Energy Incentives: Rethinking Simple Payback Period

by Mark Jewell, February 2, 2007

When it comes to deciding which projects deserve a share of finite capital, few concepts are as pervasive as “simple payback period” or “SPP.” Defined as the number of years that it would take to recover a project’s initial cost, SPP continues to dominate the consciousness of both managers and the vendors who serve them.

In this “Keep It Simple Sam” world, it’s not surprising that managers are drawn to easy-to-apply rules of thumb. However, unless the principal objective is quickly recapturing invested funds so that they can be put to use in other places, SPP is not the most useful metric. Moreover, in situations where maximizing return on invested capital is of paramount importance, approving projects based on SPP alone can lead to seriously flawed decision-making.

SPP’s shortcomings are well known. Perhaps most obviously, it does not consider post-payback cash flows. Let’s say you have two $100K projects. The first returns $50K per year for two years and nothing thereafter. The second returns $25K for each of 10 years. The second investment’s SPP may be twice as long, but it generates far greater financial returns over time.

Speaking of time, SPP doesn’t consider the time value of money either. Assume you have two $100K projects, each of which has an SPP of 2 years. Project A returns nothing in Year 1 and $100K at the end of Year 2. Project B returns $50K at the end of each year. Assuming a market interest rate greater than zero, Project B’s cash flows would have a higher “present value” than Project A’s.

And speaking of cash flows, what about the risk of receiving them? Normally you’d apply a higher discount rate to reflect the risk that one or more future cash flows might not be received as projected. However, since SPP treats all cash flows equally, it cannot reflect any such risk.

Perhaps the most often cited shortcoming of using SPP is that the “acceptable” time period tends to be arbitrary. Isn’t it strange that despite significant variation in market interest rates over the last three decades, most decision-makers have continued to embrace a mantra of “less than 2-year SPP”? It would make more sense if SPP hurdles changed as rates of return on competing investments varied.

Simply wrong

The more complicated it is to discern the true costs and benefits of a given project, the more wary one needs to be of SPP. Taking the time to understand all the cash flows is a vital prerequisite of calculating SPP properly. If you’re not careful, you could wind up with the wrong “project cost” in the numerator, or the wrong “annual savings” in the denominator.

Let’s say the owner of a multi-tenant office property is considering a building-wide lighting upgrade. The project’s first cost and annual savings are estimated to be $100K and $33K, respectively. A third of the building’s rentable square footage (Group A) is under gross lease, meaning that the landlord is responsible for all energy costs (and enjoys any savings that result). Another third of the building (Group B) is under net lease, meaning that the tenants are responsible for all energy costs (and receive all savings). The final third of the building (Group C) is also under net lease, but the leases in that subset include a provision that allows the landlord to recover the cost of any capital improvement that reduces operating expenses. Moreover, leases in Group C contain the following stipulations: a) the landlord may only recover that portion of the upgrade cost that applies to those tenants’ rentable square feet; and, b) in any given year, the dollar amount of those recoveries cannot exceed the dollar amount of savings that are realized by the tenants in Group C.

At first blush the project appeared to have a SPP of approximately 3 years (i.e., $100K divided by $33K per year); however, the varying allocations of project costs and benefits call for a more sophisticated analysis. In the above example, if the landlord invested $100K, he would realize $11K in annual savings from the Group A leases, nothing from the Group B leases, and a maximum of $11K in capital expense recoveries from the Group C leases. Given the ways in which this building’s leases allocate costs and benefits, the SPP that the landlord would experience now appears to be longer than the project’s SPP. But that’s not the end of the story.

One also needs to consider how the landlord’s share of savings would affect the building’s net operating income (NOI) and asset value. According to the Income Approach to Appraisal, an incremental dollar of NOI supports an incremental $10 in asset value at a capitalization rate of 10%. This, of course, assumes that the NOI increase is persistent enough to be incorporated into the appraisal when the property is refinanced or sold.

For example, if the landlord’s share of savings from the leases in Group A alone added $11K to NOI, that would support $110K in incremental asset value at a 10% cap rate. Provided that the landlord’s share of savings were verified (and persistent), one could say that from the landlord’s perspective, the project had an SPP measured in days not years – the increase in appraised value alone would exceed the landlord’s original investment.

Nuances such as these underscore the need to look beyond SPP when selecting projects to fund, especially in landlord/tenant settings where calculating “who pays and who benefits” can be tricky. On a similar note, the chart above suggests just how much lower a project’s SPP has to be in order for the landlord’s SPP to be satisfied by the share of savings that the landlord would actually receive from the project.

Mark Jewell
Bringing the perspective that comes with over 20 years in commercial real estate and 12 years in energy efficiency, Mark Jewell, founder and President of RealWinWin (mjewell@realwinwin.com), is a national expert on the role of energy-efficiency economics in commercial real estate.