BetterBricks: Would you give us a brief overview of your philosophy on financial motivators for decision makers. Mark: Clearly, owners and managers of income-producing properties face special challenges when it comes to making their buildings energy-efficient. Several years ago I was making a presentation to an income property owner with a large portfolio and I mentioned that energy efficiency represented a “cleaner and greener” approach to operating his buildings. He smiled and said “Let’s start with ‘greener’ and we’ll talk about ‘cleaner’ later.” And he meant financially greener, not environmentally.
Some people recognize only the immediate financial benefits—actual energy cost savings—from a building upgrade. Others extend their view to include related savings, such as an increase in asset value that can occur when the owner’s share of savings helps boost net operating income (NOI), which is a key factor when using the Income Approach to appraise a property.
Still other people are forward-thinking enough to recognize less direct, but still legitimate, factors that may drive other financial benefits. For example, one might see an increase in tenant comfort and convenience after installing energy-efficient lighting that also has less flicker. Or occupants enjoy better zoning and control of an HVAC system that used to generate a lot of hot/cold complaints. Improved tenant attraction and retention can have a profound effect on the owner’s bottom line. The more square feet that are occupied and paying rent in an income-producing office building, the higher the NOI and asset value will be.
“We simply cannot optimize financial decision-making unless we have all the costs and all the benefits out on the table, and we make sure those costs and benefits are allocated properly between the owner and the tenants.”For example, where will the energy-related capital spending happen—specifically in which tenant spaces and which common areas? How is energy currently handled in each of those areas? Is energy included in the building’s master meter, sub-metered, directly metered by the utility, allocated on a pre-determined cost per square foot basis, etc.? How do the leases apportion responsibility for energy costs in each of those tenant spaces and common areas? Are there caps on what the building owner pays for energy? How about the tenants—do certain tenants have gross leases with the owner paying all energy costs? The bottom line question is: who will benefit from lowering the energy costs in each of these spaces—the owner, the tenants or both?
One final comment I’d like to make on this point: we always need to compare the risk-adjusted return on investments in energy efficiency with the alternatives. Here’s an example: which makes more sense, investing $1 per square foot for efficiency improvements in each of an owner’s existing buildings to gain, say, $0.25 per square foot in net operating income, or building a new building, or buying another building, or investing in stocks or bonds? If we really do the numbers we see that an even-handed analysis of the alternatives will allow intelligently applied energy-efficiency improvements to shine, given today’s investment alternatives.
BetterBricks: How can we get building owners and managers to see the value in sustainability and energy efficiency?
Mark: As I mentioned earlier, one of the most important first steps is to move from myths to math. That applies to both the seller’s and the buyer’s side of the energy-efficiency sales equation. The seller’s claims must be quantified. Case studies really help in this regard. Where else has “Technology X” been applied, and what was the true impact on energy costs? Have the audits and subsequent proposals for the building considered which tenant and common area spaces will be affected by the installation of “Technology X” and who will benefit from the savings?
On the buyer’s side, there is a need to dispel myths that so often stall project approvals. Here are some of those myths:
- “Our buildings are already energy-efficient.” (Is the whole building energy-efficient, or is the landlord limiting his focus to common areas and gross leased spaces?)
- “We prefer the equipment with the lowest first cost when fitting out tenant space.” (Does the specifier have any idea who will bear the increased operating costs of such a strategy?)
- “We need a two-year simple payback or less.” (Is this still realistic, given that the percentage return on money markets is literally one-tenth what it was 20 years ago?)
- “Tenants pay all energy costs, and will get all the savings.” (Do tenants really pay all energy, or just the energy over a pre-set base year or expense stop?)
- “We’re selling the building.” (Should we assume then that lowering the operating expenses and reaping the increased asset value are not important?)
In April 2002, I wrote an article for Energy User News called “Energy Efficiency Boosts Property Values” that had a whole page of these myths, as well as approaches to dispelling all of them. That article should be required reading for anyone attempting to promote energy-efficiency improvements in income properties.
BetterBricks: What are the "above average" returns that building owners and managers can expect to see by incorporating some of your recommended energy-efficiency solutions?
Mark: One need only look at the rates of return that professional real estate investors are requiring today on their core business (i.e., buying/operating/ selling properties) to realize that energy-efficiency improvements can be positioned as very attractive alternatives. For example, it is not unusual for investors today to buy office buildings at prices that reflect cap rates of 10 percent or lower. This means that the net operating income produced by a given property would represent a 10 percent annual return on the purchase price if that property were purchased with all cash.
It is also not unusual to see institutional real estate investors pleased with total returns of between 10 and 20 percent per year. How does this compare with returns on energy-efficiency improvements? Provided that returns on energy-efficiency projects are verifiable, reliable and persistent, one can certainly make the case that energy-efficiency improvements that generate returns above 20 percent annually offer “above-average” returns to the real estate investor.
Of course, in order to do that, we need to take an investment-grade approach to evaluating each upgrade opportunity: how much would the upgrade cost, who would pay, who would benefit, over what period of time, etc.? Once we can calculate how much of the return will be enjoyed by the building owner, we are in a much better position to recommend energy-efficiency as a legitimate approach to creating value. This is especially relevant in a real estate market where “internal growth” (i.e., maximizing the value of buildings already in your portfolio) is a much preferred strategy to “external growth” (i.e., increasing the size of the portfolio through new development or acquisition).
BetterBricks: Is there anything else you’d like to add in terms of financial motivators?
Mark: The decision-making chain in commercial real estate is typically comprised of portfolio managers, asset managers, property managers and building engineers. If we ask the portfolio managers if their properties are energy-efficient, they’ll likely respond, “Of course they are. I have very skilled asset managers covering that issue for me.” If we ask the asset managers the same question, they might say, “Of course they are, since I have very skilled third-party property managers working for me.” If we ask the property managers the same question, they might reply, “Of course my buildings are efficient, since I have very skilled building engineers who know all about energy-efficiency. I’m sure they’re on top of the situation.”
Now, if we start our questioning at the bottom and go up the chain, the building engineer might respond, “Well, not really. The last time I suggested an energy upgrade, my property manager said it had to be a two-year payback or less, so it didn’t get done.” If we move up the chain to the property manager, he might say, “Well, the last time I suggested an energy project, the asset manager said he thought the property might be going up for sale, so putting more capital into the property might not be a wise move.” If we ask the asset manager, he might say, “The portfolio manager told me he’ll probably need to decrease the portfolio’s allocation to real estate this year, so I figured that we should put a hold on all capital expenses in these properties pending final word on which ones might be sold.” Is there any surprise that upgrades don’t get done more frequently in income-producing property?
One of the biggest challenges that needs to be addressed in this sector is the lack of clear communication between the stakeholders. Mismatched language prevents even the most compelling projects from getting the attention they deserve (e.g., the engineers like to talk in “therms” and “kilowatts” but the capital budgeting folks need to base their decisions on “net present values” and “internal rates of return”). Unknown or misunderstood goals can also stand in the way of financially attractive improvements to income properties (e.g., should we be investing now to maximize value or are we appraising this building for sale next month?). The good news is that if you recognize and address issues such as these, you can create a tremendous amount of value in income properties by improving their energy-efficiency.
(May 2003)
RealWinWin is a team of financial analysts, energy engineers, lease specialists and other experts. Each of its consulting services is powered by RealWinWin’s proprietary software: Financial Incentives National Database™, Rebate Administration, Building Triage™ and NOI Builder™. You can find RealWinWin at www.realwinwin.com or you can contact Mark Jewell directly.