The Economics of Green Retrofits

The Economics of Green Retrofits Nils Kok, PhD Visiting Scholar, University of California, Berkeley Assistant Professor at the University of Maastricht n.kok@maastrichtuniversity.nl Norm Miller, PhD Professor, Burnham-Moores Center for Real Estate University of San Diego nmiller@sandiego.edu Peter Morris Davis Langdon, An AECOM Company pmorris@davislangdon.us

OverviewGreen retrofits are taking the lead• Context: the future is in the past – Most buildings that will be here in 20 years are already here – Historically we build new about 2% of the stock each year• In this session we examine the majority of the renovated office buildings that became LEED under EBOM – Note: today most (87%) LEED EB buildings are Energy Star labeled, something not true prior to 2008 – We provide both a market perspective (survey) as well as market verified (hard data) analysis of benefits and costs• Most of the costs in green retrofits are energy related, but the benefits of greening go beyond energy costs

Green talk…and green walk Financial crisis has slightly dented interest…6,000 30,0005,000 25,0004,000 20,0003,000 15,000 Counts of the usage of "green building" in the popular press2,000 Visitors at "Greenbuild" conference 10,0001,000 5,000 0 0 2005 2006 2007 2008 2009 2010

Green building in the marketplace…but LEED and Energy-Star-ratings have “exploded”

The focus has shifted LEED EB certification now outpaces LEED NC 450 400 350 300Square Feet (in million) 250 200 150 100 50 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 New Construction (NC) Existing Buildings (EB)

A gentle reminder…2007 – 2009 office market dynamicsOffice rents, vacancy rate, and unemployment Office rents –30% Vacancy rate +40% Unemployment +115%

The “economics” are ever more importantFinancial implications of “greening” buildingsA higher initial outlay… – Not clear how much higher (0 – 20%) – But we know to hit LEED Silver is very modest – “Smarter” building managers, software… may be compensated subsequently – Direct cost savings • Energy savings (up to 35%) • Emission reduction – Increased rents, faster absorption, lower turnover • Reputation • Corporate preferences (IAQ, corporate policies) – Lower risk • Increased economic lives • Lower risk (reduced depreciation)

What do we know so far?Effects on demand side have been well-documentedSome evidence on a “green” premium:– Eichholtz, Kok and Quigley (2010, 2011)– Fuerst and McAllister (2011, 2009)– Miller, Florance and Spivey (2009)Some evidence on health and productivity— Singh, Syal, Grady, and Korkmaz (2010, Am J Public Health)— Miller, Pogue, Gough, Davis (2009)Continuing Operations and Management Studies by CBRE & USDBut limited systematic evidence on costs– Case studies on the economic implications focus often on new buildingsAnd most research focused on new construction (LEED NC)– Comparing apples with oranges

This study”The economics of green retrofits”Identify office buildings built before 1990: – Multi-tenant – Renovated to LEED EB:O&M standards – 2005 – 2010 period – Matched age and size of samplesExamine: – Survey attitudes and typical improvements – Impact on rents and occupancy – Cost of typical improvements and possible return results

Sampling methodologyPre-1990 office buildings in 14 MSAs• LEED vs. Non-LEED office building samples – LEED and Non-LEED building samples drawn from the same 14 major U.S. markets where we had the largest number of renovated properties. The total filtered sample included 374 properties.• Data Source: Costar• LEED building criteria: Existing, class A or B, built prior to 1990, minimum 15,000 square feet, multi-tenant only• Non-LEED building criteria: existing, class A or B, built prior to 1990; earliest year built and minimum size varied by market to match average size and age of buildings in LEED sample, multi-tenant only.

LEED EB:O&M sample locationsGeographically diversified across the US

Survey of LEED EB managers and owners• Survey of LEED EB:O&M building property managers and owners• Survey link emailed to 317 property managers in Costar LEED sample (same sample as above but some managers oversaw more than one building)• 41 responses received back (13% response rate).

Survey respondents by LEED certification25% certified, but “Gold” is the standard 5.0% Platinum Certified 22.5% 47.5% 25.0% Gold Silver Source: Survey of LEED buildings in 14 major U.S. markets

Percent improvements related to sustainabilityvs. improvements to merely remain competitive Impossible to Separate 18.2% 30% or Less 36.3% 100% 13.6% 22.7% 9.0% 40%-60% 70%-90% Source: Survey of LEED buildings in 14 major U.S. markets

Major improvements during retrofitStrong focus on energy, but water is increasingly important100% 87.5% 83.3% 83.3% 80% 70.8% 60% 54.2% 41.7% 40% 29.2% 20% 16.7% 8.3% 4.2% 0% Windows Insulation Floors Roof Irrigation Motion Recycling Water Flow HVAC Lighting Systems* Detectors Containers Systems Source: Survey of LEED buildings in 14 major U.S. markets *Includes rain capture systems

Major improvements by certification level Multiple responses allowedResponses 24 20 16 12 8 4 0 Platinum Gold Silver Certified Source: Survey of LEED buildings in 14 major U.S. markets *Includes rain capture systems

Savings on expense items after LEED retrofitReductions in energy and water expenses are universal 100% 100% 95.5% 82.4% 80% 60% 40% 20% 17.6% 4.5% * 0% 0% Water Energy Other Operating Expenses *“Other” responses: Source: Survey of LEED buildings in 14 major U.S. markets Yes No waste removal, recycling, janitorial, landscaping

Change in operating expenses following LEED retrofit 9% noticed an increase (?) Increased Impossible to Estimate 9.1% 18.2% 13.6% No Change 59.1% DecreasedSource: Survey of LEED buildings in 14 major U.S. markets

Expected ROI sustainable-related improvementsComplex for most respondents 30% or Less 22.3% 55.6% 11.2% Impossible to 40%-60% Estimate 11.1% 100% Source: Survey of LEED buildings in 14 major U.S. markets Note: No responses in 70%-90% range

Expected payback in years on sustainable-related improvements Impossible to Estimate 13.6% Less than 5 10+ Years 9.1% Years 45.4% 31.8% 5 to 10 YearsSource: Survey of LEED buildings in 14 major U.S. markets

Market implications?What does this mean for building owners?• Why go “green”? – Regulation – Stay competitive (tenant demand) – Improve asset• The split-incentive problem – Benefits flow to tenants – But this should be reflected in rents

Rent increase following retrofitNo respondents indicated a decrease in rent 8.0% Increased Impossible to Estimate 24.0% 68.0% No change Source: Survey of LEED buildings in 14 major U.S. markets

Current rental level Compared to similar but non-LEED buildings +1% to 5% 21.7% 56.5% 17.4% No Difference +6% to 10% 4.3% +11% to 15%Source: Survey of LEED buildings in 14 major U.S. markets

This is what the data tells us…Average rents on all LEED EB versus non-LEED withrenovations since 2005 $50.00 Rents Non LEED $45.00 Rents EBOM $40.00 $35.00 $30.00 $25.00 $20.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Effects differ per marketLEED EB vs. Non-LEED average rents, 2011, by market$70$60$50$40$30$20$10$0 LEED Non-LEED Source: Costar; criteria: existing buildings, class A or B, built before 1990

Effects differ per marketLEED vs. Non-LEED percent leased, 2011, by market100%90%80%70%60% LEED Non-LEED Source: Costar; criteria: existing buildings, class A or B, built before 1990

Let’s dig a little deeper…LEED and non-LEED are quite similar

Model specificationStandard hedonic pricing model The market implications of “green” certification in commercial office properties:(1)  Rin is the rent or effective rent per sq.ft.  Xi is a vector of hedonic characteristics  Size, age, renovation, class, amenities, public transport, …  City cn dummies to control for location – 14 separate dummies in the sample

LEED EB certification and office rentsPublic transportation matters…

LEED EB certification and office rentsAchieved rents higher by about 7 percent

LEED EB certification and effective cash flowsEffective rents higher by about 9 percent

Financial implicationsEco-investment real estate sector is not only “doing good” Ceteris paribus, green buildings 1. Have higher rents by 7% or about $2 per sq.ft. 2. Have higher effective rents by 9% or about $3 per sq.ft. Effects go beyond energy efficiency alone Respondents indicate investments pass ROI hurdle The missing analytical piece…what is the cost of “greening” properties?

Total dollar amount invested in retrofit Thousands $2,500 $2,093,846 $2,000 $1,500 $1,000 $438,957 $500 $0 Median MeanSource: Survey of LEED buildings in 14 major U.S. markets

Where’s the capital cost in greening building?It’s about energy (mostly)• “Greening” commercial property – Green cleaning – Water re/use and reduction – Transportation – Recycling – Energy use • Optimization/management • Lighting, heating, cooling, ventilation, plug-load

Where does the energy go? Standard Office Building • 500,000 GSF • 12 Stories • Skin Area:135,200 • Skin Ratio: 0.271 • Lighting load normalized at 10.7 kBtu/SF/yr • Plug load normalized At 15.34 kBtu/SF/yr

Where does the energy go? Miami Anchorage (Colder climates as you move to the right on the horizontal axis)

Where does the energy go?Matching the Energy Star Score with Energy Consumption

How do you get to the target?Reducing the ES Score from 50 to 80, 90, 95, 100

How do you get to the reduction target?Primary strategies• Plug load• Lighting• Ventilation• Cooling• Heating

How do you get to the reduction target?Plug Load• Baseline: 10 – 20 kBtu/SF/Yr• Current best practice: 4 – 10 kBtu/SF/Yr – Energy star/best in class appliances – Reduced equipment quantity – Occupancy sensors• Reduction: 6 – 15 kBtu/SF/Yr• Cost: negligible if managed in equipment life cycle

How do you get to the reduction target?Lighting• Baseline: 10 – 15 kBtu/SF/Yr (1.25W/SF)• Current best practice: 4 – 7 kBtu/SF/Yr – T8/T5 Lights – Motion sensors/day lighting control – Task lighting• Reduction: 6 – 8 kBtu/SF/Yr• Cost: $3 - $5/SF (mainly for controls)

How do you get to the reduction target?Ventilation• Baseline: 6 – 10 kBtu/SF/Yr (1.25W/SF)• Current best practice: 3 – 6 kBtu/SF/Yr – Seal ducts – Optimize/commission air handlers – Optimize/commission terminal units – Balance heating & cooling requirements• Reduction: 4 – 5 kBtu/SF/Yr• Cost: $2 - $5/SF• Note: Operable windows are also a possibility but this tends to be a fairly expensive option.

How do you get to the reduction target?Cooling: Basic Strategies• Baseline: 15 – 40 kBtu/SF/Yr (Except zones 6 – 8)• Current best practice: 10 – 20kBtu/SF/Yr – Replace/Optimize primary equipment – Improve controls – Optimize/commission terminal units – Balance heating & cooling requirements• Reduction: 10 – 15 kBtu/SF/Yr• Cost: $3 - $7/SF

How do you get to the reduction target?Cooling: Deeper Strategies• Deeper Strategies – Envelope sealing – Improve glazing: thermal & solar – Reinsulate exterior cladding – Chilled Beams or some form of radiant cooling• Reduction: 10 – 25 kBtu/SF/Yr• Cost: $10 - $75/SF

How do you get to the reduction target?Heating: Basic Strategies• Baseline: 5 – 15 kBtu/SF/Yr (Except zones 6 – 8)• Current best practice: 2 – 8kBtu/SF/Yr – Replace/Optimize primary equipment – Improve controls – Optimize/commission terminal units – Balance heating & cooling requirements• Reduction: 3 – 10 kBtu/SF/Yr• Cost: $1 - $2/SF (over cooling cost)

How do you get to the reduction target?Heating: Deeper Strategies• Deeper Strategies – Envelope sealing – Improve glazing: thermal & solar – Reinsulate exterior cladding• Reduction: 2 – 10 kBtu/SF/Yr• Cost: $10 - $75/SF

How do you get to the reduction target? kBtu/SF/Yr Cost/SF (Reduction)Plug load 6 – 15 0Lighting 6-8 $3 - $5Ventilation 4–5 $2 - $5Cooling 10 - 15 $3 - $7Heating 3 - 10 $1 - $2Total 30 - 50 $10 - $20

How do you get to the reduction target from 50?

How do you get to the reduction target from 60?

How much do you save? That depends on where you are!

How much do you save?

How much do you save? Capitalized Value Impact = $8 to $15/SF from simply the energy savings

Expected payback in years on sustainability-related improvements Impossible to Estimate 13.6% Less than 5 10+ Years 9.1% Years 45.4% 31.8% 5 to 10 YearsSource: Survey of LEED buildings in 14 major U.S. markets

Major improvements during retrofitStrong focus on energy, but water is increasingly important100% 87.5% 83.3% 83.3% 80% 70.8% 60% 54.2% 41.7% 40% 29.2% 20% 16.7% 8.3% 4.2% 0% Windows Insulation Floors Roof Irrigation Motion Recycling Water Flow HVAC Lighting Systems* Detectors Containers Systems Source: Survey of LEED buildings in 14 major U.S. markets *Includes rain capture systems

Reduction in the carbon footprint?

Summing upThe cost-benefit trade-off• Assuming a triple-net rental contract: – Benefits • $2/sf rent increase, $2.7/sf cash flow increase • At current cap rates of 6.5% this translates into $30/sf – $40/sf of value increase • Additional energy costs value impacts in the range of $8 to $15 which accrue to the landlord if a full service lease. – Costs • $10-$20/sf for an energy retrofit saving 30-50kBTu, on average – Other considerations • Lower insurance costs (i.e., Fireman’s Fund) • Reduced tenant turnover will save leasing commissions • Doing good by carbon footprint reduction!

Summing upThe cost-benefit trade-off• The energy part of “green” retrofits seems to make financial sense – On average, benefits outweigh costs especially for the low hanging fruit -- quicker payback options – Deeper retrofits make sense in raising the overall quality and competitiveness of the building in a time of lower opportunity costs – that is after losing a major tenant when occupancy is low• Split incentives are not necessarily impediment – Rents increase, occupancy rates increase – More use of full service leases – More evolution of green leases

Concluding thoughts• Our research shows: – Green retrofits happen, even without accurate knowledge of ROI – Data suggests that average benefits exceed average costs• Negative investment yields for most assets in current market – Increases attractiveness of energy efficiency • Reduces fat tail risk (hedge) • Should have lower return threshold• Payback versus return – are investments capitalized?• What other aspects of “green” are priced?

Thank you……more at PL12 (The Retrofit Triangle) @4pm Nils Kok, PhD Visiting Scholar, University of California, Berkeley Assistant Professor at the University of Maastricht n.kok@maastrichtuniversity.nl www.nilskok.com Norm Miller, PhD Professor, Burnham-Moores Center for Real Estate University of San Diego nmiller@sandiego.edu Peter Morris Davis Langdon, An AECOM Company pmorris@davislangdon.us

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The Economics of Green Retrofits

by nilskok on Oct 19, 2011

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