Green Business Case Starts with Critically Questioning Your Base Case

How do you get more value from your green business case?

Real estate investors like to say that you buy most of your value in a good deal at the time of purchase. In short, buy for the right (read: low)  price.

When it comes to determining the added value that sustainability brings an asset, we’re finding that a good deal of the value is often hidden in the base case. Because there’s often more cost and downside risk trapped in there there than the typical pro forma projection indicates. And keeping that information hidden unfairly penalizes the green business case.

The base case should reflect the most accurate economics and total value creation possible by building and operating the asset as a conventional building over the holding period.

Examples

Here are a couple of basic ways that base cases often bury the true risks and costs of  doing business as usual:

One problem we frequently see is that future operating projections do not trend energy and water costs at an accurate rate of inflation. For the most part,  energy and water costs in many markets are increasing well above the rate of inflation. However, lots of practitioners still apply one static inflationary rate — usually the CPI — to all income and expenses for the asset’s entire holding period.

Fighting climate change has caused many state and regional authorities to introduce new regulatory frameworks aimed at improving land use, transportation, building codes and even cap-and-trade frameworks. Take California, for example. The AB32 legislation  has been clearly designed to have a systemic effect on where we locate, how we build and commute to buildings. Most of these regulations have announced implementation dates well within the next ten years.

Even though it might be difficult to predict exactly how these regulations will change market forces over the holding period, the base case discounted cash flow, in California particularly, should also recognize the impact of long-term systemic changes to the project’s marketability due to changes to broader market systems and demographics, such as those being introduced by AB32-related legislation.

Lots of investors haven’t yet begun to explore the effect these issues have on doing business as usual — only adjusting terminal cap rates over a ten year holding period by the typical ~50 bps, reflecting a “same old same  old” point of view about their asset’s future.

While the investors cannot predict ten years into the future exactly how much of a direct change to exit risk these actions might have, leaving these issues altogether ignored unintentionally, and unfairly penalizes the green business case.

So it’s amazing to us that — even as commercial real estate is in the midst of a great strategic disruption, due to green building as well as capital markets forces — investors still prepare pro forma operating projections as if nothing’s ever going to change.

What Kind of Market Will We Be Selling Into?

Take a look at “Connected Real Estate”, a collection of essays by subject matter experts, edited by Kevin O’Donnell and Wolfgang Wagener.

In it, the authors and Cisco Systems lays out many ways that technology and connectivity will drastically change the expectations of building construction, operation and workplace activities.

In addition to Cisco’s marketing of building internet services, the book includes some pretty sobering ways that information technology will impact the ‘business as usual’ case for conventional buildings.

One graphic called “Where Work Gets Done in 2010″, presents the following estimates of where work happens next year: corporate facilities, 40 percent, in between, 20 percent, and at home, 40 percent.

If 40 percent of work gets done at home by 2010 (basically now), what will the need for space in your property’s submarket be like over the next ten  years?

Other quotes:

We think of buildings with technology as one combined solution. Unconnected buildings are pieces of concrete and mechanical equipment, and of no use to anyone.

We believe that the move to smart buildings will be driven by the home.

These are all bold opinions, which support Cisco’s business model, but also highlight the need to critically question how much of the conventional building’s base case will really be valid throughout the coming decade.

I think not much.

Photo credit: Flickr - Kunsthaus Graz/Fatlum

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Reminder: Let’s Talk About Your Leadership

Come see my talk with Kira Gould and other Sustainability Leaders at OWA on 18 August 2009!

This is a last call to come out and join the discussion on leadership and collaboration within sustainability  tonight  (18 August). The link above includes info on the event location and registration.

I look forward to seeing you there.

Water Supply and Price Risk Flows to Investment Underwriting

Are you underwriting a green and/or retrofitted property in Los Angeles?  Well, your business case might have improved (unfortunately).

The Los Angeles Department of Water and Power (LADWP), the largest municipal utility in the United States,  has voted to adopt a water rationing plan in principle. The Water Department board will formally vote on the plan next month, in response to a drought now in its third year. The plan hopes to cut water usage in the City of Los Angeles by 25 percent.

If enacted, penalties(!) will be levied on homes and commercial properties with water usage exceeding a set threshhold. What is not discussed is the silent cousin, which we always see trailing water rationing actions and penalties — regular usage rate increases that are significantly above the rate of inflation (remember this advice from the late George Carlin –> “you gotta watch the quiet ones!”).

Asset Value and Underwriting Implications

If this measure passes, “brown” or unretrofitted buildings will be much more affected by lower NOI via higher water costs than their higher performance peers. Sooner rather than later.  All owners are already dealing with properties being devalued by a weaker real estate market, however these “brown” building owners will have the additional challenge of the real erosion of net operating income that further depresses property value.

Apartment owners need to factor in the fact that water price and supply risk triggers food price increases. Even those renting submetered units should bear in mind that a larger portion of their tenant’s incomes will be allocated to food prices, putting further pressure on a resident’s ability to pay rent.  Most apartment owners we talk with do not really know the total cost burden that water, fuel and electricity price risk pose for residential tenants.

Perversely, higher water rates improves the lifecycle costs and payback analysis and thus, the business case on any water related retrofit projects you may be considering. The element of risk that is not properly captured within this type of analysis are any of the insurance and business risks tied to insufficient water supply for certain types of businesses or an abrupt stoppage. That hasn’t happened in Los Angeles, yet but the article details that Los Angeles will be facing serious problems for years into the future even when the drought is over.

And if you are running an equity fund with Los Angeles as part of your investment footprint, then you will want to make sure you  are properly underwriting your property’s water costs in Los Angeles — an essential part of the integrated finance strategy.

What’s different about underwriting sustainable real estate?

Do you see the unique value that green brings to your real estate investments reflected within their appraisals? No? Well, join the big crowd and read on: this is a special post for you.

Not everybody in commercial real estate is immersed in gloom and doom. Some folks, like the Appraisal Institute, are using the downtime coming from fewer transactions to get themselves fit for the sustainable real estate future. In case you missed the announcements, the AI is in the midst of a series of classes for their members, to introduce them to sustainability principles and the basic considerations for appraising green buildings.

I’ve had the chance to talk with the seminar’s co-developer,  Theddi Wright Chappell, Cushman Wakefield’s new National Practice Leader for Green Buildings & Sustainable Real Estate. The overall course is framed around the question “how is a sustainable building different?” than conventionally built property.

With good questions focused around understanding the differences, appraisers will be more likely to surface up more relevant facts that help them to better distinguish the risk profile of the green vs the non-green building.

As for the potential differences, any of these may be present within the green transaction:

• lower exposure to energy and consumables costs increases
• potential for greater construction and delivery risks, depending on factors such as availability of trained professionals
• different pattern of lease-up and absorption risks
• different pattern of tenant retention and turn-over risks
• different pattern of periodic capital improvements
• lower exposure to obsolescence.
  

The Green Journey Take

This is just a tidbit of the considerable body of knowledge that Theddi and her AI colleagues have packed into this very timely course for those just getting into the green real estate game.

Within our own practice, we typically receive detailed investment cases from clients for green buildings, which completely overlook any type of enhancement that sustainability brings to the assets. Nearly 100% of the time, some portion of our investment client work involves working with the the investor to “connect the dots” between the green building’s design and construction budget and the operating pro forma assumptions during the holding period. The clients rightfully want to know how appraisers might handle these same issues, under the logical (but incorrect) assumption of if the appraiser won’t count it, why should we do change our underwriting? So, from our point of view, it is good to see that the AI is helping to address this question with their new course.

What can you do? Talk with your appraisal colleagues about how they might evaluate sustainable real estate and urge them to take this new course, if they have lots of questions.

Retailers Increase Customer Loyalty with Green Initiatives – The Landlord’s Angle

With the economy weathering tough times, all eyes in commercial real estate have been on declining retail performance. So it’s no surprise to see recent reports about how retailers are using green initiatives to improve both store performance as well as stay close to customers.  And we think those successes have wider implications for underwriting green real estate.

The Aberdeen Group recently published “Getting from Green to Gold: Retail Success Factors and Outcomes”. Note: you’ll need to register for free to download the report. They surveyed over 100 retailers with sustainability initiatives and identified the key components to a successful green strategy for retailers.

Here’s a high level download:

• Green Upside: The top 20% of the surveyed retailers are reducing their energy costs by an average of 20%.  Additionally, they are seeing significant reductions in logistics and merchandise costs.
• Green Downside: The green “Laggards” – those who were less successful with their green initiatives – reported their energy, logistics, and merchandise costs increased by 39, 16, and 17 percent, respectively.

The Green Journey Take

Aberdeen research also indicates that sustainability strategies help retailers improve their customer relations, which can be instructive for commercial real estate professionals interested in underwriting the value that green initiatives can bring to a property.

Retail profits can be quantitatively traced to attracting and retaining customers.  In the retail world, “customer value” is a euphemism for the dollar value a new or returning customer brings to the bottom line.  And the research indicated that over 80% of the “Best-In-Class” green retailers think that their sustainability strategies have improved their customer service and brand image.

We green real estate professionals love “quantifiable” green initiatives that we can directly tie to asset value creation.  Yet, in our practice we review many green projects where the value-add of tenant retention for a green project is not  underwritten into pro forma assumptions, to avoid overstating the green business case. Plus, frankly, most info about retention rates within green projects out there is self-reported and anecdotal.  Lots of folks want more data on this one.

But lots of investors lease to retailers. And most of those retailers have done the rigorous work of quantifying the value of customer loyalty. That subset of those retailers employing sustainability initiatives will undoubtedly know in the short term the contribution that green initiatives make to retaining customers and their bottom line as well.

Like my previous post about Google tying the leasing of green space to employee satisfaction, a retailer leasing in a green shopping center will be able to figure out how that helps customer loyalty and, hence, their bottom line.

While it is good for landlords to be prudent underwriters, they probably do not intend to be less sophisticated about understanding how to quantify the value of green than their tenants. The smarter ones will be working on quantifying the relationship between green initiatives and tenant retention in order to be more competitive and maximize their position in the market.

http://www.environmentalleader.com/2008/08/18/green-retailers-six-key-focus-areas/

Download and read the entire study from Aberdeen Group (free registration required):
http://www.aberdeen.com/summary/report/benchmark/5213-RA-green-to-gold.asp

Finance Industry Spin or Denial on Sustainability?

I thought I’d share some of the latest that has made its way over to my inbox over the past  few days. Take a look and let me know what you think. Is it spin? Denial? Spinial?

The Mortgage Bankers Association on Green Lending: “We’re already underwriting green.”

MBA research director Jamie Woodwell put out an article in the March 2008 issue of Mortgage Banking, their trade magazine, titled “Class G–The New Class A” (sorry, folks, no link, it was sent to me from a subscriber). Within a piece that includes decent info on the greenwave hitting finance, begins a decent lead-in to the MBA’s take on green lending:

“For most lenders, green lending is simply a new shade of their traditional lending programs.

As with any request for financing, a lender approaches the financing of a green building by developing an underwriting of the property that takes into account property-specific income, expenses, property value and costs. The extra challenge in financing green buildings has been the degree to which the underwriting associated with a building’s green features differ from those of a standard building.

But the commercial/multifamily lending industry is accustomed to heterogeneity in the same properties it underwrites. No two properties have the same location, tenants, lease rolls, rents expense mix, purchase price and cap rate — think, for example, 1970’s New York office tower, 1980’s Sacramento, California, industrial park; and 1990’s Atlanta apartment building. The industry has become extremely adept at recognizing these differences through underwriting — a process in which a property’s unique circumstances are researched, assessed and factored in.”

And that leads to this:

“As a result, in most cases, the existing commercial/multifamily lending paradigm already takes into account a property’s green characteristics. When fully revealed, a full underwriting and appraisal discounted cash flow (DCF) takes into account, for example, that a green property’s initial cost may be higher, its rents  higher, its utility expenses lower, its lease rollovers shorter and its terminal value higher. The result is that economic costs and benefits inherent in a green building can be recognized in, and will generally flow through its underwriting.”

Green Journey Take: Two observations: 1) Green buildings in total make up only about 2% of the entire real estate market, and 2) the nationwide credit crunch has been going on for much of the time that sustainability has been getting traction within commercial real estate. There are lots of deals out there that are not getting done. Nevertheless, the MBA has already counted so many private sector green loans being underwritten, not to mention confirming the underwriting on those loans as being ‘green’, that it can publish “typical” underwriting standards.

At the time of this writing, two major industry coalitions, the Green Building Finance Consortium, and the Market Transformation to Sustainability, are still pushing hard for leading institutions, some of whom are named in the article as green lenders, to adopt a common set of underwriting protocols for sustainable real estate. Also note that there are some major lenders cooperating with these efforts — they’re just not quite ‘there’ yet. Real estate investors are filling conferences, looking for elusive ‘green finance’ packages.

But you can prove me wrong and educate all of us: How many commercial real estate loans have you done with your lender, where they’ve already given you economic underwriting credit for the green features on your investment property? Please share your comments here, as there are many in the industry who would like to know. Plus these pacesetters deserve to get credit where credit is due.

The Mortgage Reports: Even $150/Barrel Oil Doesn’t Matter — Consumers Will Keep Drivin’

I dig Dan Green. He gives some of the most consistently straight-up download on the residential finance market. And he’s big on the crunchy technicals, which is good. Regular Green Journey readers also know that I’ve got a “thing” about energy price risk’s negative effects on US real estate.  Actually, it is fair to say that quite a few of us in the real estate industry do. Now read Dan’s recent post about oil prices and consumers.

You make the call: Is Dan tellin’ it like it is or like it ain’t?  Are US consumers really going to keep up their current driving habits no matter how high gas prices rise?

Please tell us what you think.

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