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.

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.

New Paper Highlights Decision Approach on Green Property Valuation

How can professionals approach valuing green buildings, when there is still a lack of performance data?

Lots of folks accuse appraisers of being roadblocks to advancing green real estate because many still don’t provide any recognition for the higher value of sustainably designed projects in their valuations.

Check out a new report, “High Performance Building: What’s It Worth?” by the Cascadia Green Building Council, Vancouver Valuation Accord and Cushman Wakefield.

Co-authored by appraiser and thought leader Theddi Wright Chappell of Cushman Wakefield (covered previously here), this paper provides leadership on this problem via an appraiser’s professional insight into three sustainably built projects.

The authors acknowledge hurdles to green property appraisal up front: modern valuation methodology, like investment and lending as a whole, is solely focused on “economic considerations”.

In their words, “neither the methodology that is practiced by the valuation profession nor the methodology that is typically used by the investment community or major lending institutions includes specific considerations of social or environmental factors. It is largely assumed these are reflected in the price or rent paid in the market”.

They reviewed three LEED-certified buildings in detail, pointing out areas on each project where sustainable design strengthened the property’s marketability and operations, with strong connections to positive valuation support.

The connection between design and its possible value-add was highlighted via comments like the following:

- “experienced a comparatively quick absorption period”

- “high or moderately high” tenant satisfaction feedback

- “higher than average level of occupancy”

- “achieved competitive rents”

Particularly useful, is their presentation of questions that can accompany a particular valuation approach (cost, sale or income), designed to help the valuer incorporate a deeper analysis of sustainable design impacts on the project. These questions will be useful to anyone underwriting a potential investment into a green building. One example:

[For the Income Approach]: Was the building commissioned? Commissioning could impact assumptions relative to both operational and performance risk.

This particular paper’s value (excuse the pun) is in showing the many deciders out there that the lack of long years of economic performance data on green buildings need not be an impediment to increasing financing, investing and appraising green buildings.

By adopting the right review approach, anyone underwriting a project can learn to uncover and analyse the pertinent issues, which can lead to a more accurate investment decision.

Take a look at the paper and let us know your thoughts.

Part 3: JP Morgan Chase Talks Green Real Estate Investing

When JP Morgan Chase says that sustainability is creating fundamental changes to how they invest in real estate, you pay attention. Part 3 of our special series on the Green Building Finance and Investment Forum - New York, co-sponsored by Galley Eco Capital, continues with the perspectives of  keynote speaker, Doug Lawrence, Managing Director at JP Morgan Chase Asset Management.

“Achieving sustainability can be an uphill battle-but it’s crucial that you get there. Your future customers will demand it, and your ROI will depend on it.” - Doug Lawrence, JP Morgan Chase

Doug set the stage by reminding everyone about the basic objectives of investment banking:  1) preserve and grow clients’ capital and 2) make money for themselves in the process.  In JP Morgan Chase’s case, sustainability has become a profitable strategy for them that also preserves and grows client capital, which in turn ensures their competitiveness in the ever-changing financial marketplace.

Case in point: Doug manages the Urban Renaissance Fund, JP Morgan Chase’s newest vehicle, which focuses on cities and their first suburbs — where population density is high and the payback on energy efficiency is substantial.  The Fund sees investing in sustainable real estate as a way to improve returns and reduce investment risk. However, “getting there” with green real estate is not without it’s challenges.

Green real estate is a different animal than conventional real estate. Successfully investing green means re-calibrating underwriting metrics and changing many of the fund’s business procedures. It costs money to do this and it can take quite a  bit of time to change hearts and minds about what constitutes a great sustainable real estate investment. On top of that, you have to manage organizational inertia, which can often be the worst enemy of change.

“Green means changing our procedures, our underwriting, our vendors, the way we put our products together.” -Douglas Lawrence, JP Morgan Chase

So how did Doug and his team help the powers that be at JP Morgan Chase embrace green real estate? Well, first of all - it took them two years, plus some organizational change, but the repeated message to leadership was clear: if we don’t do this, we will lose our edge, and our financial products for real estate will be obsolete.

Doug drove home his point about obsolescence in real estate with the example of the emergence of building air conditioning back in 1950/1960s. The technology was rapidly implemented, and buildings that did not incorporate air conditioning became obsolete. They faced appraisal risk, and their valuations decreased quickly. For owners, their failure to upgrade their properties increased their investment risk and devalued their real estate holdings.

Wanted: Experienced and Knowledgeable Green Developers and Investors

So now that your fund is focused on sustainable real estate, what’s next? Well, your next challenge is identifying experienced and qualified developers/operators who can reliably build your project in a way that gets you the great green benefits you (and your investors) seek.

In today’s market, a successful track record is key to investor confidence; and Doug made it clear that, while they are supporters of green real estate, they are not interested in any developer learning about it on their dime. However, since green real estate is still in its infancy, they realize that they have to be flexible in how they evaluate their partners, otherwise they will have a difficult time generating a sufficient level of investments.

“If you have a great idea, tell us how you are going to mitigate risk.”

So what do you do if you’ve got a great development track record, but are new to sustainability and want to attract green equity capital? From Doug’s perspective, if you want their money, you need to reduce the execution risk within the investment.  And creating strategic alliances between the experienced developer and firms with proven sustainability expertise is a smart way to mitigate those types of concerns.

And with that great team in place, what aspects about green real estate are driving JP Morgan Chase’s involvement in the sector?

• Green retrofits to existing buildings can be done profitably: JP Morgan Chase estimates that existing buildings which have been retrofitted green enjoy a 3% higher occupancy, a 7.5% higher valuation and use 25%-30% less energy than their non-retrofitted counterparts.

• There is no cost question about building green real estate: Despite the fact that many in the industry still talk (incorrectly) about hefty cost premiums to build green, JP Morgan Chase sees that an experienced developer of green property can deliver LEED-certified and LEED-Silver product to market at absolutely no cost premium whatsoever.

• Integrated design is the key: Engineer value at the beginning instead of value engineering at the end of a project. Also, integrated design optimizes both first and life-cycle costs.

Selling Your Deal: Know The 7 Fears of Real Estate Equity Funds

Doug finished the presentation by educating the audience on how to best position themselves and their transactions for investment by other funds like his. He presented seven key issues (or fears) that many funds have when it comes to sustainable real estate. By understanding and addressing these concerns, investors and developers can remove many of the roadblocks to getting funding for their projects. The seven fears are:

1. Fear of being too early. Equity funds fear the failure of your concept, because there is no protection for their capital. You need to have a lot of data to support what you are doing, and develop an executable business plan that can be understood by potential investors.

2. The fear of learning new stuff. As previously mentioned, bankers are conservative. They know certain things, and they know them well. They have their favorite product types, their favorite developers, and they have their risk management down to a science. Your project may represent a major departure from their investment machine, and they might resist. It is up to you to educate them, and to be persistent.

3. Loss of power. This fear is a derivative of fear #2. Changing the game forces individuals at the top of the corporate structure to either adapt, or risk becoming obsolete. When it comes to understanding sustainability, it’s your responsibility to educate your potential partners in a way that maintains their leadership as the smartest people in the room.

4. Maintaining deal flow. Equity funds don’t want to upset their developer partners; as that might  put their investment pipeline at risk. Therefore, they will tread lightly when it comes to convincing their existing partners to become more sustainable.  The antidote: re-read all of the above.

5. Fear of losing return. As a green developer/investor, you can use your potential equity investor’s fear of losing returns to your advantage; help them understand how their returns will be diminished if they don’t invest in green.

6. Fear of execution. Unfortunately, there is a flip-side to fear #5. If equity investors think that your sustainable real estate investments raise the execution risk for their capital, they will be less inclined to invest. Structure your deal and your strategic partnerships to mitigate as much risk as you can. (Our note: You should be doing this for every deal anyway)

7. Fear of being too late. Whether by law or by simple economics, green real estate will become the norm. When that occurs, the incentives for green building and the learning opportunities will be gone. If equity funds don’t understand how to evaluate and fund green investment before the market transformation, they will lose their competitiveness. Make sure that you emphasize this to your potential equity partners.

Doug’s perspective was well received by the audience at the conference, and we think that green developers and investors would be wise to heed his recommendations.

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