Addressing the "Green Building Premium"
As LEED celebrates its 10th anniversary this year, one of the most common questions you hear among those unfamiliar with the rating systems is whether it costs more to build/renovate to LEED certification. What they may not realize, however, is that after 10 years and more than 5,000 certified projects, there has been enough research and observation to dispel the notion of a "green premium."
While it is true that in some extreme cases (especially so-called "trophy buildings"), there may be an associated premium with constructing a green building, generally green buildings need not cost anything more than a conventional building. This has to do with the maturity of green buildings in a given market as opposed to some endemic characteristic of green building construction. Like any new entrant to a market, time and experience lead to a reduction in cost until the process/product has become streamlined and a suitable infrastructure has been developed to support it. It makes sense that, at LEED’s inception, a green building premium existed, but as LEED APs have become prevalent, project owners and consultants have gained more project experience, sustainable products have become more available, and construction/renovation processes have evolved, the premium has all but disappeared. A 2008 survey by Turner Construction found that 50% of respondents believed there was no premium associated with green building construction, while just one year later; a study by RREEF Research (PDF) had this to say:
"[C]ost premiums for green construction are now generally thought to be minimal, at least for the less extreme levels of sustainability, and any putative cost premiums can be more than offset by a variety of incentives for which green buildings are eligible. These factors add up to premium returns on new green construction."
Moreover, in the instances where an upfront cost for green building construction or renovation is incurred, that expenditure is often recouped in the first two years the building is operational as a result of increased efficiency of the building and/or benefits garnered by increased rental premiums, leasing velocity, and higher average occupancy levels. Several papers published on the subject have found that green buildings can capture rental premiums anywhere from 3-6 percent above similar non-certified buildings and typically average 8-10 percent higher occupancy levels. Find green building related research »
As LEED continues its steady growth, it stands to reason that entry into the green building marketplace will continue to become easier while the benefits will continue to grow.
Practical Strategies in Green Building: Existing Offices
USGBC’s "Practical Strategies in Green Building: Existing Offices" guide (PDF) is now available for free download. This guide provides office owners and managers of existing buildings with examples of simple green strategies that have helped other projects achieve LEED certification. All of the included strategies are from office projects that successfully achieved LEED for Existing Buildings certification, and provide information that can help project teams and real estate executives better understand and pursue certification under LEED for Existing Buildings: Operations & Maintenance.
Download "Practical Strategies in Green Building: Existing Offices" (PDF) »
Find more green building resources for the commercial real estate market »
The Green 14: Finding Value Points in High-Performance Commercial Real Estate
From the Desk of James Finlay
Commercial Real Estate Appraisal Manger, Wells Fargo
Commercial and investment real estate designed to meet LEED, or other high-performance benchmarks like Energy Star, has been found to have a higher market value than conventionally built or non-certified buildings. Wells Fargo has lent over $3 billion to such projects, and in my role as the principal appraisal manager/reviewer of appraisals for these projects I have looked closely at this question.
There is no different or "special" appraisal process to value a LEED high-performance office building. In fact, the discounted cash flow (DCF) is both the most common market value financial analysis tool and a perfect vehicle to clearly show the various value impacts of high performance design. Real estate financial analysis software programs like Argus use dozens of input fields regarding the building, operations, tenant lease features and investment risk. It takes the complex analysis of income, vacancy, expenses and risk and produces a large spreadsheet modeling a theoretical 10-year holding period and with an asset sale at the end. Net income for every year is then "discounted," or adjusted for the investment risk and the time value of money, to yield a present value as of today or the "date of value."
Many people imagine "value" as just being tied to rent levels, but a DCF shows many influences exist within four general value classes:
The many individual software input fields address every aspect of the property operation and risk. High performance design features have the potential to impact some of these fields – and I call the most common of these the "Green 14." Of course, the actual number for any particular property and situation might vary. The Green 14 breakdown is a good starting point for anyone to consider where high-performance design impacts an actual market value determination.
The "influence" impact on value can be positive, zero, or negative. The important point is that the DCF is an existing and widely accepted valuation method that breaks down value analysis sufficiently to tease out the places where high performance might impact value.
The Green 14
The following is a quick look at these 14 (more or less) individual software inputs for a hypothetical leased office building. Support for adjusting each input for the High Performance (HP) design is based on the typical appraisal process: general market research, specific market data confirmed via interviews with knowledgeable local real estate professionals. The results are filtered thru the appraiser’s experience to reach a credible opinion of value.
While rent premiums have been identified in national studies, an appraisal would need strong specific data, which is currently missing except all but a few sophisticated markets.
Market rent assumption – the expected rent level of any vacant space. Rent premiums are tough to prove as many, many things influence this one number.
This is perhaps the biggest impact as this adjustment is made early in the calculations and even a small adjustment here impacts other items that follow it in the cash flow. For example a minor change in the tenant retention percentage impacts tenant improvement costs, real estate commissions, lost rent during lag vacancy, marketing and lost tenant contributions to operating costs.
Absorption time – applies to new construction, the time it takes for new vacant space to lease. This is particularly important to a lender who wants income for debt coverage. LEED buildings generally have higher levels of pre-leasing and faster lease-up rates.
Stabilized vacancy – based on the overall market vacancy, typically determined using published brokerage studies. Occupancy levels in HP buildings are often above average.
Tenant retention or rollover percentage - When a lease ends, the tenant has the option to leave (which is undesirable) and this is expressed as a retention percentage. Portfolio managers report a higher tenant retention rate in HP buildings.
Lag vacancy – the time it takes to fill a vacancy with a paying tenant.
Tenant improvements: new construction or re-tenanting – a dollar per SF cost for a new or renewing tenant to build out or upgrade their space. Design with raised floor and re-useable demising walls can impact remodel time, cost and waste stream.
Depending on the lease structure, some expenses might be paid by the tenant, some by the landlord and some split. The "split incentive" problem to incent both tenant and landlord to keep costs down is a tricky one addressed with either a NNN (all expenses paid by tenant) lease basis or "green" lease with special clauses.
- Energy - Electricity and gas use is generally documented to be 30% lower in HP buildings, much of that is high efficiency lighting and controls systems
- Water – Both consumption and discharge can impact billing. On-site retention and grey water use, while still not a large cost line item there is little doubt that water, along with carbon, might be the next pricing shock.
- Waste - Recycling programs can reduce costs and might provide an income stream
Repairs and Maintenance – New high performance construction materials hold the promise of lowering maintenance costs but are often untried and not without risk. Some complex high efficiency systems might actually increase the maintenance budget, but in general it lowers costs, sometimes significantly. It covers both personnel and materials.
Management – Sensors and automation features are first cost investments that can help reduce and improve day to day management. Investing in better data allows asset/portfolio managers to better integrate CapEx (capital expenditures) investments and OpEx (operating expenses) savings for simple ROI [Return on Investment] analysis.
Marketing Promotions – Brand or "trophy" value of LEED and Energy Star labels can attract the best tenants and lower vacancy/rollover. This might mean an increase in marketing and costs to maintain certifications like LEED for Existing Buildings: Operations & Maintenance.
Insurance – reduced premiums are offered by some carriers for LEED certified buildings.
Property Taxes – Incentives and low/no assessment adjustment for energy efficiency and on-site power upgrades can exist. Rapidly growing PACE type property tax lien financing can appear as a line item, but should be off-set by lower energy/resource costs.
These inputs adjust for the investment risk, not unlike other rates of return. Lower rates for lower risk investments (like a treasury note) and higher rates for higher risk investments (like junk bonds).
Discount rate - The overall investment risk and opportunity cost, often influenced by the quality of the building, location and tenant quality. Strong, long term tenants equal more reliable rent and net income which results in a lower discount rate.
Terminal cap rate – At the end of the holding period the property is assumed sold. An estimate of that value is estimated using the last year net income and an overall rate of return. Based on current market acceptance of high performance design, chances are good that in 10 years, high performance might be even more than norm than it is now.
So what does all this mean to overall value?
In one case (and they are all unique) I paired DCFs run on a spec mid-rise office building with high performance features vs "old normal" and the value delta was about +4 percent for the HP design. When the building is able to show 3 years operating history this might increase. Other appraisers have quoted 2-8 percent value increase via a DCF so I am in the range. While this can be real money when enough zeros are involved it can also be a rounding error, it’s not a game changer. The real story is in the flip side of value loss for not designing to the new normal. I am currently watching accelerated obsolescence, potentially a much more negative consequence for doing nothing.