August 18, 2009
Green Business Case Starts with Critically Questioning Your Base Case
Galley Eco Capital
How do you get more value from your green business case?
Real estate investors like to say that you buy most of your value in a good deal at the time of purchase. In short, buy for the right (read: low) price.
When it comes to determining the added value that sustainability brings an asset, we’re finding that a good deal of the value is often hidden in the base case. Because there’s often more cost and downside risk trapped in there there than the typical pro forma projection indicates. And keeping that information hidden unfairly penalizes the green business case.
The base case should reflect the most accurate economics and total value creation possible by building and operating the asset as a conventional building over the holding period.
Here are a couple of basic ways that base cases often bury the true risks and costs of doing business as usual:
One problem we frequently see is that future operating projections do not trend energy and water costs at an accurate rate of inflation. For the most part, energy and water costs in many markets are increasing well above the rate of inflation. However, lots of practitioners still apply one static inflationary rate — usually the CPI — to all income and expenses for the asset’s entire holding period.
Fighting climate change has caused many state and regional authorities to introduce new regulatory frameworks aimed at improving land use, transportation, building codes and even cap-and-trade frameworks. Take California, for example. The AB32 legislation has been clearly designed to have a systemic effect on where we locate, how we build and commute to buildings. Most of these regulations have announced implementation dates well within the next ten years.
Even though it might be difficult to predict exactly how these regulations will change market forces over the holding period, the base case discounted cash flow, in California particularly, should also recognize the impact of long-term systemic changes to the project’s marketability due to changes to broader market systems and demographics, such as those being introduced by AB32-related legislation.
Lots of investors haven’t yet begun to explore the effect these issues have on doing business as usual — only adjusting terminal cap rates over a ten year holding period by the typical ~50 bps, reflecting a “same old same old” point of view about their asset’s future.
While the investors cannot predict ten years into the future exactly how much of a direct change to exit risk these actions might have, leaving these issues altogether ignored unintentionally, and unfairly penalizes the green business case.
So it’s amazing to us that — even as commercial real estate is in the midst of a great strategic disruption, due to green building as well as capital markets forces — investors still prepare pro forma operating projections as if nothing’s ever going to change.
Photo credit: Flickr - Kunsthaus Graz/Fatlum
Lisa Michelle Galley
is Founder and Managing Principal of Galley Eco Capital in San Francisco California.
Galley Eco Capital LLC
71 Stevenson Street
San Francisco, California 94105
(Telephone): +1 (415) 655-6668
(Fax): +1 (415) 655-6601
Copyright Galley Eco Capital 2009. Used with permission.