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.
3 ways monitoring building performance can help you innovate
While some property owners may look upon increasing building energy performance requirements as a burden, we think that early adaptation of your portfolio to these new regulations opens up opportunities to innovate within your platform.
As reported by The Real Estate Development Law Blog, Washington State’s SB 5854, following the “lead” of USGBC’s Building Performance Initiative and California’s AB 1103, will (when passed) require the use of Energy Star Portfolio Manager as its benchmarking tool for calculation and reporting of building energy performance data to be provided to a prospective buyer, lessee or lender.
The promised benefit is more effective market transformation via reporting transparency on existing buildings. However, we also know about lots of frustration from owners, who find additional regulations for existing buildings to be burdensome.
But it doesn’t have to be that way.
In fact, early compliance with these new regulations might open up unique opportunities for property owners to get ahead of the pack in achieving competitive advantage for their firms.
How to create opportunities from compliance…
The September 2009 Harvard Business Review focuses on sustainability and innovation. In it, authors Nimudolu, Rangaswami and Prahalad lay out the typical phases companies go through to build a sustainability platform. Interestingly, that process begins at the place where many portfolio owners are at now today – compliance with new regulation.
They argue that early adaptation of a property portfolio to comply with anticipated sustainability regulation opens up the potential for innovation in several ways:
1. First mover advantage: First movers on compliance gain knowledge and time to experiment. Adopting emerging energy reporting compliance standards (whether binding or not) provides property owners critical time to develop solutions best suited to their portfolios and fosters genuine best practices.
2. Lower overall costs of compliance: Conforming to the highest compliance standards allows for scale benefits across markets and better insulates diversified portfolios from changing legal regimes. Attempting to create and manage different compliance approaches based on lowest local thresholds is costly and inefficient.
3. Critical stakeholder development: Early adoption of the tougher building performance reporting standards sets the stage for better relationship building with city officials in the markets where the company operates. Property owners with building performance data in hand will become preferred partners of city officials because they are able to prove that they are the better partner than their competitors. This creates meaningful advantages in terms of future permitting and entitlement actions, as well as allowing those owners preferred status in helping the city adopt other emerging standards.
Embracing building energy reporting early across your portfolio can be a catalyst for innovation that spurs market leadership, enhancing asset value sooner and better than your competitors. Early adopters to emerging building performance measurement requirements will position their businesses to outpace the competition and secure deeper relationships with capital sources and policy makers.
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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.
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.
Is it a good idea to guarantee LEED certification?
Cheap stunt to grab market share?
Or is this just a sign of how commoditized the LEED consulting market is becoming?
LEED consultants Energy Ace have announced that they guarantee LEED-certification on their projects, which has caught quite a bit of attention around the industry over the past few days.
I am sure attorneys all over the nation are getting pretty curious about how this firm got comfortable with making this offer.
As this lawyer writing for GreenerBuildings points out:
Energy Ace doesn’t appear to serve any design or construction role. Remember, important decisions are made at both the design and construction stages that impact achieving LEED certification. How can Energy Ace be comfortable that LEED administration is enough?
So what makes Energy Ace comfortable with offering this ? The lawyer writing the article alludes to revealing more information on Friday, and we’ll be checking in to see what that is.
My take on these things is that there is no free lunch and most people do things for rational reasons (most of the time).
So we just need to locate the quid pro quo in this deal and decide if it contains sufficient countervalue for Energy Ace to make this offer.
What limits their exposure on this type of agreement? Possible issues to explore are:
- What does the owner have to agree to contractually to get this kind of protection?
- Is it worth it to the ownership? Have owners really been that skittish about “certification risk” in the first place, since the real estate industry has largely accepted the need to green their properties already?
- Isn’t there already enough knowledge present in the industry about the certification process that makes a guarantee redundant?
- Does the presence of this guarantee allow them to charge more for services (as they are theoretically offering more protection to the owner for the economic risk they are taking)?
- Is it transferable? When a bank forecloses on a project that Energy Ace is working on, can the lender take over the guarantee and enforce it once they step into the owner’s shoes? Or would the guarantee be void the moment any of the other key parties are no longer on the active on the job (like the general contractor, for example).
- How is liability determined if LEED-certification is ultimately not achieved as promised?
Yep, we’re pretty curious here.
With real estate construction volume and transactions down so dramatically, third parties such as LEED consultants have to market extra hard to win business within the much smaller pool of projects available.
LEED consultants are currently price takers within their sector, as fees have been decreasing in a weak industry. That is partly due to the presence of more firms entering the sector as green building is taking off.
So while the certification guarantee might help Energy Ace win more business, I’m concerned that it opens the strategic floodgate to intensify competition and weaken pricing for LEED consulting services beyond what is reasonable.
It is not a good point in the real estate and overall economic cycle for this intensity of competitive forces to become so active in green building, just as it is starting to take off.
My questions to the (many) Green Journey readers who are LEED consultants:
