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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2017

Energy’s Hidden Risks and Rewards

Going green saves money and results in fewer defaults

Energy’s Hidden Risks and Rewards

Residential and commercial buildings accounted for about 40 percent of the nation’s total energy consumption in 2015, according to the U.S. Energy Information Administration. The $400 billion spent each year to power American buildings could be cut drastically if commercial property owners and investors implemented more cost-effective energy strategies and solutions.

Studies also show a link between energy costs and mortgage default risk. These findings suggest mortgage originators and underwriters should pay careful attention to how energy risks factor into the loan-approval process.

McKinsey & Company, a worldwide consulting firm, produced a 2009 study that stated Americans could save $130 billion annually through more efficient building practices. Commercial real estate investors and property owners understand this already and have historically pursued energy-efficiency improvements to lower their operating costs and enhance operating income.

Research is beginning to show, however, that buildings with green certification offer a myriad of other financial benefits, including higher rental prices, sales prices and occupancy rates. Other studies show high-performance buildings even can improve the health and productivity of occupants while reducing operational and ownership risks.

Last year, a study conducted by the Lawrence Berkeley National Laboratory and the University of California-Berkeley’s Haas School of Business found a statistically significant correlation between energy factors, such as energy-use intensity and energy price and mortgage default risk. The analysis was based on Trepp mortgage-loan data and energy use for almost 500 buildings across several major U.S. metropolitan areas. It suggests a 30 percent increase in annual energy use, which could easily occur with poor facilities-management practices, translates into a 10 percent increase in default risk relative to Trepp’s average default risk.

Why energy matters

Energy factors can be broken down as costs, consumption and volatility over the term of a mortgage loan.  Energy costs, an operating expense included in net operating income (NOI) calculations, are important in mortgage valuations because they comprise, on average, 12 percent of base rents and represent as much as 30 percent of total ownership costs in many regions of the country.

These costs fluctuate based on a building’s energy use and the price of energy in a region. Volatility accounts for unintended or unexpected changes in average energy use or price, and is of greater interest for risk management because it evaluates the impact of extreme events and default risk. 

Energy-use volatility can result from three factors — weather variations, operational practices and occupancy/vacancy rates. Property operations and tenant behavior have been shown to have a significant impact on energy consumption.

A poorly operated building can use 30 percent to 60 percent more energy relative to average practices, for example, while an operationally efficient building can use up to 20 percent less than average. Factoring in aging equipment with volatile electric and natural gas prices shows how the true impact of energy warrants more attention than a single average figure in the NOI calculation.

Energy considerations

There are three ways to insert additional energy-factor information into the mortgage underwriting process: a pro forma calculation, an appraisal and a property condition assessment (PCA). For a pro forma calculation, building owners provide information about the building’s operating expenses and lease revenue in order to establish a market value for the building.

Energy is often incorporated into a summarized utility expense as an aggregated monthly cost per rentable space in a pro forma calculation. Building owners also can provide detailed information about the building’s energy performance to be factored into the pro forma. This includes access to the building’s Energy Star score, utility expenses, Leadership in Energy and Environmental Design (LEED) or other green-certification scorecards, and relevant information on energy-system upgrades.

If more information is required, lenders can order a third-party appraisal to provide verification of the market price of the property, using a reconciliation of the cost, income and sales approaches to valuation. Typically, industry-standard assumptions for utility costs are used by appraisers in the NOI calculation, rather than data indicating the property’s actual performance.

Lenders that want a full picture of a building’s energy characteristics should ensure the appraiser they select is competently trained and experienced to work with high-performing buildings. In turn, the appraiser should confirm the borrower has submitted all relevant energy data in their pro forma application.

Several resources exist to assist appraisers in using this information effectively. One is the Appraisal Institute’s “Commercial Green and Energy Efficient Addendum,” which provides templates to assist appraisers in valuing high-performance properties. Continuing-education courses on the topic also are available.

A third potential intervention point for energy information occurs after a lender has evaluated underwriting criteria and prepares to approve the loan. For larger mortgages, lenders will require a PCA, which is an engineering report that evaluates the remaining useful life and quality of major mechanical systems in the building. These systems include chillers, boilers and air-handling systems that consume significant amounts of energy.

The PCA ensures a property’s quality and value by acknowledging future maintenance and capital-equipment replacement costs. It also presents an opportunity to assess the presence of efficient, high-performing systems that require less routine attention. A PCA should not occur after the point when information about a mechanical system’s future value could impact the lender’s determination of the mortgage terms, because it does not allow for effective communication of potential energy-use risks or efficiency opportunities.

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Although further investigation is needed into the connections between a building’s energy performance and mortgage risk, detailed information about a building’s energy performance can support appraisers in more accurately valuing commercial buildings and provide lenders with another tool for risk assessment.


 


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