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Building Energy Retrofit - Owners Need Convincing, Not Just Financing

The pace of energy-efficient upgrades by portfolio owners in the U.S. is slowing. In a recent survey, 78% of building owners plan to perform upgrades over the next two years, compared to 91% who said they spent money on sustainability improvements during the past two years. It is a commonly-held belief in the U.S. that the recent decline in the number of sustainable retrofits to commercial buildings by owner/investors is connected to a lack of available financing. While that may certainly be true in some instances, the experience of Jones Lang LaSalle's teams serving office building owners suggests otherwise. In more instances,

these clients have told us that the biggest hurdle is not finding capital, but proving that the expenditure is worth it on the bottom line.

This discovery is backed by industry findings as well. In extensive research used to create its SmartMarket Reports, McGraw-Hill Construction reveals that in a survey of owners who had recently performed a sustainable capital improvement, 85% had self-financed it. Only 6% took out bank loans. The notion that a post-recessionary reduction of lending capital has held back sustainable retrofits is less of a factor than some might have believed.

Altruism aside, investors often feel that they lack many of the incentives that motivate corporate or public sector owners and/or occupiers to make sustainable property upgrades. Corporate occupiers can recoup investments many times over in energy cost savings, but landlords either transfer utility costs to the tenant or share them on a pro-rata basis, so that the benefit is diminished or non-existent. Investors also are less concerned about public image than brand-conscious corporations or public entities that answer to taxpayers and voters. Neither do they see it as a way to help motivate, attract and retain key employees, as occupiers do.

Making the case

Owners invest in buildings to make money, and are programmed to spend only what is necessary to maximise their return. A key issue affecting owners' willingness to spend on sustainable upgrades is the so-called 'split incentive' where much or all of the monetary savings from energy reduction migrates to their tenants, not them. While this can't be denied, there are ways for owners to increase their payback from a sustainable investment. One way is to include a clause into leases stating that if an owner makes a sustainable investment, they are automatically entitled to recover a stated percentage of energy cost savings through an increased rent or other means. This is becoming a more common practice.

It is also important for owners to look at other ways a sustainable investment can generate payback. Like a new lobby or elevator bank, a capital improvement in sustainability makes an office building more desirable to tenants. They know that they can save on operating expenses, that their employees typically feel better about working in green space and that, in the case of large corporations, environmental benefits can contribute to overall organizational, even global targets for sustainability, such as carbon reduction. These benefits can justify collecting higher rent, or can increase competitive advantage and occupancy rates. And when the building is sold, sustainable investments can be recouped in an increased sales price.

In fact, a 2011 study by Eichholtz, Kok and Quigley indicated the premium for LEED certified or ENERGY STAR label buildings is about 13%.

Owners/investors making sustainable retrofits have reported that while they don't expect 'windfall' profitability from going green, they do feel that it contributes to their bottom line beyond energy savings. While almost all building owners expect to decrease operating costs thanks to their investments,

  • Four out of five also expect to attract more tenants
  • Almost three-quarters expect increased ROI, with an average increase of 4%
  • One-fifth believe they will receive higher rents, with an average rent increase of 1%
  • 57% expect to see an increase in building value at an average of 5%

This confidence is borne out in the market as well. According to the SmartMarket Report, rental rates for LEED-certified buildings - the cream of the sustainable crop - are 13% higher than for non-LEED. Another study cited in the report revealed that 14% of tenant firms said they would pay more to rent space with green features, with the premium threshold for most falling in the 2-3% range. Considering that tenants are hard pressed in the current economic climate to spend anything they aren't compelled to, this willingness to pay more for green space is even more significant.

Research suggests that owners favor sustainability upgrades that are 'visible' to tenants, and improve occupant comfort. Lighting was the most popular upgrade, figuring in 94% - almost all - of owners' retrofit programs. Improving both natural and artificial lighting of offices is not only popular among tenants, it is typically one of the lowest cost, highest value green improvements an owner can make. Next in line were other upgrades directly related to high savings and tenant comfort: more efficient HVAC systems (85% of owners), zoned temperature controls (74%) and building automation controls (72%).

Evaluating the actual need

Even when the importance of the business case exceeds that of obtaining financing, owners still want maximum impact - and proof of the value - for every dollar they spend. Less than one-third of ownership/investment firms have staff dedicated to sustainability issues. However, most firms are demonstrating a general willingness to pursue green retrofits if the cost is fairly reasonable and the financial value can be quantified. This is creating an 'open door' for sustainability consultants to educate owners/investors about less obvious opportunities that can be as green financially as they are for the environment.

Jones Lang LaSalle advises its clients that before seeking investment capital, it is prudent to consider how all the systems and components work together, as well as individually. By making improvements holistically instead of in isolation, an owner's need - and expense - may be less than they think. It is important to analyze how all sustainable building components affect each other. For example, part of a $20 million sustainability upgrade that one of our teams managed for New York's iconic Empire State Building was the replacement of 6,500 79-year-old windows with triple-glazed panes. The windows improved building temperature retention so well that a planned upgrade to the HVAC system was scaled back to a cost level that more than covered the cost of the windows, resulting in a net saving.

From building automation systems to more efficient fans to cooling tower upgrades, individual sustainability improvements can prompt corresponding efficiencies in other components and systems. Before owners look at financing options, they should consider - with outside expert assistance if necessary —creating a formal energy model that evaluates all aspects of the building for current performance and helps prioritize energy conservation measures. The outcome will help to develop an 'energy improvement roadmap' to achieve the greatest energy savings at the desired level of spending.

Another way to stretch the value of your investment is to aggressively pursue tax incentives, utility rebates and other 'reward' programs for sustainable investments. In the U.S., green tax incentives can offset the upfront costs by 30-50% or more. At the federal level, encouraged by the White House's aggressive energy and climate program, proposed legislation includes extending tax credits to owners and allowing them to claim energy tax credits for sustainable development. Existing tax incentives include deductions of $0.60-$1.80 per square foot for HVAC and lighting systems that meet defined standards.

Financing outside of the box

Most owners/investors are well aware of conventional capital sources for financing commercial property. Those in the U.S. also may want to investigate non-traditional financing mechanisms including:

Property Assessed Clean Energy (PACE):

In PACE programs, municipal governments loan money to consumers and businesses/investors for energy retrofits, and the loans are repaid over an assigned term - typically 15-20 years - through assessments on their annual property tax bills. Unfortunately, PACE has created problems with original lenders on properties because property taxes are superior to all other obligations, creating problematic subordination scenarios. PACE was dealt a major blow in 2010 when the Federal Housing Finance Agency, a major impetus to the program, stopped residential PACE financing in most locations. Though PACE is available for commercial financing in roughly half of U.S. states, many mortgage holders have non-subordination clauses in their contracts. The industry is currently trying to develop answers to this issue, so that PACE could become a viable option for energy retrofit financing.

Energy Service Company (ESCO) Loans:

In an ESCO arrangement, an energy service company will pay for, implement and own a sustainability improvement to an owned building, charging the owner an agreed-upon percentage of the savings generated, which in theory will pay for the upgrade over time. Unfortunately some mortgage holders have balked at ESCOs as well, and include clauses prohibiting any permanent installations of equipment or systems that they do not own. For this reason, ESCO is not an option for many owner/investors.

Managed Energy Service Agreements (MESA):

In a MESA arrangement, an energy service company installs a sustainability improvement at its own expense and actually pays the utility bill. The landlord pays a monthly fee that typically represents some savings over previous conditions for them, but also permits the energy service company to profit from the arrangement. Since it is represented on the balance sheet as a fee instead of a capital investment, it is considered an operating expense which can, depending on the lease, be passed through to tenants. Though somewhat complicated, MESA may represent the best potential 'win' financing mechanism accessible to the greatest number of owners.

In summary, most owners/investors are open to green retrofits, but they have to see that there is a good business case - translated as profit generating - for doing so. And the sustainability community can help by:

  • Establishing benchmarks based on peer experience that demonstrate what owners can expect to gain financially from not just energy savings, but tenant attraction/retention, rate premiums, building resale value and other considerations directly related to ROI
  • Increasing the accessibility and value of tax concessions, utility rebates and other incentives aimed directly at owners/investors
  • Making available more uncomplicated non-traditional financing options that directly serve their needs and ability to participate

The bottom line for sustainability investing is the same as it is for any other spending: regardless of how you pay for it, it must meet the owner's investment objectives. No matter how green the investment might be, if the return on investment is too low or the payback period is too long, the financing options are irrelevant; the investment will not be made.

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