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Thursday, June, 25, 2009

Ellen Sinreich: Green real estate is not just good for the environment; it's good for business

PLI: We often hear the "environmental" case for green; what is the business case for green real estate?

ELLEN SINREICH: What is often referred to as the "business case" for green real estate is beginning to be understood, documented and quantified. Intuitively, it makes sense: buildings that use minimal amounts of energy and that have highly efficient and appropriately sized mechanical systems, that feel better to be in, incorporate recycled, rapidly renewable and regional materials, make the most of sun, wind and storm water patterns, contribute to diversifying natural ecosystems, allow for more open green space, reduced water consumption and minimize their burden on aging, overtaxed municipal water systems are more valuable buildings than they would otherwise be. This translates into an increased bottom line. How can anyone argue with the benefits of a building that conserves the earth's natural resources, is healthier to occupy and costs less to operate and maintain?

The hitch is understanding the cost involved in order to get to this increased bottom line and more valuable, green asset. Value creation can only occur if the cost of green does not overwhelm the benefit derived from green. Because "green building" does not mean any one particular thing and every green building has its own unique green features and therefore its own unique green cost, the cost/benefit analysis of developing or renovating a green building must be made on a case by case basis. Payback, a term that is often associated with evaluating the potential green features of any real estate asset, is key to determining whether any particular green feature is a worthwhile addition to or inclusion in a building. Payback refers to how long it will take to recoup the incremental cost of a green feature. In some cases there is no incremental cost, in other cases the incremental cost is significant but the payback is relatively short, thus justifying the additional expense, and in still other cases the payback would take so long that the incremental cost is not justifiable.

None of us in the industry would be doing our jobs of developing or demolishing, leasing, managing, financing, buying or selling property responsibly if we did not consider how "green" enters into the equation. And the same goes for those of us who represent these players in the world of real estate. A good place to start is to understand the financial benefits of potential green features and how they could result in value creation. There are two types of factors to evaluate: market factors and regulatory factors.

Market Factors: Let's start with just one of the market factors: lower operating and maintenance costs. Consider reduced energy consumption. Given today's technology, there should not be significant incremental cost involved in designing and building a high rise office or residential building that is 15% more energy efficient than a "traditional" building. And by traditional, I mean a building that meets minimum ASHRAE requirements.¹ A 15% savings in energy costs, which could be nickels and dimes per square foot, can lead to millions of dollars in additional asset value. Here's how: Assume that energy costs are $3.00 per square foot for a typical first class office building in Alexandria, VA. Your client builds a new office building in Alexandria which is 15% more energy efficient than a traditional building. This means that your client is saving 45¢ per square foot in energy costs and if the building is 500,000 square feet, they are saving $225,000 per year. Going one step further, assuming an 8% cap rate, this savings of 45¢ per foot in energy costs translates into a $2,812,500 increase in the value of the building. Spread that savings and increased asset value over a portfolio and the value creation proposition is hard to resist.

The trickier payback analysis is the evaluation of increasing energy efficiency in an existing, multi-tenant occupied building. Once an energy efficiency initiative has been evaluated from a technological perspective and a determination has been made that significant savings can be achieved in terms of on-going energy usage and costs (which some experts predict will increase, on average, 20% per year), a further analysis must be undertaken to see how the money will flow. The existing leases will determine how the financial costs and benefits of the initiative will be allocated between the owner of the building and the tenants who occupy the building. Often there is a "split incentive": the landlord bears the capital costs of the energy efficiency upgrade and the tenants reap the rewards of lower operating costs. Progressive landlords would be well advised to approach existing tenants to negotiate a more balanced result. With respect to new leases, building owners and managers should consider and incorporate leasehold strategies that properly incentivize the parties for future "green" building upgrades.

Green buildings should enjoy other value add opportunities. In addition to reduced energy costs, there is the potential for lower insurance premiums, lower waste disposal fees, income from recycling, reduced water and sewer charges, lower replacement costs resulting from longer life cycles of certain building components, increased rentable square footage resulting from smaller mechanical systems, and increased rental rates.

Evidence of higher rental rates for green buildings is just beginning to be documented.² Strong, conclusive data confirming that rents in green buildings with lower occupancy and operating costs and superior indoor environmental quality are greater than rents in traditional buildings may take time to gather given the global economic slowdown. In the meantime, consider the following: According to the U.S. Green Building Council, tenants of green office buildings experience a 2 — 16% increase in productivity. For most commercial tenants, their greatest expense is their labor cost. If their employees are more productive — because they are more comfortable in buildings with fresh, filtered air (vs. the recycled air that makes us prone to catch each other's colds), more daylight and views and less — or no — toxins from the carpeting, furniture and paint, that has to impact their bottom line and thus the amount of rent that they can and will pay for a green office. This should translate into higher rental rates and lower vacancy rates for green buildings with superior indoor environmental quality. That means higher revenue for the building owner, and a building that generates higher revenue is a more valuable building than it would otherwise be.

Governmental Incentives: The other key value creation factors are those regulatory factors that are designed to incentivize green building features.³ Regulatory incentives can be divided into four categories:

outright grants,
tax incentives,
increased density and
expedited permitting.

In practically every state, there is some state, local or utility program or a combination of programs that offers incentives which can be monetized for green building features.

There is a terrific web site that describes and summarizes federal, state, local, utility and not for profit rules, regulations and incentives for various aspects of green buildings, entitled the Database of State Incentives for Renewables & Efficiency: www.dsireusa.org.⁴ The DSIRE website provides a fast and convenient method for accessing information about renewable energy and energy efficiency incentives and regulatory policies administered by federal and state agencies, utilities, and local organizations. In Chicago and Portland, Oregon, which were two of the first cities in the United States to embrace an incentive based approach to green buildings, there are a myriad of incentives for green buildings, ranging from the Green Roof Improvement Fund in Chicago, which provides matching funds of up to $100,000 for putting a green roof on any downtown building, to Portland's green investment grants of up to $200,000 per project.

In New York City the public financial incentives available for the latest state of the art green high rise office tower include over $8,000,000 in funding benefits attributable to New York State Green Building Tax Credits and New York State Energy Research and Development Authority funding. In addition, the Empire Development Corporation provided the land.

In Austin, Texas, where green buildings are eligible for expedited permitting: a "big box" store that was designed to use 40 to 70% less energy and 50% less water was permitted in 3 months, vs. the typical 15 months. Given profits of $85,000 a day from that store, there was a $3,000,000 savings as a result of incorporating green features into the store.

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More from Ellen Sinreich — The Economics of Green Real Estate — Download

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