By: Alan Scott and Bruce Wood

Green buildings are sprouting up all around the nation. Among the first to sow the seeds of this trend were government agencies, public and private institutions, and corporations that developed their own facilities. This makes sense because these long-term building owners benefit from reduced life cycle costs. They are also responsible for the health of their employees and profit from improved productivity. In addition, they earn public approval by demonstrating good environmental stewardship.

But what about the significant volume of private commercial real estate development? With a few notable exceptions such as 4 Times Square in New York City and Honda America’s LEED® Gold-certified build-to-suit facility in Gresham, Ore., private developers are late bloomers in the green building movement. One of the most significant barriers is that typical financial models for commercial real estate development do not produce the same gains reaped by public and institutional building owners.

Weighing the Returns
Several studies have quantified the costs and benefits of sustainable buildings for long-term owner-occupied buildings. Combined with our first-hand project experience, findings demonstrate that green building and LEED certification can provide significant return on investment through:

• Incremental capital costs ranging from -1% to +6%1, 2, 3
• Energy cost savings of 20% to 60% or more
• Water cost savings of 10% to 30% or more
• Workforce productivity gains of 5% to 16%1, 4, 5

Although these financial analyses emphasized projects that generally have a long investment horizon and a lower cost of capital than private developments, potential advantages of green buildings in commercial development do exist. They may vary depending on the specific development model, but benefits can include:

• Cost neutral or reduced development costs
• Rapid absorption into the market
• Increased Net Operating Income (NOI)/higher rents
• Higher appraised building value
• Reduced vacancy
• Improved public relations and project approval

Private Development Landscape
Commercial developers fall into three basic development models: the merchant developer, owner/developer, and build-to-suit developer. The merchant developer will develop a property and market the building for sale after it is leased, usually less than one year after completion. An owner/developer follows the same model as a merchant developer but will retain the property for an average of ten years. The build-to-suit developer typically owns land and constructs a building to meet a specific tenant’s needs. This developer may maintain the building and lease it to the tenant, sell the building to the tenant, or sell it to a third party real estate investor.

While the core financial proposition for these developers is the same, each has its unique financial drivers. Commercial
developers are guided primarily by the “value = net operating income/rate of capitalization” formula.

To illustrate how the model works for each type of developer, we will examine a hypothetical suburban office development on the next page.

In this example, the developer rents the building for $16.45 per square foot/year triple net (in addition to the rent payment, tenant pays all operating expenses for maintenance, utilities, insurance and taxes), which results in a total net operating income of $1,645,000 per year.

Let’s assume a merchant developer receives an offer based upon a 10 percent return to the investor, so the property is sold for $16,450,000. The profit calculation is simple:

Sale price $16,450,000
Total project costs - $13,700,000
____________________________________
Development profit = $ 2,750,000

The merchant developer’s profit is influenced only by project costs, the first year’s income, and the market value of the property based upon the expected return. Unless sustainable techniques positively impact these variables, the merchant developer has no financial incentive to pursue implementation. While a green building will have lower utility costs, in a triple net lease the tenant will realize these savings.

An owner/developer operates on a longer investment horizon and value is determined using the ten-year cash flow and an Internal Rate of Return (IRR) analysis. Building upon the above scenario, the NOI remains $1,645,000/ year for five years and then increases to $1,809,500 for the next five years, assuming an increase in lease rates. At the end of ten years, the building is sold at a 10 percent cap rate for a total sales price of $18,095,000. The resulting IRR will be 14.07 percent.

Here too, the developer’s return is driven solely by the income and costs. If sustainable measures add to the cost and the income does not include a higher rent to offset this cost, the IRR will be lower, while the tenant reaps the primary benefits.

In build-to-suit developments, tenants and owners can take a more holistic approach when evaluating sustainable practices and often use a capital
budgeting model to determine investment decisions. For example, a tenant may consider an HVAC system that costs $150,000 more than a typical
system, but will reduce the energy costs by $25,000 per year. A typical cost of capital the company would use to evaluate its investment decisions is 15 percent. Over a ten-year lease period with projected savings of $25,000/year, the IRR equates to only 10.56 percent, which does not make the investment financially justifiable. At $30,000/year in savings, the IRR increases to 15.10 percent and meets the tenant’s investment criteria.

Utility incentives are often available to offset the incremental capital cost of energy efficiency measures, usually by as much as 50 percent. If an incentive program paid 50 percent of the incremental cost of the HVAC system, the IRR for the scenario with $25,000/year in savings jumps to 32 percent.

The tenant may also consider the financial benefit of increased worker productivity, estimated in numerous case studies1,4,5 to be greater than 5 percent. These productivity increases are attributed to sustainable strategies such as day lighting, indirect lighting, improved thermal comfort and ventilation. For a company with 500 employees in the example building, a productivity increase of only 1 percent would represent a savings of approximately $250,000 per year.

Fertile Ground
Our research includes two case studies of commercial real estate developments that successfully incorporated green building strategies.

Gerding Edlen Development (GED) developed the Brewery Blocks, a fiveblock retail, commercial office, and residential development in Portland, Ore. that is seeking LEED certification. GED’s Senior Project Manager Dennis Wilde reported that the added cost of green building and LEED certification was less than $1 million - about 0.3 percent of the project cost - and that the project qualified for approximately $1.2 million in utility incentives and state tax credits. The office space leased quickly and the condominiums sold out long before completion of construction. Wilde believes the developer’s leadership is critical to completing a successful green building project.

“Beyond any direct financial benefits, creating green projects is the right thing to do,” said Wilde. “It also gives a developer greater market exposure,
improved public and political relations and enhanced credibility, all of which can have significant value.”

MBC Development, LP is a developer, builder and property manager in Pennsylvania that developed two financially successful LEED Gold-certified build-to-suit office buildings, which they lease to the Pennsylvania Department of Environmental Protection (DEP).

“Implementing all the strategies used in the DEP buildings doesn’t compute for our typical projects, but some technologies are broadly applicable and provide both financial and environmental benefits,” said Jim Miller Jr., director of development at MBC Development.

The strategies Miller found viable include high quality, low-maintenance TPO roofing; pendent mounted direct/indirect lighting that provides high-quality lighting with a 40 percent reduction in lighting energy usage; and rainwater collection systems for toilet flushing, which have a rapid return-oninvestment.

Incentive to Grow
Utility incentives are available in many areas that provide upfront funds to offset incremental costs of more energy efficient building envelopes, HVAC
systems, and lighting. Incentives typically pay for up to 50 percent of the incremental costs but they may also be considered taxable income, which will reduce their value.

Several states, including New York and Oregon, offer tax credits for energy efficient buildings and, in some cases, LEED certified buildings. The Oregon Department of Energy administers a Business Energy Tax Credit that provides two incentive options. The first offers projects a credit worth 35 percent of the incremental costs for implementing energy saving measures. The other option allows projects that achieve at least a LEED Silver rating to take a credit based on the project’s square footage and level of LEED certification. Under this program, the example 100,000 square-foot building would earn a credit worth $52,000 for the premium HVAC system or $140,000 for achieving LEED Silver ($177,435 for Gold).

Gleaning Opportunities
As new studies surface, evidence continues to accumulate regarding the clear advantages of sustainable practices in long-term, owner-occupied buildings. There are also numerous opportunities to make building green financially viable and perhaps even profitable for commercial developers. By selecting specific sustainable strategies, the shift to green building can be cost neutral for developers and conserve diminishing resources. A successful integrated design approach will incorporate technologies and systems that work together to improve performance and offset costs. State governments and utilities can promote and expand energy efficiency incentives and energy/green building tax credits. City governments can provide
new incentives such as Floor Area Ratio (FAR) bonuses for building green, allowing developers to build more leasable space on a given property. Additional incentives could include reduced system development charges based on water efficiency and on-site stormwater management.

Other possibilities will require leadership and initiative by developers, leasing agents, appraisers, lenders and investors as well as changes in the marketplace. When tenants are educated on sustainable benefits and given a choice, they prefer green buildings to conventional ones. These tenants will likely pay a higher fixed cost rent if they can count on lower utility bills and help protect themselves against expected utility increases in the future. Green buildings also provide a higher quality work environment and companies with healthy, productive employees who are comfortable in the workplace are more inclined to renew their leases. While current financial models do not take these issues into account, tenant preference for green buildings is gaining momentum and lenders are beginning to recognize the value of this trend.

According to Dave Harmon, commercial lender for ShoreBank Pacific, high tenant turnover often associated with “sick buildings” is a common red flag for lenders and rising utility costs are increasingly impacting NOI.

“Lenders respond to low vacancy, longer lease terms, and higher NOIs, which are all factors that green buildings can positively influence,” said Harmon.

The Royal Institute of Chartered Surveyors (RICS) is currently conducting a study of government, commercial office, retail and residential properties in the UK, Canada and the United States to establish the links between sustainable building and asset value, taking into consideration factors such as rapid absorption and reduced vacancy (www.rics.org). Savvy developers and real estate investors will capitalize on the green building trend. Those who build and own green buildings and educate their tenants about sustainable benefits will find themselves ahead of the curve and harvesting profits from building green. SLDT