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

Why colleagues are attending our Competitive Edge 3 workshop

I regularly talk with colleagues about how and why they are using green finance, to make sure our course content is at least meeting, if not exceeding, their needs.

Here are the perspectives of Jon Gibson and Rowan Edwards, who’ve already signed up for the upcoming Competitive Edge 3 workshop, Communicating the Value of Green Building Using Principles of Real Estate Finance.

The workshop is happening on June 24, 2010, here in San Francisco (download the course flyer here↓).

Why Jon and Rowan will attend this class

Jon Gibson, Hedge Fund Accountant, San Francisco

My background is in accounting for hedge fund portfolios, but I am transitioning into a green real estate finance position. I found the green finance series extremely valuable in helping me find my way; I have learned about the green real estate value proposition (the basic financial underpinnings), met many industry contacts-from architects and engineers to financiers, lawyers, and investors-who now serve as a network of resources, and developed a sense of the market. The guest speakers, drawn from a host of high-level public and private organizations, were exceptional.

The extensive (and high quality) handouts have allowed me to continue to learn and enrich myself long after the course was over. Lisa, George and the rest of the team (including USGBC-NCC) do a great job organizing, presenting and making sure each participant has several great takeaways.

Rowan Edwards, Sustainable Developer, San Francisco

My interest in Galley Eco Capital seminars is to find new ideas. As a sustainable business developer I am looking for new opportunities that may exist, not only in light of the current economic situation, but because innovative methods always seem to flourish and gain traction in times like these.

We have seen that other methods of financing exist like micro-financing (Grameen), and on the horizon, B-to-B micro lending. It is exactly this type of out -of-the-box thinking that creates new opportunities. It is this new way of thinking that would be the primary reason for taking the green real estate financing seminar.

With LEED and The Living Building Challenge gaining momentum, fostering a new language, and offering long-term value for all stakeholders, the time is at hand to capitalize on new innovative methods. I look to Galley Eco Capital to be the thought leader in this direction.

More About → Competitive Edge 3: Communicating the Value of Green Building Using Principles of Real Estate Finance

» Click here to find out more about the workshop and register today for early bird pricing!

» Click here to download the flyer↓

Please pass this on to a friend

Feel forward this post or the course flyer↓ to anyone in your firm or network who you feel would benefit from this course.

Questions about this course? Can’t make the date and want to buy the materials for self-study? Write and let us know!

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.

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.

More on green lease clauses: Out with the bad, in with the good

Today’s post shares details about that “bad” green lease featured last Friday. Also I’m sharing a few green lease tips from BEPN that talk about ways green lease language can help support value creation in environmentally certified buildings.

The “bad” green clause’s web of risk

Several folks pointed out that LEED-EBOM certification can be achieved without any cooperation from the tenants. Unfortunately, our “uniquely negotiated” lease contained other typical provisions, which, when combined with the green clause in question, made the green business case uncertain, in the eyes of the buyer.

The lease in question was that of a major tenant - and major tenants are often able to negotiate special terms many other areas of the lease, with a deep focus on the expenses that can be passed through via common area maintenance and capital expenditures.

The major tenant lease was no different.  Lease language required the Landlord to obtain the major tenant’s permission in advance of passing through any expenditures, which were outside of a stipulated list. On top of that, the pro rata formula for calculating the tenant’s share of base building common area included an alternative common area square footage.  The formula denominator was a negotiated larger number, so the major tenant would pay less than its full share of common area expenses.

All of the above moves are typical, and limit the major tenant’s exposure to unforeseen or undesirable cost increases over the lease term.  In exchange for this, the Landlord gets a great tenant on a long term, which greatly enhances the building’s image and value.

The limiting of expenses (which is typical) plus the questionable “green” clause, created a situation for the investors where, a) much of the CAM and capital expenditure repayments were “locked in” by the prior owner over a very long time, limiting the new landlord’s flexibility, and  b) if any type of CAM or cap-ex charges were related to “green features” over the major tenant’s lease term, they couldn’t recoup those charges from the major or any other tenant either.

These investors’ business plan is to hold assets for a long term and realize an explicit increase to NOI from operating them as certified green buildings. So they were very focused on lease language not limiting their ability to execute that strategy. Losing part of the CAM recovery via the negotiations might be typical, but being further prevented from recovering costs from any tenant for any sustainable features over a long term put the lease contract into their “risky” column.

BEPN: “Green leases essential for achieving landlord’s environmental goals”

Check out this article from BEPN titled “Green Leases are Coming” (subscription might be required). It lays out a few issues that green leases address, all aimed to make sure that tenants and landlords are aligned with the environmental goals set for a project.

Essentially, the article talks about the kinds of lease provisions that can be negotiated with tenants so that it is easier for the landlord to achieve environmental objectives for a building.

The only part of the article that I would question is the assertion that most leases in the United States are triple net. During my tenure on the San Francisco Mayor’s Task Force, we talked about this point at great length. Large owners and property managers on the task force indicated that most office buildings are leased with gross leases. Of course, retail and industrial properties are nearly always triple net leased.

In any event, the main point here is to make sure you do not exhaust yourself trying to develop or retrofit green, then negotiate the “same old same old” in your leases. If you do, you are passing up a great opportunity to maintain and enhance the value of your environmentally certified building.

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