ENERGY EFFICIENCY ECONOMICS:
What You Need to Know
Using sophisticated financial modeling to make the most-informed decisions when upgrading multi-tenant office buildings
In 2001, the U.S. Environmental Protection Agency conducted a review of all of the office buildings that had used its online Energy Star benchmarking system (www.energystar.gov).
A startling statistic came to light: The lowest-scoring buildings used four times as much energy as the highest-scoring ones. Granted, the buildings with the highest scores were extremely energy-efficient. Still, the gulf between them and the lowest-scoring buildings makes one wonder about the magnitude of energy wasted in this country.
The benchmarked buildings included both income-producing and owner-occupied properties.
One might expect income-producing properties to take energy efficiency more seriously than their owner-occupied counterparts because lower energy costs imply higher net operating income (NOI), the mother’s milk of real-estate investors.
However, too many income properties continue to have very inefficient building systems for a variety of reasons: “lowest-first-cost” decision-making, dysfunctional owner/tenant dynamics, and popular myths that lead owners and managers to ignore or reject worthwhile energy upgrades.
If you were to ask a roomful of income-property owners and managers if improved energy efficiency could make their buildings more profitable, competitive, and valuable, most, if not all, probably would say yes. Pose the same question to a roomful of engineers, vendors, and consultants, and most probably also would say yes. However, only those who understood leasing and real estate finance would be able to support their yes with compelling mathematics.
To make the most-informed decisions when selecting energy projects to approve, it is vital to know how a property’s leases might allocate energy savings between the owner and the tenants (see the sidebar “Understanding the Basic Types of Leases”), how much the tenants would be obligated to contribute toward the cost of an expense-reducing capital project, how the owner’s share of savings could boost NOI, and how a higher NOI could support an increase in appraised value. Clearly, replacing myth with math goes a long way toward better decision-making regarding energy throughout the life cycle of a typical income property.
This article offers new time- and cost-effective best practices for analyzing the merits of proposed energy-efficiency upgrades to multi-tenant; income-producing office properties (see the sidebar “Huge Potential in Office Sector”). Keep in mind that, as with most analytical approaches, the “devil is in the details.” The ultimate value of this analysis depends on many factors, such as the reliability of projected costs and savings and the volatility of utility prices. Moreover, unless energy-saving equipment is properly installed, intelligently operated, periodically re-commissioned, and otherwise well maintained, any predicted savings may prove elusive. In multi-tenant buildings, other devilish details, such as disturbances associated with installations, can be important as well. Fortunately, knowing about each of these issues is the first step in addressing them. Each year, countless energy-saving projects are successfully implemented in income properties because the right questions were asked and answered at the right time.
WHO PAYS? WHO BENEFITS?
Before you can quantify the value of improved energy efficiency in a leased property, you need to evaluate carefully who will pay for the improvement and who will benefit from it (see the sidebar “Calculating the Owner’s Share of Savings”). Only then can you take the next step: determining how those savings might drive improved profitability, competitiveness, and value.
Take the example of an income producing office building. If the operating expenses are lowered, the owner, the tenant(s), or both will realize the savings, depending on the expense sharing provisions of the leases and certain other factors. The portion of the savings that goes to the owner will increase NOI, which, in turn, could improve the appraised value of the building when it is refinanced or sold.
Meanwhile, the improved comfort and convenience that often accompany energy-efficiency upgrades may help with tenant retention and attraction. The portion of the savings captured by the tenant will lower occupancy cost, which will improve the tenant’s ability to pay rent. The combination of energy savings and the improved look/feel of the space may make the tenant more interested in renewing the lease.
The moral of the story: It does little good for engineers to focus on kilowatts, kilowatt-hours, simple payback period (SPP), and other commonly used metrics to describe and evaluate projects if they forget to consider other vital issues, such as who would pay for the upgrade, who would benefit, and the downstream effects of the projected energy savings.
WINNING STRATEGIES NEED - WINNING MECHANISMS
According to Jim Collins, internationally known management expert, even the best strategies will fail without well conceived mechanisms for executing them. If you are serious about saving as much energy as possible:
• Have you adopted best practices for finding, evaluating, and approving expense-reducing capital projects for your properties?
• Do you apply these best practices on a systematic, portfolio-wide basis so that you know you are focusing your limited time and capital on the most promising upgrade opportunities at all times?
• Are you on the lookout for rebates and other incentives (tax credits) so you can be sure you are not missing “free money” (see the sidebar “The Money Is Out There”) that could help you improve your properties?
• In the case of income-producing properties, does every proposed expense reducing capital project include a financial analysis of who would pay for the improvement, which would get the savings, and how that allocation of costs/savings might influence the owner’s total return?
• If you are an engineer, a vendor, a contractor, or a consultant advising a client on opportunities to improve energy efficiency, do your analyses go beyond SPP and consider the impact of the estimated energy savings on your client’s business?
These are just some of the questions that need to be answered with a yes if you want your winning strategies to have a positive impact on the bottom line. Applying energy-saving strategies to properties and projects becomes more practical if you keep a few key lessons in mind:
Expense-reducing capital projects must be positioned properly to compete for two precious commodities: time and money.
There is only so much “management bandwidth” to select and pursue initiatives. Similarly, there is only so much capital to fund even the best projects. Staff cutbacks and the current economy have only tightened these two constraints.
Whether you work with owner-occupied or income-producing property, can you honestly say that energy-saving projects compete effectively for the owner’s time and money? Might there be ways to raise the perceived importance of energy projects so that they receive the attention they deserve?
Does your organization need to grow its income properties’ NOI and asset value? Could low-risk, high-return expense-reducing capital improvements to your existing portfolio provide “internal growth” that would offset the present lack of opportunities for “external growth” (i.e., building or buying additional properties)?
If you are a vendor or service provider, do you understand your prospect’s business well enough to position your offerings as being more compelling than whatever else may be distracting the decision-makers?
Finding the opportunities that most deserve a share of that finite time and capital requires a systematic, portfolio-wide approach.
This implies that (1) all decision-making criteria are clearly listed and prioritized; (2) the building portfolio is systematically screened for these criteria in the order of least to most expensive to study; (3) the decision-making chain is well-defined, and each stakeholder in that chain understands not only his own goals, objectives, and responsibilities, but those of the stakeholders directly above and below him; (4) all of the costs and benefits are analyzed; and (5) the cost/benefit analysis is communicated in a language that all stakeholders can understand.
When it comes to devising a strategy for pursuing energy savings, have all of the decision-makers agreed on which criteria make projects the most compelling?
If you are working with a large, geographically dispersed building portfolio, has a top-level screening of all buildings been performed so that the top projects worth pursuing can be ranked?
Is there a well-defined decision chain from the person with the authority to approve the project down to the frontline person charged with finding/evaluating the opportunities?
Are the downstream benefits of improved energy efficiency fully understood by the individuals preparing the proposals? Do these individuals know how to quantify the positive impact reduced operating expenses have on NOI and appraised value? What about the positive effect lower operating expenses can have on tenant retention and attraction?
Do they realize that lower operating expenses may allow the owner to set lower expense stops for leases signed after the upgrade is completed?
Do you find your engineers trying to convince senior management to fund energy upgrades with elaborate analyses calibrated in kilowatt-hours, therms, or other decidedly non-financial language?
If you are an income-property owner, wouldn’t it be great if your energy-service company took the time to translate projected energy savings into benefits that you consider when making other capital decisions?
If you get the right answers by asking the wrong questions, you are just lucky.
So many building owners, property managers, and vendors/contractors are guilty of placing too much emphasis on SPP. This mistake is particularly egregious in the case of income properties.
If you own/manage a multi-tenant office building, which do you think is more important to know: the SPP of a project or who would get the savings—the owner or the tenant(s)? Would it surprise you to learn that, depending on the leases in place, a four-year SPP project may be a more profitable investment than a two-year SPP project when viewed from the owner’s perspective (Figure 3)?
How do you feel about your project being judged solely on the merits of its SPP, with financial benefits realized after the SPP ignored?
In the absence of math, decisions often are governed by myths. Do not let fiction fill the vacuum left by a lack of facts. Blindly accepted myths and inappropriately applied “rules of thumb” play a major role in the continued waste of energy in this country. When selecting projects to fund, you need to know the facts. Who pays? Who benefits? You need access to tools that deliver actionable information automatically. If your financial analysis requires an impractical level of time and effort, it will not get done, especially if you need to see multiple scenarios before approving a project. If your people lack the time or skills to perform and present these calculations, you should consider outsourcing the financial analysis to someone who has Automated the number-crunching.
In the case of a multi-tenant building, are the people who approve/reject capital expenses the same people who signed the existing leases? If not, have they at least read the leases lately? How much of the energy cost is paid by the owner? How much of the projected upgrade’s savings would inure to the landlord on a tenant-by-tenant, month-by-month basis? Can the owner assess tenants for capital?
Improvements that reduce operating expenses for tenants?
If you are an engineer recommending an energy-saving capital project for a multi-tenant building, have you detailed the costs/savings of the project on a tenant-by-tenant and common-area basis? Do you know how much of the projected savings will inure to the owner and how much capital cost could be assigned to the tenants according to the terms of the existing leases? Do you have a best practice of including a leasing analysis in every proposal you present to multi-tenant building owners/managers?
See the sidebar “Winning Strategies, Winning Mechanisms” for three sets of strategies and mechanisms you might want to consider adopting.
What You Need to Know
Using sophisticated financial modeling to make the most-informed decisions when upgrading multi-tenant office buildings
In 2001, the U.S. Environmental Protection Agency conducted a review of all of the office buildings that had used its online Energy Star benchmarking system (www.energystar.gov).
A startling statistic came to light: The lowest-scoring buildings used four times as much energy as the highest-scoring ones. Granted, the buildings with the highest scores were extremely energy-efficient. Still, the gulf between them and the lowest-scoring buildings makes one wonder about the magnitude of energy wasted in this country.
The benchmarked buildings included both income-producing and owner-occupied properties.
One might expect income-producing properties to take energy efficiency more seriously than their owner-occupied counterparts because lower energy costs imply higher net operating income (NOI), the mother’s milk of real-estate investors.
However, too many income properties continue to have very inefficient building systems for a variety of reasons: “lowest-first-cost” decision-making, dysfunctional owner/tenant dynamics, and popular myths that lead owners and managers to ignore or reject worthwhile energy upgrades.
If you were to ask a roomful of income-property owners and managers if improved energy efficiency could make their buildings more profitable, competitive, and valuable, most, if not all, probably would say yes. Pose the same question to a roomful of engineers, vendors, and consultants, and most probably also would say yes. However, only those who understood leasing and real estate finance would be able to support their yes with compelling mathematics.
To make the most-informed decisions when selecting energy projects to approve, it is vital to know how a property’s leases might allocate energy savings between the owner and the tenants (see the sidebar “Understanding the Basic Types of Leases”), how much the tenants would be obligated to contribute toward the cost of an expense-reducing capital project, how the owner’s share of savings could boost NOI, and how a higher NOI could support an increase in appraised value. Clearly, replacing myth with math goes a long way toward better decision-making regarding energy throughout the life cycle of a typical income property.
This article offers new time- and cost-effective best practices for analyzing the merits of proposed energy-efficiency upgrades to multi-tenant; income-producing office properties (see the sidebar “Huge Potential in Office Sector”). Keep in mind that, as with most analytical approaches, the “devil is in the details.” The ultimate value of this analysis depends on many factors, such as the reliability of projected costs and savings and the volatility of utility prices. Moreover, unless energy-saving equipment is properly installed, intelligently operated, periodically re-commissioned, and otherwise well maintained, any predicted savings may prove elusive. In multi-tenant buildings, other devilish details, such as disturbances associated with installations, can be important as well. Fortunately, knowing about each of these issues is the first step in addressing them. Each year, countless energy-saving projects are successfully implemented in income properties because the right questions were asked and answered at the right time.
WHO PAYS? WHO BENEFITS?
Before you can quantify the value of improved energy efficiency in a leased property, you need to evaluate carefully who will pay for the improvement and who will benefit from it (see the sidebar “Calculating the Owner’s Share of Savings”). Only then can you take the next step: determining how those savings might drive improved profitability, competitiveness, and value.
Take the example of an income producing office building. If the operating expenses are lowered, the owner, the tenant(s), or both will realize the savings, depending on the expense sharing provisions of the leases and certain other factors. The portion of the savings that goes to the owner will increase NOI, which, in turn, could improve the appraised value of the building when it is refinanced or sold.
Meanwhile, the improved comfort and convenience that often accompany energy-efficiency upgrades may help with tenant retention and attraction. The portion of the savings captured by the tenant will lower occupancy cost, which will improve the tenant’s ability to pay rent. The combination of energy savings and the improved look/feel of the space may make the tenant more interested in renewing the lease.
The moral of the story: It does little good for engineers to focus on kilowatts, kilowatt-hours, simple payback period (SPP), and other commonly used metrics to describe and evaluate projects if they forget to consider other vital issues, such as who would pay for the upgrade, who would benefit, and the downstream effects of the projected energy savings.
WINNING STRATEGIES NEED - WINNING MECHANISMS
According to Jim Collins, internationally known management expert, even the best strategies will fail without well conceived mechanisms for executing them. If you are serious about saving as much energy as possible:
• Have you adopted best practices for finding, evaluating, and approving expense-reducing capital projects for your properties?
• Do you apply these best practices on a systematic, portfolio-wide basis so that you know you are focusing your limited time and capital on the most promising upgrade opportunities at all times?
• Are you on the lookout for rebates and other incentives (tax credits) so you can be sure you are not missing “free money” (see the sidebar “The Money Is Out There”) that could help you improve your properties?
• In the case of income-producing properties, does every proposed expense reducing capital project include a financial analysis of who would pay for the improvement, which would get the savings, and how that allocation of costs/savings might influence the owner’s total return?
• If you are an engineer, a vendor, a contractor, or a consultant advising a client on opportunities to improve energy efficiency, do your analyses go beyond SPP and consider the impact of the estimated energy savings on your client’s business?
These are just some of the questions that need to be answered with a yes if you want your winning strategies to have a positive impact on the bottom line. Applying energy-saving strategies to properties and projects becomes more practical if you keep a few key lessons in mind:
Expense-reducing capital projects must be positioned properly to compete for two precious commodities: time and money.
There is only so much “management bandwidth” to select and pursue initiatives. Similarly, there is only so much capital to fund even the best projects. Staff cutbacks and the current economy have only tightened these two constraints.
Whether you work with owner-occupied or income-producing property, can you honestly say that energy-saving projects compete effectively for the owner’s time and money? Might there be ways to raise the perceived importance of energy projects so that they receive the attention they deserve?
Does your organization need to grow its income properties’ NOI and asset value? Could low-risk, high-return expense-reducing capital improvements to your existing portfolio provide “internal growth” that would offset the present lack of opportunities for “external growth” (i.e., building or buying additional properties)?
If you are a vendor or service provider, do you understand your prospect’s business well enough to position your offerings as being more compelling than whatever else may be distracting the decision-makers?
Finding the opportunities that most deserve a share of that finite time and capital requires a systematic, portfolio-wide approach.
This implies that (1) all decision-making criteria are clearly listed and prioritized; (2) the building portfolio is systematically screened for these criteria in the order of least to most expensive to study; (3) the decision-making chain is well-defined, and each stakeholder in that chain understands not only his own goals, objectives, and responsibilities, but those of the stakeholders directly above and below him; (4) all of the costs and benefits are analyzed; and (5) the cost/benefit analysis is communicated in a language that all stakeholders can understand.
When it comes to devising a strategy for pursuing energy savings, have all of the decision-makers agreed on which criteria make projects the most compelling?
If you are working with a large, geographically dispersed building portfolio, has a top-level screening of all buildings been performed so that the top projects worth pursuing can be ranked?
Is there a well-defined decision chain from the person with the authority to approve the project down to the frontline person charged with finding/evaluating the opportunities?
Are the downstream benefits of improved energy efficiency fully understood by the individuals preparing the proposals? Do these individuals know how to quantify the positive impact reduced operating expenses have on NOI and appraised value? What about the positive effect lower operating expenses can have on tenant retention and attraction?
Do they realize that lower operating expenses may allow the owner to set lower expense stops for leases signed after the upgrade is completed?
Do you find your engineers trying to convince senior management to fund energy upgrades with elaborate analyses calibrated in kilowatt-hours, therms, or other decidedly non-financial language?
If you are an income-property owner, wouldn’t it be great if your energy-service company took the time to translate projected energy savings into benefits that you consider when making other capital decisions?
If you get the right answers by asking the wrong questions, you are just lucky.
So many building owners, property managers, and vendors/contractors are guilty of placing too much emphasis on SPP. This mistake is particularly egregious in the case of income properties.
If you own/manage a multi-tenant office building, which do you think is more important to know: the SPP of a project or who would get the savings—the owner or the tenant(s)? Would it surprise you to learn that, depending on the leases in place, a four-year SPP project may be a more profitable investment than a two-year SPP project when viewed from the owner’s perspective (Figure 3)?
How do you feel about your project being judged solely on the merits of its SPP, with financial benefits realized after the SPP ignored?
In the absence of math, decisions often are governed by myths. Do not let fiction fill the vacuum left by a lack of facts. Blindly accepted myths and inappropriately applied “rules of thumb” play a major role in the continued waste of energy in this country. When selecting projects to fund, you need to know the facts. Who pays? Who benefits? You need access to tools that deliver actionable information automatically. If your financial analysis requires an impractical level of time and effort, it will not get done, especially if you need to see multiple scenarios before approving a project. If your people lack the time or skills to perform and present these calculations, you should consider outsourcing the financial analysis to someone who has Automated the number-crunching.
In the case of a multi-tenant building, are the people who approve/reject capital expenses the same people who signed the existing leases? If not, have they at least read the leases lately? How much of the energy cost is paid by the owner? How much of the projected upgrade’s savings would inure to the landlord on a tenant-by-tenant, month-by-month basis? Can the owner assess tenants for capital?
Improvements that reduce operating expenses for tenants?
If you are an engineer recommending an energy-saving capital project for a multi-tenant building, have you detailed the costs/savings of the project on a tenant-by-tenant and common-area basis? Do you know how much of the projected savings will inure to the owner and how much capital cost could be assigned to the tenants according to the terms of the existing leases? Do you have a best practice of including a leasing analysis in every proposal you present to multi-tenant building owners/managers?
See the sidebar “Winning Strategies, Winning Mechanisms” for three sets of strategies and mechanisms you might want to consider adopting.
Compiled by: YJ Draiman
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