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.

Getting Institutional Real Estate to Invest in Sustainable Buildings

In my work, the hot question from my sustainability friends is “how do we convince lenders and investors to allocate capital towards green real estate?” They are baffled about why institutional lenders and investors often nod their heads politely in meetings, but are still largely noncommittal about writing the checks for green real estate, despite all of the verified proof of its superior investment performance. You would think that such a crowd would automatically embrace the higher return and value story. So why is that not happening, yet?

A classic problem, really. The idea that people and companies will act to enlarge their own self-interest is accepted as conventional wisdom. Not true, says the Rockridge Institute’s George Lakoff, people routinely make decisions and take actions, which are not in their self-interest. In Don’t Think of an Elephant, Lakoff explains that people’s actions are driven more by how the subject fits with their view of themselves in the world as opposed to their self-interests. This could help us understand the slow adoption by institutional real estate as well as hint the way forward to greater capital flows into sustainable buildings.

The sustainability community is focusing on this disconnect. Earlier this week, Joel Makower covered the LaFarge and United Technologies study which highlighted the fact that compartmentalized expertise within the real estate value chain, incorrect perceptions about sustainable real estate costs, plus many not-so-obvious complexities of building green combine into daunting challenges to widespread capitalizing of green real estate projects.  Financiers and developers are specifically identified as the biggest barriers to more sustainable approaches in the building value chain.

Among eight recommendations on influencing decision makers about sustainable buildings, the study points to personal know how, business community acceptance, a supportive corporate environment and individual personal commitment as the four main barriers to “greater consideration and adoption” of sustainable building. Bring in Lakoff’s explanation about people acting according to their identity more than their self-interests and we have a more focused definition of the disconnect and how we can better advocate for greater investment in sustainable buildings:

• Know US institutional real estate’s identity. This industry has been experiencing a long, successful economic cycle without having to differentiate assets in the way the sustainability requires. Sustainability doesn’t exist within the investment world view. And this world functions around highly compartmentalized expertise. Integration, a basic tenet of sustainable building, does not naturally exist between participants in the institutional real estate value chain. So it is difficult for already successful real estate executives to fully appreciate how their investments will benefit from concepts and processes which do not exist in their world.

• Talk in the language they understand. These days, interest rate increases are eroding financing proceeds and are expected to result in a drop in property valuations. Did I hear someone say, “decreased net asset value”? This is a good time to start presenting sustainable building’s financial benefits as a potential hedge against eroding values from interest rate increases and lower sales prices. It is also a problem within their world  that they can understand. Lenders and investors could understand this as ‘cash flow preservation’ and/or ‘risk management due diligence’.

• Use a metaphor from their world. I like the Carrier Division’s way of borrowing tools and techniques from its aerospace division to lead real estate executives through the green building decision making process. Airplanes are a powerful metaphor to assist institutional real estate in its evaluation of risks, costs, tradeoffs and profits. Air travel is full of emotional decisionmaking. Airline travelers have a monetary, health and safety interest in the condition of a plane. Airlines must invest in updating their fleets in order to remain competitive. Most real estate executives are frequent business travelers. Their emotional stake in an airplane’s safety and their innate understanding of the relationship between a new, state of the art fleet and an airline’s reputation could be used to convey the important messages about the risks of not investing in sustainable building.