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.

Energy Star, rigourous performance data shall set you free

“Talk is cheap” might be a tired cliche, but there’s always someone around who seems to forget.

Not a week passes without another example of someone taking the easy way out on verifying green and/or energy efficient performance.   And anyone who cares about green building investing or even just making money from their buildings in the future should be vigilant about avoiding this particularly vicious delusion.

This week’s (most unfortunate) case in point is the US EPA’s EnergyStar appliance certification program, facing accusations of being vulnerable to manufacturer fraud by the General Accountability Office, as featured in the 26 March New York Times.

If you picture the emerging green real estate finance and investment ecosystem as being a giant computer, the US EPA’s EnergyStar Program is the “Intel inside” –  a powerful, branded technology within the nascent green investment “operating system” that drives the circulation of capital into and throughout the nearly $200 billion ecosystem, via providing the market standard in tools to collect and measure building energy data as well as certification regimes for the energy performance of most kinds of buildings and equipment.

EnergyStar is a big player, providing a sort of “software” that systemically links the value proposition of building energy savings throughout communities, environmentalists, investors, and citizens. Look at all the roles it plays in our green real estate finance and investment universe:

• Regulation: Building energy disclosure laws in California and Washington, D.C. are largely premised on the availability of and reliance on EnergyStar.  Regulating building energy disclosure as a part of market transformation is showing early promise in Washington, D.C. where practitioners attribute these new laws to the rise in green building certifications there.

• Green building certification: The US Green Building Council’s LEED 2009 rating systems require achieving an EnergyStar rating of 75 as a prerequisite to certification. Co-Star data (April 2009) indicates 433 million square feet of LEED-certified green building space in operation in California alone. The US Green Building Council estimated that green buildings will represent $180 billion in construction value by year-end 2009.

• Investment best practice: Within ULI’s CLUE 2009 study¹, nearly 80% of the respondents (investment funds, financial services, lenders) indicate that they perform “an explicit analysis of energy efficiency when completing a due diligence review on a project or transaction”.  Among larger property owners and managers, EnergyStar’s Portfolio Manager is as ubiquitous as Microsoft Excel for spreadsheets.

• Property Valuation: Lower exposure to energy supply and price risk is a key tenet supporting the lower operating costs, which partially drives the superior valuation of green and energy efficient (mostly defined as Energy-Star rated) homes and buildings. While we haven’t yet achieved sufficient transaction data to say with certainty the amount of valuation increase attributable to energy efficient buildings, we do know that lower operating costs are a key point of property value and value appreciation is an essential wealth creation mechanism in the United States (current economic climate aside).

• Monetary support: Closer to today’s focus, billions of dollars in taxpayer money and utility fees,  in the form of rebates and incentives, are allocated to support the purchase of EnergyStar-rated appliances and equipment within residential and commercial buildings.

With that in mind, the report about possible fraud vulnerabilities within EnergyStar’s appliance certification system should be a concern for anyone who builds, lives in or operates buildings in the United States.  It is not an understatement to say that the fortune of US green real estate finance and investment is directly linked to that of EnergyStar as a certification, data collection and reporting tool.

To be clear, I am not saying that EnergyStar Portfolio Manager, the energy data and benchmarking tool of choice commercial building owners, is faulty due to the appliance snafu. However, the residential and commercial real estate industry directly relies on EnergyStar-certified appliances and equipment, as well as the taxpayer-funded rebates attached to them. The growth of the green finance and investment industry in the United States, still very much at an early stage, also relies on faith in EnergyStar’s positive reputation, which can be compromised by false performance data on the equipment it certifies.

Add to that the weight of political capital at risk within hundreds of cities with climate action and/or energy conservation goals, based in part on residents and businesses (like property owners) switching to EnergyStar-certified appliances and equipment over the next couple of decades.

EnergyStar, rigorous performance data shall set you free

Trust is built on truth. In green real estate English that means real, vetted performance data.  Smart homeowners and investors deserve the truth about the energy performance of everything and they’ll keep their money in their pockets until you proved it. Don’t forget that the speed of the internet economy can make everybody equally smart about performance data in an instant.

Like Intel chips in computers, EnergyStar is an extremely valuable technology within our green investment “operating system”. Our reliance on it drives billions of dollars of annual growth in green and energy efficient buildings (even in a recession economy).

Nipping appliance certification concerns in the bud is not only a big deal for the EPA, it is an imperative for for the real estate finance and investment industry.

I hope that EnergyStar and the broader real estate industry will recognize what, not to mention how much, we stand to lose if we don’t take swift action to make sure that every aspect of it’s programming and reputation represent the platinum standard in energy performance data, measurement and certification.

¹Sorry to footnote a blog post, but I couldn’t find a link to the ULI 2009 CLUE report anywhere on their site, despite some intense searching. If you do want to look up this citation, and have the study handy, look at survey question #5, on page 8. I only have it in hardcopy form.

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.

Use these metrics to measure your portfolio’s triple bottom line performance

Get this new research on metrics that helps you measure property triple bottom line performance.

We are pleased to share a new report titled, Metrics for Responsible Property Investing: Developing and Maintaining a High-Performance Portfolio.

You can download the report here.

This research was co-authored by Jean Rogers of Arup, David Wood of the Responsible Property Investing Center and myself. This is a working draft for comment that was presented today (4 November 2009) to a joint session of ULI’s Responsible Property Investing and Sustainable Development Councils.

Why do we need metrics for triple bottom line investing?

Our survey of the industry indicated that the spread of triple bottom line investing was being hampered by the fact that most currently available real estate sustainability reporting came from investors who would green a couple of showcase buildings in their portfolios.  This lack of transparency leaves the broader real estate industry and capital markets with several pressing problems:

• They cannot determine if sustainability performance on the portfolio is improving over time.
• They do not know how the portfolio’s green performance compares with the portfolio’s of other investors.
• There is no way to judge sustainability risks hidden within any portfolio.

Drafting and road-testing proposed metrics with the Bay Area Council and TIAA-CREF

After developing a set of metrics that would represent the ten RPI principles in action, we worked with the Bay Area Council Family of Funds and TIAA-CREF to road test them, to obtain real world feedback from actual investor users.

Bay Area Council Family of Funds tested the metrics on recent acquisitions to see how the metrics might be useful during the property acquisition process.

TIAA-CREF tested the metrics on a portfolio of properties they own, to determine how the metrics could possibly assist them with asset management activities.

Both investors were also at today’s ULI session and provided in depth comments on the use of the metrics and their recommendations.

Key takeaways

Here are a few of our findings based upon investor feedback about their use of the metrics:

• RPI metrics do provide a tangible link to asset and portfolio value by pointing to possible decreases in operating expenses and/or increases in rental revenue.
• The use of RPI metrics can assist with opportunity finding: a key objective of due diligence during  acquisition.
• The use of RPI metrics can help drive social responsibility within the portfolio, instead of just monitoring it after the fact.

We need your help!

This report is currently a working draft for comment. It was submitted to members of the Sustainable Development and Responsible Property Investing Councils for their review and comment. We would also appreciate hearing the comments and questions of real estate investors and practitioners within the Green Journey community.

Let us know your thoughts about these proposed metrics. Also feel free to forward this report to anyone in your network whose practice might benefit from the information.

We look forward to hearing from you and will keep you updated on this effort as it evolves.

You can download the report here.

Related reading:

• We’ve covered the emergence of responsible property investing many times before.
• You can also view a short presentation on the basics of responsible property investing here.

*   *   *

Don’t Build a Certified Gas Guzzler

Some investors narrowly focus on obtaining the LEED-plaque without doing sufficient analysis of whether they are approving the right kinds of energy-savings features for their investment dollars.

And that can cost them more than they assume — here’s a real cautionary tale:

The GSA’s Federal Building in Youngstown, Ohio is highlighted in today’s NY Times as a LEED-certified gas guzzler. The barebones fact is that, despite achieving LEED-certification, the building failed to qualify for Energy Star rating, when its utility bills were assessed last year.

What did they do wrong?

The GSA focused on things like daylighting, native landscaping and a white roof. They also paid for a “gas guzzling cooling system” and didn’t funding enough “structural energy-saving features”.

What’s at stake for the real estate industry is the enormous investment of time and capital into creating green and energy efficient buildings, in order to avoid the potential appraisal risk tied to obsolescence now facing many conventional buildings.

The USGBC’s own research indicates that “a quarter of the new buildings that have been certified do not save as much energy as their designs predicted and that most do not track energy consumption once in use.”

In addition to possibly leaving an owner open to reputation damage from accusations of greenwashing, failing to make the right decisions about structural energy and water saving design could harm the viability of the green building investment in a few ways:

a) Wasted money: in our opinion, an investor operating an underperforming certified green building is still open to the appraisal risk that they were trying to avoid in the first place,

b) Breach of duty to your shareholders: in the opinion of some attorneys, the investor is breaching his fiduciary responsibility to his shareholders for not taking sufficient steps to avert material risks to their investment.

b) An entre to litigation hell: in the opinion of some other attorneys, the green building’s subperformance can possibly leave the A/E/C partners possibly open to litigation related to the subperformance issues.

And on top of all of that, absolutely no one wants to be the operator who has to come up with a clever response for his investors because his firm is featured in the press as the owner/operator of a gas-guzzling green building. The damage from that sort of press is enough to outweigh any concerns about potential first cost fears on structural energy-saving features.

So if one of your partners or clients doesn’t see much value in paying for structural energy-savings features, hand them the story of Youngstown Ohio Federal Building.

Ask them if they’d like to see their name in the papers as the next owner of a LEED-certified asset that has been officially assessed as a gas-guzzler.

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