Market Risk Analysis: Peak Oil and Investment Real Estate

Synopsis & Recommendation

Energy company officials have estimated that global oil production will start to decline in the near to mid term (“peak oil”), if it has not started already. Experts warn that there is a strict correlation between economic growth and oil supply. Properties currently in design and construction will probably be put in service at or near the time when peak oil is expected to occur. Real estate practitioners must incorporate a more thorough assessment of energy availability and pricing within their transaction underwriting as well as think about shifting their development focus to more resilient properties and investment scenarios.

The (Latest) Download on Peak Oil

Check out Biopact’s very instructive report on the connection between peak oil and economic decline. Not only have energy company executives largely agreed upon peak oil occurring around 2010-2012,  experts stress that the prolonged, permanent decline in global oil production can trigger an economic crisis.  Moreover, they believe that we will directly suffer from the energy crisis more quickly and a lot worse than from climate change in the same time frame.

“…a new study by Dr Robert L. Hirsh, senior Energy Program Adviser at the Science Applications International Corporation (SAIC) demonstrates the economy-destroying effects of peak oil. His conclusion is that economic growth will decline at a similar rate as oil output, that is, by 2 to 5 percent per year. There is a strict correlation between economic growth and oil supply.”

Remember:

A recession is defined as two quarters of negative growth in GDP.

Landlords & Energy Costs Today: “Just Passin’ Through”
Every real estate practitioner spends a considerable amount of time engrossed in market and economic analysis, to bullet proof their underwriting and make sure that their investments actually perform according to shareholder expectations, if not better.  You constantly ask yourself, “what could go wrong?” over the life of your deals. Energy costs have been gradually rising over the past few years and those costs are a key factor in real estate construction, operation and maintenance, not to mention at every point of the business supply chain. So far, the timing and velocity of energy price increases have allowed them to be absorbed by tenants, so investments continue to perform within expectations and we practitioners have not had to radically adjust the structures of our deals or property design and construction.

Time for a New Scenario Analysis
Because we have been able to pass through any increased energy costs to tenants, investment professionals have not had to grapple with the ways in which a permanent change to energy availability and cost would affect the way they do business. The common underwriting practice is the correlate energy price increases with projected inflation, but I have never seen a deal package that analyzed the potential effects of:

• energy prices increasing significantly above the rate of inflation,
• tenants broadly resisting further energy cost increases, meaning that the landlord now “eats” further cost increases,
• widespread reduced petroleum availability, and worse still –
• all of the above occurring at the same time.

If the two to four year timing of peak oil happens as predicted, then most of the properties under construction right now could be put into service in markets facing energy-related economic shocks a short time later. That means that we all could be working on transactions right now that are doomed to go sideways.

Building New Green Buildings Does Not Help
Currently, green building is just beginning to be taken seriously within the investment real estate community. However, even though the gross value of green building activities should nearly double to nearly $12 billion in 2007, most of it represents new construction, albeit with greater energy efficiency over that of non-green buildings. Unfortunately, in the context of an energy crisis, the current green buildings in production today still largely rely on petroleum-based energy –  meaning they are “less bad”, but are still unfortunately not “good”. Very few green buildings being put in service actually run 100% on renewable energy.  So even though  investment professionals are doing the great work of going green, the property construction and performance standard required to adapt to a peak oil economy is still much more sophisticated than the green buildings we will most likely be living and working in when energy conditions deteriorate.

(Re-)Positioning Real Estate Investments for a Peak Oil Economy
While no one can foresee how to navigate the market uncertainty coming from the energy crisis predictions, real estate practitioners can start positioning their businesses and portfolios in such a way that they will have better options to improve their outcome when such events occur by:

• factoring in a larger volatility in energy costs during deal underwriting to account for the growing risk of potentially increased operating expenses.
• investigating switching as much of your properties’ energy sources to renewable energy.
• focusing on adaptive reuse investment plays and renovating existing properties for higher energy efficiency,
• obtaining the maximum rating possible, when going for certification on green buildings,  and achieving the maximum amount of energy efficiency points possible for that given rating, no matter what,
• joining forces with those pushing government officials and public utilities for greater overall availability of renewable energy,
• refocusing their investment dollars on urban properties with a smaller, more compact footprint that reduces the need for vehicle travel by occupants and suppliers
• starting to think about sustainable markets: when preparing annual investment plans, redefine your target markets to include regions that have a combination of economic base, mass transit infrastructure and progressive policies to facilitate the above.

Photocredit: Flickr/AZRainman

Warning: Common Sense Lurks Behind Integrated Design

Have you ever been on a project team with or for a commercial real estate owner who had high expectations of their new green building project? Or maybe the better question is, who hasn’t?

Timothy Corbett, President of SmartRisk, recently cautioned an audience at the AIA’s conference on public space and design to carefully manage an owner’s heightened expectations of green buildings. If the finished product doesn’t meet their expectations, ‘then lawsuits and claims could follow”.

No duh.

When I read through Corbett’s examples of green building lawsuits and claims, I began to think that someone on those project teams also drove their car around with hot coffee between their knees.

Corbett is quoted as saying that the best way to manage the exposure to such claims is “direct contact with the client”.

Another duh.

All of the green building professionals that I know continually stress that an integrated design process from the very beginning helps to reduce the risk of misunderstandings about what the green building can and cannot deliver.  They contrast that with the tendency of some owners to think of green as an added feature than can be plugged into the project at some later point, creating more costs and the potential for miscommunication.

The article’s title, indicating that ‘risks lurk’ in green building, as well as its appearing on GlobeSt.com, a website targeting real estate investors, unfortunately makes me think that GlobeSt was more interested in getting a few more clicks on their website by playing on investors fears about green building, instead of helping to educate them.

Click here to read the article and decide for yourself.

Photo credit: Flickr/Everydaylifemodern

Climate Change Legal Risks: Energy Companies Feel the Heat

“Selective disclosure of favorable or omission of unfavorable

information concerning climate change is misleading.”

- New York Attorney General Andrew M. Cuomo to Energy Companies

Check out OneAtlantic.net’s excellent post on the creative use of existing law to sensitize corporate investment practices to climate change risks. Following predecessor Eliot Spitzer’s example, New York Attorney General Andrew M. Cuomo is using an almost forgotten law to investigate five energy companies, which intend to build coal-fired power plants.  The Attorney General’s correspondence advises the energy companies that they should have made their investors aware “of the growing potential that they may be taking on big financial risks by building coal-fired plants.”  The Attorney General’s overarching thesis is that publicly-traded companies are legally liable for taking undisclosed risks that could diminish their value to shareholders. The goal appears to be one of forcing polluting companies to proactively reduce their carbon emissions.

My synopsis: this investigation, if successful, will propel commercial real estate’s risk management practices and corporate social responsibility into a new millennium — at warp speed.

In commercial real estate finance and investment, hard money liability, regulatory and reputation risk directly affect bank and investor decision making. Such amounts flow through to net cash flow or funds from operations, meaning the potential for deterioration of net asset values and with it, market capitalization and shareholder value.

Real estate investment trusts (REITS), being publicly-traded, should immediately begin to incorporate climate change risk into their corporate and portfolio risk management processes. Their client investors (pension funds, etc.), are probably following this carefully, too, and will start requiring similar reporting disclosures.  It goes even further: other investment real estate developers and operators who want to do business with REITS (practically everyone else in the industry) will have to be similarly compliant. After all, no one will take an asset into their portfolio until they are sure that they can understand and economically manage that building’s carbon footprint in compliance with the law and market expectations.

And here’s the competitive advantage angle for Green Real Estate Investors.

In the course of meetings yesterday with a couple of investor clients who already develop green apartments and retail, I asked about their motivations to focus on building green real estate. Besides the fact that they felt it is the right thing to do, they honed in on their perceived risks of not going green. Both developers indicated that they see the potential of the federal or state government passing some form of carbon tax on commercial property as being imminent. They, too, perceived any type of carbon tax as being a direct hit to their bottom lines and, therefore, a valuation risk to their properties. Already being green puts them at a competitive advantage in such an environment.

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.

« Previous Page