August 11, 2020

Devil is in the Details: The Impact of Energy Efficiency Improvements on Building Valuation

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Sound business considerations, coupled with growing regulatory requirements, are driving commercial real estate owners and investors to better understand how building energy performance can impact building valuation. Energy saving improvements can have a significant impact on a building’s net operating income (NOI) and asset value.

Business driving forces associated with energy efficient buildings stem from many potential competitive advantages, including:

• Reduced operating costs
• Higher valuation
• Rental rate premium
• Lower vacancy (improved tenant retention and acquisition)
• Reduced exposure to future energy price volatility
• Less risk of obsolescence.

Energy improvements will make the building more competitive in the marketplace and, when it comes time to sell, increase its marketability and value.

In addition, growing regulatory energy performance disclosure requirements are placing a premium on energy efficient buildings. Currently three states, twenty-seven cities and two counties have passed building energy performance disclosure legislation and regulations. Many more jurisdictions have expressed interest in following suit. These disclosure policies require commercial building owners to disclose their building’s energy consumption and benchmark it against peers, with the results often made publicly accessible. The goal of these legislative initiatives is straightforward: reward energy efficient buildings and incentivize similar behavior by other building owners. Investments in energy efficiency will better position a property within the spectrum of other properties in the marketplace. For example, a building that is an energy under-performer compared to its peers could find both its competitive position and its valuation negatively impacted.

Energy Efficiency Improvements and Building Valuation

One of the most straightforward value propositions supporting energy efficiency improvements to a building is lower utility bills. The resulting energy savings reduce operating expenses and increase NOI which can have a positive impact on the building’s value.

Value attributed to these expense savings is often dependent on lease structure. Owners can directly recoup these savings when they are responsible for utility payments, e.g., if the building is owner-occupied or if the tenants have a gross lease (a property lease in which the landlord agrees to pay all expenses normally associated with ownership, such as taxes, utilities and insurance). For these owners, even small energy savings can be magnified during building valuation.

In buildings where tenants have triple-net leases, i.e., where they are responsible for utility costs (in addition to taxes and insurance), owners must pay for energy efficiency upgrades and therefore may have little motivation to make such investments because their tenants would be the sole beneficiary of the benefits. Under these types of leases, the owner’s NOI would not be reduced by the energy savings. Such situations produce a misaligned (or split) incentive.

While tenants are always interested in paying lower utility bills, making an investment in a building they do not own can be an unrealistic expectation. Fortunately, a new type of lease, the “green lease,” is growing in popularity that better aligns tenant and owner interests for investments in energy efficiency and sustainability. An important clause included in green leases involves cost sharing. Cost sharing clauses allow owners to pass all or a portion of the cost of an energy efficiency investment on to their tenants. Owners benefit from an investment that increases the desirability and value of their asset, and tenants benefit from reduced, and often significantly reduced, monthly operating costs.

Operational cost savings on maintenance can also convey value. Building owners stand to lower maintenance costs by installing longer-lived or more durable components such as LED lighting.

In a growing number of markets, rental premiums are emerging for energy efficient buildings as forward-thinking tenants, often with corporate sustainability policies to reside in sustainable space, are increasingly willing to pay a premium. For these tenants, leasing energy efficient space is an opportunity to demonstrate a commitment to sustainability, attract the best employees and improve productivity.

Occupancy premiums can also support energy efficiency investment. If it can be determined that a more energy efficient building will result in higher occupancy than an otherwise similar, but less energy efficient building, a powerful argument can be made for a higher value. Moreover, savings may be experienced from tenant retention and the corresponding reduction in lost rents, reduced retrofit costs upon releasing of space, lower vacancy at turn-over and improved lease terms.

Finally, energy efficient building value may also show up in the risk-mitigating protections these assets offer to owners and banks. In the appraisal and underwriting process, energy efficient buildings can offer hedges against changing consumer preferences as well as new laws and increasing energy prices. Best-in-class market position can future-proof assets and serve to protect the going-out cap rate.

Estimating the Valuation Impact of Energy Efficiency Improvements

Valuation of a building is designed to represent its current marketable value. One method of valuation frequently used in commercial real estate investing is the net income approach. The net income approach often relies on determining the annual capitalization rate (most often referred to simply as the cap rate) for an investment. It typically is derived from the sale of properties with similar risk and return profiles – to reflect investor requirements for a particular property type. It can be calculated by dividing the building’s projected annual net income by the current value of the property. So, if an office building is currently valued at $5,200,000 and the annual income from rentals is $504,400, the cap rate can be calculated as follows: 

$504,400 / $5,200,000 = 0.097 or 9.7%

Cap rates are generally available for most market and submarket locales for each major commercial building type, and local commercial brokers closely follow them. The NOI of a property is its rent less its operating expenses (excluding finance costs) with energy costs generally a major component of these expenses (assuming owners are responsible for energy costs). For example, energy costs can be the single largest operating expense in commercial office buildings, often representing approximately one-third of the operating cost budget.

Hence, if the NOI of a building is increased because of energy saving improvements (and any maintenance cost savings that might be associated with these improvements), the impact on valuation can be estimated.

Value = (NOI_After – NOI_Before ) / Cap Rate

Assuming all other operating expenses remain the same except for the reduction in utility costs:  

(NOI_After – NOI_Before ) = Energy Cost Savings

The energy cost savings associated with the energy efficiency or renewable energy improvements therefore have a direct and proportional impact on the asset value.

Example

A leading brokerage firm’s report indicates that Class A office buildings located in the central business district (CBD) of Wilmington, North Carolina currently reflect cap rates in the range of 6.80%. An energy audit was conducted on a Class A office building in the CBD of Wilmington where tenants had gross leases. The audit report recommended five energy efficiency improvements that would result in an annual energy consumption savings of 480,500 kWh with an annual energy cost savings of $40,850. The potential positive impact on building valuation, after consideration of the costs to implement the five energy efficiency improvement measures, and assuming all expenses other than utility costs remain the same, can be estimated as follows:

Hence, the investment in energy efficiency improvements would result in an estimated asset value increase of slightly more than $600,000.

Fortunately, a new generation of software, data and predictive analytic solutions are emerging specifically designed to empower project developers and energy efficiency contractors to provide a preliminary assessment of the impact energy efficiency improvements have on building (asset) value. This represents a particularly important metric for building owners/investors and asset managers that desire to maximize property valuation at the time of sale.

To learn more about how energy efficiency professionals are successfully meeting these challenges with SRS’s latest innovation: The Energy Performance Improvement Calculator (EPIC^TM), visit SRSworx.com.