Risk and return in the retrofit market

Investment success is a function of two things – risk and return.

Of course, a big element of any investment is determining the actual level of risk. When a big pension fund acquires a class A commercial space at a 6% cap rate, they’re implicitly saying that the risks of such an investment are commensurate with the likely rate of return on that property.  For those not in the industry, the capitalization rate, or cap rate, equals the annual net operating income divided by the value of the real estate asset.  It is a commonly used metric for understanding and comparing the different implied valuations of various properties.  It can also be thought of as the reciprocal of a valuation multiple.  A 5% cap rate implies a 20x NOI multiple, while a 10% cap rate implies 10x.

So although the thought of a retrofit project that can return 10 to 15% on an unlevered basis sounds attractive relative to the returns for most core real estate assets, which tend to generate between 6.5 and 7.5%, we know from market statistics that these investments are not being made en masse. Armed with basic finance theory, this tells us that investors (the seemingly natural retrofit investor being building owners) may view investments in energy efficiency as risky and thus require a higher level of return than even the rather impressive potential 10 to 15% returns that we believe these investments can currently offer on an unlevered basis.  

But are these retrofits really risky? After all, the potential 10 to 15% return on an energy efficiency investment is significantly greater than what large cap equities generally return, and far more than even the junkiest of CCC-rated junk bond issuances, which can issue 10 year unsecured paper in the 9% area. Can it really be that retrofits are SO risky that they require distressed levels of return to make these investments worth the level of risk? 

We’ll examine this question in detail in our next post.


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