Dan Winters
Managing Principal
Evolution Partners Real Estate Advisors
Author Note: With apologies to Eddie Albert, Eva Gabor, Arnold the Pig, and the rest of the Green Acres community in Hooterville, we strive to provide thoughtful commentary on green buildings and their tremendous value potential to an institutional real estate portfolio. This article is published in the forthcoming 3Q11 edition of the PwC Korpacz Real Estate Investor Survey.
Green buildings continue their market penetration given persistent increases in energy and water costs and continuing changes in regulatory requirements. For institutional investors, green building investment strategies present opportunities for greater asset-based financial returns and a reduced risk profile.
Investors who embrace a green building strategy with their private equity manager selections and fund allocations will be well-positioned to achieve superior returns from their real estate portfolio. The alpha-return profile delivered by green building strategies stems from three primary areas: 1) comparatively lower operating costs of the underlying assets, 2) increased asset desirability in the leasing markets, and 3) reduced incidence of asset obsolescence during the fund's life.
Taken together, these and other tangential factors provide tremendous value potential to incrementally increasing a private equity fund's income return over the holding period, reducing overall portfolio risk, and positively impacting asset valuations upon fund exit.
Generating Alpha
Green buildings employ strategies that save money; LEED and Energy Star provide roadmaps to these savings. Assets with a LEED and/or Energy Star certification have efficient systems that reduce energy/water costs and increase tenant desirability compared to their market peers. These buildings are typically characterized as being well run, amenity rich, and highly regarded within their submarkets. They provide financial advantages over non-green buildings which can be monetized by knowledgeable investors, thus creating marginal alpha returns at a lower risk profile.
The financial benefits can be significant. Over a private equity fund's ten-year life, a green fund can be expected to outperform a non-green fund on both absolute income and overall asset price appreciation. Take as example a non-green real estate portfolio where energy and water costs are 25% of the total portfolio's operating expenses compared to a green building portfolio that reduces these costs by 33%. This efficiency-based cost reduction results in an 8% increase in net operating income year after year throughout the asset's holding period [25% energy costs x 33% reduction = 8% income gain]. Further, this 8% income advantage has value at time of exit based on the asset's terminal capitalization rate.
Accordingly, a $500 million non-green portfolio yielding a 6% cash return today and growing at 3% annually will be outperformed by a green portfolio with an 8% income advantage by an additional $27.5 million in cash income over a ten-year holding period.
Besides an absolute income advantage, green buildings have "core" investment characteristics, which increase the likelihood that these assets experience top-tier capitalization rates upon exit. This reduces portfolio exit risk. Holding the current overall cap rate constant at 6%, the green portfolio's 8% income advantage grows to deliver an additional $52.2 million in sale proceeds upon fund termination.
Therefore, investors enjoy nearly $80 million in alpha-driven returns by investing in a portfolio of certified LEED and/or Energy Star green buildings that reduce energy and water input costs by 33% over the fund's ten-year life.
Supply/Demand Imbalance
Besides direct financial impacts, sustainability initiatives mandated and implemented by major corporations are driving market demand for LEED-certified and/or Energy Star space. Sustainability initiatives focus significant attention on energy and water consumption, employee commuting patterns, and the organization's overall carbon footprint. There are also intangible factors and market goodwill attained by occupying LEED and/or Energy Star certified buildings. In many cities, this dynamic is leading to a bifurcation in the commercial leasing market, where certified buildings command strong top-line competitive advantages over conventional non-green certified buildings.
Quantifying top-line income growth associated with an asset's "greenness" is tricky business. There are many moving parts in any real estate transaction and a tenant's overall occupancy costs, while important, are but one of several primary decision drivers. However, what is clear is if there are rent premiums to be had, LEED and/or Energy Star buildings will have a seat at the table while non-certified buildings may begin to suffer a negative market stigma that takes them out of the running for any green-driven top-line revenue opportunities.
Underwriting "Green"
Real estate risk factors come in many forms –- operating cost volatility, vacancy, lease-up time, tenant credit quality, competitive market profile, rent growth, physical / functional / economic obsolescence, liability exposure, cap rate on sale, and other relevant issues. Reducing these risks is paramount to achieving a fund's return expectations and an important element of an investment manager's fiduciary duties.
Factoring sustainability-related issues into financial underwriting, particularly energy/water efficiency, location, and indoor environmental quality, are important considerations when making investment decisions with long-lived real assets, such as commercial real estate.
Assessing "sustainability risk" and determining an asset's "green gap" are key factors in making superior real estate investment decisions. Exposure to current energy and water costs and their future price increases is the most controllable operational risk. As leases roll over, asset-specific investment risks for poorly performing assets will be exposed. Market factors will drive poor-performing buildings to either 1) charge lower rent, 2) experience lower occupancy rates, or 3) make untimely investments in capital improvements. All of these factors can drive negative financial outcomes for a non-green portfolio.
Solid 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. LEED and/or Energy Star certified buildings provide a strong investment proposition and downside value hedge due to their many risk-reduction features. Clearly a fund manager's in-depth knowledge of green building value attributes and evolving market practices is important to avoiding upward portfolio drift along the risk spectrum over a fund's duration.
Transparency
Perhaps the most underappreciated driver behind green building is information-age transparency. The real estate market is rapidly evolving its transparency and disclosure practices. Transparency on asset-based features allows both investors and tenants to assess building attributes on a relative basis - - green vs. non-green; efficient vs. non-efficient - - and apportion risk accordingly.
The continued introduction of new information-driven products and services into the real estate industry will further drive a valuation wedge that favors green buildings over their non-green counterparts. Ultimately, transparency is the foundation of capital market efficiency. Investment managers and their institutional investors who invest in green building features and operate their assets at higher efficiency levels will be rewarded over those who do not.
Bottom Line
Leading real estate investors who implement green-building initiatives within their stable of investment managers will be well-positioned to reap the alpha-return rewards of superior income-based cash flows along with associated value gains derived from asset operational cost efficiencies. These investors will also have a leg up given the increasing green building supply/demand fracture and the ripple effects of a carbon-constrained economy over this next real estate cycle.
Investors who fail to incorporate green building attributes into their manager and fund allocations increase the probability of awakening to a real estate portfolio that contains much more risk than one previously thought.
You might recall the Green Acres episode where Arnold, distinguished by his ability to predict the weather with his tail, called for blizzard in the summer creating a awkward situation for Oliver……until the snow came as predicted and buried the city.
From our vantage point, green buildings provide a strong value proposition. And we've got more than a pigs tail to go on. Our view is that successful real estate investors begin with the end in mind. Given this benefit of "advance hindsight"…… how will your portfolio look in 2020?
Dan Winters is managing principal of Evolution Partners, a real estate investment advisory firm specializing in high-performance green buildings, including LEED and Energy Star real estate projects. He can be reached at 202-997-3922 or
dan@evolutionpartners.com.