The Better Buildings Challenge, issued by the White House earlier this year, includes tax incentives, loan guarantees, and most importantly, a partnership between the Department of Energy and The Appraisal Institute to establish a protocol for valuing energy reductions at commercial buildings.
The final market catalyst, financing, is available by applying processes and tools already in place within the commercial real estate industry.
Most green building improvements require increased tenant demand for an acceptable return on investment. Energy efficiency measures, however, are unique in that they provide a direct return on investment. The remaining barriers to widespread adoption of energy efficiency measures are more psychological than technical or financial.
A major existing barrier is a “payback period” mindset, requiring an improvement to pay for its full cost in utility cost reductions over a limited period of years.
While an important yardstick, this framework ignores the availability of leverage and the value created by improving property income. In this economic environment, forecasting energy savings to increase net operating income has become less risky than forecasting rent increases. This fact, combined with accelerated knowledge sharing, has resulted in the gradual shift toward a “value enhancement” mindset, allowing for deeper investments in efficiency.
The basic framework for lending toward energy improvements already exists, and includes: relying on bank-ordered, third-party reports; modeling future cash flows to estimate stabilized values; and monitoring and disbursing construction funds. These core competencies allow banks to finance energy-efficiency improvements within a first mortgage, at more attractive interest rates than alternative capital sources.
Financing Energy Improvements
As part of the typical underwriting process for a sale, refinance, or modification, the bank orders a third-party energy audit. The report includes an independently prepared opinion of cost and cost savings associated with a bundle of improvements. As with appraisal and environmental reports, the expense of the audit is categorized as a loan closing cost.
Selected improvements detailed within the energy audit report will result in increased cash flow to support the increased loan amount, and an inferred value creation (net operating income improvement valued at a cap rate) that exceeds the project cost. These analyses will include tax credits and other credit enhancements, and serve as the basis for a mutually acceptable project scope.
At loan closing there is an initial loan advance to cover the cost of sale or refinance, followed by subsequent construction draws for energy efficient improvements. Once the project is complete, the owner and lender begin to track and prove operating cost savings over a period of time typically lasting a few months. When operating cost savings are proved against historical performance, the project may be sold or refinanced at a higher valuation.
One major nuance is the “split-incentive” issue, or the underwriting of cash flow savings split between the landlord and tenant based upon each lease structure. Property types that do not directly charge tenants for utilities, such as hotels, escape this complication. For other property types, there are “green leases,” which redistribute future cash flows equitably. As with all real estate transactions, additional risks include tenancy, energy costs and market conditions.
The tools, expertise, and processes are readily available for the accelerated adoption of energy efficiency in investment real estate. To be successful, we must apply them with patience, persistence and creativity. The impact of this effort would be a once-in-a-generation opportunity for disruptive change, and stand as a monument to our time as temporary stewards of the built environment.
