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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2013

The Unsung Value of Energy Retrofits

Explain to lenders how energy efficiency improves property values

Owning and managing a commercial real estate property doesn’t come easy. The profitability of any commercial property is not only tied to its occupancy and rent collection, but also to the costs associated with its operation and management. That’s why property owners and managers look at where and how they can trim expenses. As the single largest operating expense in commercial office buildings, energy certainly presents itself as the top candidate in this regard.

Energy makes up about one-third of typical operating budgets and accounts for almost 20 percent of national greenhouse gas emissions. By becoming more energy efficient, property owners and managers can reduce operating expenses, increase property asset value and position themselves as environmentally friendly.

Strategic reductions to operating costs through energy efficiency measures don’t only improve the bottom line, but they also develop positive branding of the property and increase occupancy demands. Along with these benefits comes the ability for commercial mortgage brokers and owners’ to place a property in a better position for funding or refinancing when needed.

Status quo

Current loan underwriting practices provide little incentive for building owners to make their buildings more energy efficient, however. Because the burden of high energy costs often falls on the tenants, buildings with lower utility costs can garner more demand and higher rents, which will increase the property’s net operating income (NOI).

According to Energy Star, a  government-backed program helping businesses and individuals protect the environment through energy efficiency, office buildings waste up to one-third of the energy they consume. Unfortunately, there are no readily available methods at present (other than analyzing a history of utility bills) for lenders to determine the expected level and volatility of a specific building’s consumption of energy.

Two metrics considered by commercial mortgage lenders in underwriting loans are: loan-to-value ratio (LTV), the ratio of the mortgage balance to the value of the building, and debt-service-coverage ratio (DSCR), the ratio of the principal and interest payments on the mortgage debt to the NOI of the building.

These two measures carry a lot of weight and determine the risk exposure that the lender will face in providing the loan; plus or minus a few percentage points in either direction can make or break a deal. Constructing a property’s NOI is the result of:

  • Aggregating the actual and forecasted contractual rental income from the tenant’s leases;
  • Subtracting all operating expenses, including energy costs;
  • Adding back the reimbursement from tenants to the landlord for energy- related expenses.

There are two key energy-cost considerations:

  1. Lower energy costs can drive higher rents because they reduce overall tenant-occupancy costs. Lower overall occupancy costs can alleviate the crowding out of higher rents by ever-escalating utility-cost reimbursements. These higher rents increase property value.
  2. Lower energy costs in cases where utilities are paid by the landlord make those buildings more profitable, which, in and of itself, increases their value.

Saving options

Energy Star calculates that a 10 percent decrease in energy use could lead to a 1.5 percent increase in NOI — profit that will continue to increase with further savings. There are two options that building owners can take to reduce energy costs in their buildings: low-cost measures and cost-effective investments.

The cost-effective investment strategy requires capital, and although a market for energy-efficient capital investment has not been developed fully yet, government authorities have started initiatives. One organization in particular, the New York City Energy Efficiency Corp. (NYCEEC), has been established to assist New York City implement its Greener, Greater Buildings Plan by helping private building owners get energy-efficient retrofit financing. Similar programs also have been put into action in states across the nation.

Property Assessed Clean Energy, or PACE, is a program that allows local government entities to offer sustainable energy project loans to eligible property owners. By creating financing districts, property owners can finance energy-efficient improvements through a voluntary assessment on their property-tax bills. The PACE mechanism requires little or no investment of general funds and presents relatively low risk to property owners looking to resell their property. The PACE finance industry began in California in 2008 and is currently available in more than a dozen states.

Case study

The Empire State Building recently underwent one of the largest energy-retrofit programs in the United States, reducing energy usage by 38 percent a year. It has been placed in the top 25 percent of all U.S. buildings in terms of energy efficiency, and building owners anticipate $4.4 million in projected annual energy cost savings.

The project has become an example for retrofit investments on office properties, and property owners can expect to see a return on investment greater than the cost of their energy-efficient improvements.

• • •

Until there is a way to recognize the value of energy-efficient improvements, commercial mortgage brokers should continue to work on explaining to lenders why better term structures are needed for energy-efficient properties.

Incorporating energy efficiency as part of the underwriting process is expected to take time, however. For now, property owners can seek out public organizations such as NYCEEC, participate in programs like PACE or reach out to private institutions that focus on providing capital for energy-efficiency investments. 


 


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