Republished from the 3Q08 PriceWaterhouseCoopers Korpacz Report
By Dan Winters, Managing Principal of Evolution Partners Real Estate Advisors
Green building continues gaining market penetration given the significant increase in volatility on energy and water costs along with fast-emerging tenant sustainability mandates. In many major real estate markets, this dynamic is leading to a bifurcation in the leasing market where LEED-certified green buildings have some degree of competitive advantage over conventional non-green buildings.
For years it has been quietly stated by knowledgeable professionals that green buildings will attain competitive superiority in a down market where there is a flight to quality, both in leasing and in portfolio accumulation. That time has arrived and will be with us for the foreseeable future giving green building owners and developers a superior competitive position.
Green buildings that achieve energy and water efficiency metrics drive down a tenant’s overall financial occupancy cost. They also help fulfill corporate sustainability policies and mandates; over 50% of Fortune 500 issued sustainability reports in 2007 and these are typically coveted credit tenants. Although there has been relatively little recognition of this market dynamic in the real estate finance community to date, this is likely to change over the next 12 to 18 months.
Depending on an asset’s overall competitive set, market supply/demand absorption dynamics, and changing tenant sophistication levels, strong operational cost containment coupled with a green market position can have a significant impact on financial performance. This is particularly stark in an era of cap rate compression where NOI advantages are magnified by more rational risk-adjusted cap rate treatments at valuation. In comparing two assets, a 10% NOI advantage coupled with a 25 basis point cap rate advantage results in 13% value gain to the more efficient, green asset.
Factoring sustainability-related issues into financial underwriting, particularly energy/water efficiency, location, and indoor environmental quality aspects is fast becoming an important set of considerations when making financial-based decisions with five to ten-plus year life spans.
Capital Markets Partnership
In early 2008, Evolution Partners and the Institute for Market Transformation to Sustainability
(MTS) began developing an industry-wide underwriting standard for Wall Street, lenders, capital market investors, and appraisers to use when analyzing both green and conventional buildings. Over the course of this past year, a group known as the Capital Markets Partnership
(CMP) coalesced around this effort, reinforcing the need to create a standardized system that identifies financially important green attributes, then incorporate these attributes into the underwriting process at all levels of the real estate investment chain.
CMP is structured as a nonprofit coalition of investors, investment banks, insurers, NGOs (nongovernment organizations), and city, state, and federal governments. Key CMP members include the U.S. Conference of Mayors, JPMorgan Chase, Citi, Bank of America, Wachovia, Jones Lang LaSalle, PNC Bank, Allianz, Fireman's Fund, Goldman Sachs, TIAA-CREF, Wells Fargo, U.S. EPA, U.S. Treasury, Federal Home Loan Bank of Boston, Fannie Mae, Destiny USA, the United Kingdom, and the states of California, New Jersey, and New York along with numerous other major municipalities.
This group engaged a large number of real estate capital market participants in the consensus standard process that was developed through American National Standards Institute (ANSI) protocols. This rigorous process engendered significant industry participation and input from major capital market participants resulting in a strong tool for capital market implementation.
The Green Building Underwriting Standard for both commercial and residential application was unanimously approved in September 2008 and is currently in the pilot phase in advance of adoption by the financial real estate community. The underwriting standard is designed for use by all levels of the commercial and residential real estate capital sector including direct lending, CMBS underwriting, CMBS purchasing, private equity investing, REIT analysis, and upstream investor reporting (the Standard is available through ANSI.org
or at CapitalMarketsPartnership.com
CMP received the endorsement of the U.S. Conference of Mayors
at the 2008 annual meeting
through the passage of Resolution 119 led by San Francisco’s Mayor Newsom, Chicago’s Mayor Daly, San Jose’s Mayor Reed, and Miami’s Mayor Diaz. Resolution 119
recognizes the urgency of the capital sector to generate investments in high-performance green buildings through the creation of sustainability-based investment criteria and corresponding investment products, such as securities backed by mortgages on green buildings, green building private equity funds, and asset-retrofit equity and debt funds.
The main objective of the underwriting tool
is to allow lenders, private equity purchasers, and institutional real estate owners the ability to rate an asset’s “greenness” at the time of financing or acquisition. The tool is structured as astraightforward, easy-to-implement underwriting overlay by enhancing current underwriting practices. Upon analysis, an asset is assigned a “CMP Green Score” from 0-100 based on the presence or absence of financially tangible criteria that influence the asset’s financial, operational, and market-risk profile. Once a specific asset’s CMP Green Score is determined, this analysis can expand to the portfolio level through an aggregation of asset-specific scores.
The CMP Green Score takes into account asset features that lead to energy and water efficiency thus reducing current operating costs while also insulating tenants from future energy and water price volatility. The CMP Green Score also incorporates location-based attributes that affect a tenant’s commuting patterns and/or carbon footprint, as well as factors inherent to indoor environmental quality that can affect rents, risk, and liability exposure.
By providing guidance as to an asset’s green attributes, including its Energy Star score, LEED rating and specific LEED points achieved, and/or Climate Neutral certification, investment practices will evolve to effectively incorporate a green building's value enhancement.
Understanding an asset’s green profile on a relative scale allows greater market transparency across all facets of the investment decision process. The standard addresses critical market pressures that include a rapid rise in conventional energy costs, increased operating costs, tenant preferences swaying in favor of green buildings, and current/future climate-change issues. It also helps tighten loose underwriting standards and increase capital market confidence. Ultimately, the disclosure of the CMP Green Score will better enable investors to fulfill fiduciary responsibilities, improve real estate industry underwriting, and make appropriate risk-adjusted investment decisions.
Assessing risk is a key factor in making superior real estate investment decisions. Asset-based risk comes in many forms – operating cost volatility, vacancy and lease-up time, tenant quality, competitive market profile, rent growth, obsolescence, liability exposure, cap rate on sale, and other relevant issues. Reducing these risks is paramount to an investor’s return expectation and to its fiduciary duties if investing on behalf of third parties.
A key issue specifically addressed is debt underwriting. Currently, projects with energy-efficient and water-efficient features along with proven financial metrics tend to be penalized during the financial underwriting process through the application of “greater-than-market-or-actual” on expense-based items and “less-than-market-or-actual” on revenue-based items. A market utility expense figure may be based on appraisal comparables, a lender's experience, the BOMA Experience and Exchange Report, or some other metric, all of which penalize the asset owner’s investments in efficiencies. Given the asset attributes detailed in the Green Building Underwriting Standard, efficient buildings and their favorable risk profiles can achieve the appropriate risk-reduction recognition they deserve.
On a macro scale, the many benefits of the Green Building Underwriting Standard include:
• Provide an accounting method for green building value
within existing underwriting criteria
• Increase the quality of investment underwriting
• Increase the collateral value
of the building stock via a third-party certification process
• Stimulate the investment market
for green investment products
• Stimulate the asset market to "green" existing assets
• Increase investor security
• Provide opportunities to adopt clean energy
• Further commercialize green buildings
and their many economic and social benefits
Ultimately, real estate asset underwriting requires a focus on 1) an absolute reduction in total risk exposure, and 2) the opportunity to achieve enhanced cash flow from an investment with one set of attributes as compared to an asset without those same attributes.
By allowing the finance market to assess building attributes on a relative basis, efficient capital markets will reward developers and investors who invest in tangible green building features and operate their assets at higher efficiency levels over those who do not.
At its barest fundamentals, this is free market capitalism at its finest.