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.

Free Up Cash Flow with Building Commissioning

Have you benchmarked systems performance for buildings in your portfolio? If so, do you have a system in place to continuously monitor their energy performance?

Commissioning helps optimize building systems so that they operate efficiently and effectively. This process is vital for new construction buildings and new systems in existing buildings- eliminating the need for costly capital improvements and repairs.

For existing buildings without new systems, the commissioning process is sometimes referred to as retrocommissioning, which is an investigation of all existing building systems to optimize O&M procedures.

Commissioning alone can reduce building energy costs by as much as 20%, and create permanent operating expense reductions. Portfolio owners also report reduced capital expenditures.

Commissioning typically costs 3% to 5% of the annual operating expense budget, with an average payback period of 1 to 3 years, though several portfolio owners have reported payback periods as short as 6 months.

Commissioning/Retrocommissioning should be a cornerstone of your asset management and efficiency strategy

Portfolio owners need to squeeze every cent of profit out of their existing assets, and at the same time, keep their tenants happy. Commissioning lowers operating costs and enhances value.  However, the recent upswing in LEED-EB interest has sparked some debate among portfolio managers about commissioning’s value-add.

The portfolio managers who are still on the fence about having their buildings commissioned usually state that they are confident that their existing asset management procedures already reveal any remaining efficiency opportunities out there. So, they frame the cost and process of commissioning as an unnecessary expense.

What we see, however, even in the portfolios of best in class investors, are the following patterns (which only get worse in an economic downturn):

• A great disparity in the training and education of property personnel. Also, higher turnover in property level personnel.
• Lack of standardized operational audit systems across a portfolio. When the firm does have the system formally in place, it is not always true that they consistently invest all amounts needed to achieve O&M excellence. It’s very typical to see less money being spent on a  property marked for disposition than on another that will be held in the portfolio.
• Capital expenditure programs driven by short-term gains and penalizing longer term investments.
• O&M systems that are highly specific to a particular firm (or particular individuals).

Commissioning and retrocommissioning are not cure alls. Using them, however, does help to mitigate many of the above issues. Owners not only benefit from cash operational savings, but also a documented path to those savings that is comparable across firms, which help preserve a stronger sales price when assets are put up later for disposition.

There is also a positive risk management connection, too. Some insurance companies, such as Fireman’s Fund, structured their green insurance policies with premium reductions for green buildings based upon their opinion that commissioning and retrocommissioning reduce the common types of property loss.

Key Strategies for successful commissioning:

• Create a knowledgeable team: Whether you utilize internal talent to manage commissioning, or outsource the entire process to a real estate service firm, make sure whoever leads the team is experienced. This well help maximize the monetary returns from commissioning.

• Engage your tenants in the process: They will have a lot of insight into what is working, and not working, about your building. Human behavior plays a huge role in whether buildings are operated efficiently- the most advanced energy efficiency systems are worthless if your tenants aren’t happy and find a way to override them.

• Examine your leases: Depending on your lease structures, you may be able to recover the costs of the commissioning process from your tenants. If you have net leases, the operating cost savings from commissioning will positively impact your tenant’s overall occupancy costs, making it easier for you to pass-through costs.

• Commissioning should be continuous: To keep your assets running efficiently, you should engage some level of continuous commissioning. This will ensure that systems are always operating effectively, and should continue to minimize and reduce O&M expenditures.

To learn more about the commissioning and how to start the process, reference the Whole Building Design Guide. The guide provides links to other great resources on commissioning.

Additionally, explore the California Commission Collaborative website. This site provides a directory of commissioning service providors, case studies, and a variety of online tools and commissioning resources.