” from Louis Coletti, president and chief executive of the Building Trades Employers’ Association
• Funding the bills that would have created the program really stirred the pot –NY only has $16 million stimulus funding for loans to building owners for this type of work, but the estimated total investment required for the retrofits was calculated to be nearly $2.5 billion

So now the debate rages over what this all might mean for green building. Is the Bloomberg retreat damaging for the advancement of green building?

In general no, but it did highlight the plight of an often overlooked group of property owners.

New York’s pullback from requiring the retrofitting of existing buildings doesn’t mean much, in the sense that so much industry level data and momentum has been generated about the positive economics associated with the energy efficiency of buildings, that larger, quality landlords will retrofit it anyway (albeit according to their own schedules). They’ll do it because they fear devaluation of their assets within the global investor circles they travel.

More importantly, they are more likely to be capitalized in a way that allows them to implement retrofits along a decent timeline. I’m saying here that real estate cycles will force them to pony up the cash just to “keep up with the Jones” and maintain property values as real estate markets recover and investors expect rents and values to grow.

Mid-sized landlords have a different reality. Many cities are just now waking up to this. Their smaller property sizes and smaller portfolio’s make them more cash constrained. The industry owes it to these landlords to come up with existing building retrofit solutions that fit their wallets. Many mid-sized landlords own buildings larger than Bloomberg’s suggested 50,000 square foot threshold, but the costs and fees associated with implementing the retrofit are still expensive for them.  They would have been very hurt by this legislation.

The lesson I see in this is about how much of successful green building and energy efficiency retrofits (and their finance!) is about growing  partnerships within markets over time. Exuberant public officials who only propose requirements, but haven’t created the deep, lasting partnerships with the real estate community necessary to support these kinds of efforts find themselves in Bloomberg’s situation — announcing pullbacks even as experts have clearly demonstrated the excellent economics that building owners can enjoy if they retrofitted their assets.

More clearly for me, is that other cities should take a closer look at making sure that their engagement of real estate owners is differentiated between larger and smaller property owners. Larger owners often deal with different kinds of shareholders and the size of their assets gives them more cash flow on hand to consider retrofits.  Plus they are getting pressured by even larger shareholders.

Smaller property owners need special attention, and services tailored to their specific needs. They are much more cash constrained. Yes, in California and some parts of the Northeast, PACE loans are helpful for these types of building owners, but PACE is still a new phenomenon and not available everywhere.

In the meantime, let’s hope that officials in other towns are involved in more relationship building within their own markets, so that they are able to come up with green building plans that make better sense and therefore, might be more palatable to the local real estate community.

Download report: Net-metering winners and losers

As you head off to Thanksgiving, you can take stock of how your state has progressed on renewable energy (and based on what we’re showing here today, you can hopefully be thankful).

We follow renewable energy trends because one of the central challenges of district or regionally-focused green finance strategies involves having a base of renewable energy policy that the jurisdiction authority can build from.

Renewable energy policies which reward systems owners for electricity generation can go a long way to support sustainable finance funding mechanisms. These mechanisms, depending on their structure, can allow for a transparent flow-through of renewable energy benefits, and the creation of lower carbon districts as well as achieving regional greenhouse gas emissions.

Net metering update

Net-metering is a critical influence on the uptake of renewable energy, since it allows the solar power system owner to earn money by selling electricity back to the grid. So… is your state a pacesetter on net metering? What’s its grade?

Network for New Energy has put out some new figures, detailing how different states make the grade on renewable energy. You can download a copy of the slide deck on this page as well.

Winners

In terms of net metering policies, Network for New Energy names the following states as being top:

1. Colorado
2. Delaware
3. Maryland
4. New Jersey
5. California, Oregon and Pennsylvania (tied)

Losers

According to Network for New Energy, the following states have no policy on net-metering, which resulted in them receiving a failing grade:

1. Alabama
2. Alaska
3. Mississippi
4. South Carolina
5. South Dakota, Tennessee and Texas

LIIF green fund launches and Bond Co’s gets pulled

Two green funds have made the news recently, due to movements in opposite directions.

The Low Income Investment Fund announced a $50 million green community fund, to fund green buildings in underserved communities over the next three years. Per their press info, the funds will be used to invest in LEED certified building development, transit oriented development (TOD) projects and greener child care centers in underserved communities across California and the New York area.

The Bond Companies and Abraham Group, on the other hand, seemed to have pulled the plug on their planned $350 million fund, which would have targeted green real estate opportunities. This comes per Real Estate Alert (no link, subscription based only).

The fund originally focused on developing and redeveloping urban market properties, but switched gears to repositioning existing buildings when the market downturn worsened. With a return goal of 13.5%, it is fair to say that equity return expectations have shifted significantly upwards since the fund was announced. That, plus the overall investor pullback from real estate could make it tough to achieve the original fund-raising targets.

In our view, this shouldn’t be seen as any negative comment against green funds generally.  The shift in real estate valuation and the capital markets downturn have stalled any vehicle that is development and/or sub-20% targeted return.

Expect to see a similar fate hit other green funds announced over the past 24 months. It’s all part of the economy and current real estate cycle.

The upside (if you can call it that) can be seen in green funds, which are announced right about now: the market is widely expected to be at or near bottom by mid-2010, and so those vehicles will be in a better position to purchase real estate more cheaply and, other factors being acceptable, generate the kinds of returns investors expect. Having said that, it is our view that it will be quite a while before new development  returns to the forefront of anyone’s focus.

And that, of course, keeps things very interesting for the retrofitting of existing buildings.

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