Decision making contexts: How do building owners decide what to do?

Green Building Finance Consortium v1

Now, we may be biased because Geoff is a contributing author to the book, but we honestly can’t think of a book more fundamental to the emerging field of energy efficiency finance than Scott Muldavin’s Value Beyond Cost Savings: How to Underwrite Sustainable Properties, published through the Green Building Finance Consortium (GBFC).  We will try not to go overboard, but every so often we will do a write up of an important concept in the book and what it means for energy efficiency financing.

Today’s topic is the GBFC’s framework for how real estate decisions are made by owners.  The framework breaks decisions relating to real estate into 3 levels: strategic, tactical, and property-specific.

Strategic questions would include considerations like “should we invest.” Tactical decisions would be something like “which properties?” And of course, property-specific considerations are the next level of detail – “are the returns of an energy efficiency investment at a particular property sufficient to compensate for the risks taken?” Or “what efficiency measures should we implement in a particular building?”

The thing that is most intriguing about this framework is that it can help explain one of the things that some energy efficiency advocates find so frustrating about building owners – namely the tendency for a number of senior real estate people to fully agree, understand, and even evangelize the fact that energy efficiency is a great investment. Yet many of these exact same senior real estate people do not pursue energy efficiency to the most economically efficient extent that is possible in their own portfolios.

Where is the missing link? We think the GBFC’s decision level framework sheds some light on this situation. It’s very easy for a real estate owner to pick up a research report or look at broad data trends and understand that, at a high level, investing in energy efficiency makes intuitive sense. This is why the strategic decision, “should we invest in energy efficiency,” is often the easiest.

The next level of tactical decision making is where things begin to get difficult for decision makers. Let’s assume a building owner has made the strategic decision that retrofits are broadly good investments and wants to invest. Now how do they implement that in their buildings? The difficulty is that the quality of the data at a tactical level is not nearly as good or as widely accessible as the strategic level data. While an owner can certainly take CBECS data and make broad inferences regarding energy usage and building type, the reality is that the data are not really sufficient to make a fully defensible fiduciary decision.

This lack of tactical data and support often requires the owner to hire an energy auditor or outside consultant to analyze a building portfolio and develop the tactics for how to choose the best retrofit candidates. As the building owner implicitly knows, this expense is merely exploratory, as tactical decisions are still one level away from property level decisions, where real life real estate decisions must be made. The end result: a material expense with uncertain returns.

Of course, if a building owner makes it past the tactical stage, the real thorny questions appear. What will the particular tenants in this building think? Is the building separately sub-metered? None of these questions by themselves are insurmountable, but in aggregate, they serve as a psychological barrier that can often keep a building owner from making the decision to undertake a retrofit. Death by a thousand cuts strikes again.

The key takeaway from the decision making framework is that although the business case has been established for retrofits at a strategic level, this does not necessarily translate into implementation. To use an analogy, every corporation knows it must be innovative. Any corporate board would obviously support such a strategic statement. However, the difficulty arises in how to tactically apply these things to the daily operations of a business. How does a company take “innovation” and turn it into something actionable? It is clearly very difficult.  Turning back to energy efficiency, from a building owner’s perspective, a “retrofit” can be something almost as abstract and hard to implement as a concept like innovation. It is up to energy efficiency advocates to help owners make the appropriate tactical and property level decisions that are necessary to make a retrofit a reality.

Creating a market for energy efficiency investment: Why securitization doesn’t matter (at least for the next 10 years)

If only we could just consistently originate and securitize loans for building energy efficiency retrofit projects, we could flood the energy efficiency market with cheap capital, overcome the aggregation problems we’ve covered here, and put the market well on its way toward scaling building energy efficiency. And thus many market participants seem to be on the quest for the holy grail of securitization. But I think embarking on that quest today is misguided.

Now, let me be clear. I do think that secondary markets for energy efficiency loans would be beneficial to energy efficiency for a number of reasons. Because a secondary market would provide additional liquidity for lenders in building energy efficiency projects, this would reduce the required return hurdle for energy efficiency projects, theoretically boosting the number of projects that would meet that hurdle. Moreover, since we know that on average building retrofits perform quite well but individual projects can vary somewhat widely around an average, the diversification provided by a portfolio or package of energy efficiency loans should reduce risk and lower required returns. Pooling energy efficiency loans together to make a larger security to sell to institutional investors would help overcome the “too small to care” problem. Sounds great right? After all, isn’t lowering the barriers to capital investment in energy efficiency what we’re all about here at Financing Efficiency?

Well, yes, of course. But the point of this post today is not to deflate the idea that securitization is a good idea or that it will one day play an important role in the energy efficiency finance market, but merely point out that the road between today’s energy efficiency finance market and a future where the energy efficiency finance markets are liquid enough to securitize packages of energy efficiency loans is a long and arduous one.

We can start by looking at the historical precedent for securitized markets. The first and most famous (or infamous at this point) securitization market is the residential mortgage backed security market, the biggest securitization market globally.*

The development of the securitized mortgage market really depended on three things:

1) Historical data for housing defaults. Given the massive volume of mortgages that had been written in the post-World War 2 era, there was plenty of data for investors, rating agencies, Government Sponsored Entities like Fannie Mae and Freddie Mac, banks, mortgage brokers and others to convince themselves that securitization of mortgage backed loans was a safe investment (or at least that the risk of a set of loans could be accurately priced). Now, while it turned out that a lot of this risk was severely mispriced, the historical default data was still a critical first step in establishing the market.

How does this apply to energy efficiency? The efficiency industry is clearly making progress toward standardizing the data around energy efficiency investment returns through a number of efforts, including the Living Cities / Deutsche Bank project, the DOE project to produce an actuarial quality database showing historical retrofit project performance, and continually improving Measurement & Verification programs from groups such as IPMVP.

This important progress notwithstanding, it is still difficult today to get primary lenders comfortable with energy efficiency, and it will certainly take even more time to get institutional investors in the secondary market comfortable.

2) Standardized mortgage documentation. Most mortgages look pretty much the same. And that’s important, because in order to tranche together a pool of mortgages to be sold to investors, the documentation should be substantially similar across the entire portfolio. Otherwise it’s too hard for investors to evaluate the risks of the portfolio.

Standardized energy efficiency investment documentation? Not so much. MESA, EPC, ESA, ESPC, etc, etc. Thankfully, many organizations are making progress on this front as well, like BOMA (standardized ESCO contracts) and Empire State Building (freely publishing their performance contracts). But broadly speaking, the market has yet to settle on standard documentation that works for all involved parties, and until that happens, it will be very difficult to securitize large packages of energy efficiency investments.

3) Balance of supply and demand for the product. Mortgage backed securities made for a great securitization market because of huge amounts (trillions of dollars a year) of supply coming from mortgage originators on the one hand, and voracious demand from pension funds, hedge funds, insurance companies, etc for the securities on the other hand.

Based on conversations with a number of secondary market investors, demand for investment in energy efficiency definitely exists today. The key bottleneck here though is supply. All it takes is a look around at the number of programs that have way too much money to spend (DC’s $250 million program – $5 million spent to date; Con Edison’s financing program of $100+ million – $5 million spent to date) to see evidence that supply of energy efficiency investments remains paltry at best.  Additionally, most of these programs sweeten the deal for existing retrofit projects rather than helping to create actual retrofit securities. Until a category of investments that pay returns purely through the success of a retrofit project emerges, securitization will be impossible. And because most arrangers of securitization products require at least $75 – $100 million of minimum size before they could be sold to the secondary market, this will be a serious hurdle to overcome in the near term.

The Path Forward

 In our view, the barriers to securitization can all be overcome by increasing supply. More origination of energy efficiency investments means more data points to help investors price the risk. More energy efficiency investments will also help to standardize documentation as building owners, third party capital providers, and energy efficiency developers work out the kinks and come to agree on a set of contracts that works for stakeholders.

So my advice to energy efficiency securitization advocates is not to ignore the potential benefits of securitization, but rather to avoid putting the cart before the horse – the market will need to see a lot more energy efficiency loans and investments before a working secondary market can develop. Driving primary investment in energy efficiency projects should be the focus now.

*This post will largely ignore the huge structural difficulties the crisis exposed, and instead focus on how the RMBS market got built in the first place. I’d be happy to discuss the crisis and how that would affect building energy efficiency securitization in more detail in the comments.

“Mind the GAAP” – Why off-balance sheet financing is essential for retrofits

One of the main barriers to financing energy efficiency in privately owned real estate is the challenge posed by incurring additional debt.  Most privately-owned buildings are either unable to assume additional debt or are faced with difficult restrictions on taking on more debt.  Currently, the Financial Accounting Standards Board (FASB) is contemplating changing accounting standards to classify many different types of potential financing for efficiency projects as debt.

The primary change the FASB is contemplating is a convergence with the IFRS system used by the International Accounting Standards Board (as opposed to GAAP used by FASB).  The changes relate to the treatment of capital leases vs. operating leases.  Currently, capital leases qualify as debt and must be carried as a liability on a company’s balance sheet.  Operating leases are classed as off-balance sheet, and therefore do not increase the indebtedness of a company.  Under the IFRS system, operating leases are effectively removed, and all leases qualify as debt.

Most buildings are purchased through a capital structure representing a split of debt and equity.  This is similar to how a homeowner purchases a house – there is a down-payment (equity) and a loan from a bank (debt).  In the case of privately-owned real estate, the equity portion is put down by the investor, and the debt is traditionally sourced from a large lender, often an investment bank.  The primary portion of the debt, the first mortgage, has many covenants attached to it.  Covenants are conditions imposed on the owner in return for the loan.  A common covenant is that the first mortgage holder (the lender) requires the building owner to receive permission before assuming additional debt beyond some agreed upon level (generally very small).  Similarly, many loans have limits on the amount of additional indebtedness that a building can assume vs. its value or income.  Currently, a lot of commercial buildings are “underwater” because their values have fallen relative to the peak of the market when the loans were written.  The total amount of debt on the building has not changed, but the ratio of value to debt has decreased. Therefore, due to market movements, many buildings may have either passed levels of total indebtedness dictated in mortgage covenants or are significantly closer to them.

If a building owner does not want to pay cash for energy efficiency retrofits, the owner will have to seek some sort of outside financing.  Traditionally, owners have sought loans to cover additional investments, seeking to pay off the loans through the proceeds of the investment.  Given the current status of their buildings and the various covenants in the first mortgage, it is very difficult for owners to receive approval for additional loans.

It is worth noting that the securitization boom led to many mortgages now being held by a large portion of investors through the purchase of Commercial Mortgage Backed Securities.  Given the generally widely dispersed ownership of the loan, it is now incredibly difficult to modify the terms of many of these loans.  A key element to scaling investment in energy efficiency for the privately-owned real estate sector will require the development of off-balance sheet investment mechanisms.

“Mind the GAAP,” a study issued by Johnson Controls’ Institute for Building Efficiency in 2010, covers this topic very well in terms of the impact it may have on financing efficiency.  As illustrated by the study, the exact impact will vary slightly by category of building / owner type, but the impact will be quite large.

This is where off-balance sheet financing becomes so important: It allows organizations to install energy efficiency retrofits at no up-front cost and without impairing their existing debt picture, or market value. This obviates the need to go through a capital budgeting process that either does not exist or does not allow the full value of a retrofit to be realized. In effect, it fulfills the basic premise of performance contracting as a truly self-funding facilities renewal. Another perspective is that these off-balance-sheet arrangements create an opportunity for building owners and third-party asset ownership entities to effectively arbitrage the inefficiencies in utility and operating budgets by replacing old, inefficient equipment. Currently off-balance sheet structures account for only about 5% of all energy efficiency projects, although those deals tend to be much larger given the increased transaction costs (i.e., legal and accounting) associated with them. The remaining deals are all done either through capital leases or up-front purchases.

If the FASB changes go through, off-balance sheet treatment will become even more important, and more difficult to achieve.  Emerging companies such as Transcend Equity and Metrus Energy are attempting to offer innovative solutions that serve building owners.

Given the importance of off-balance sheet solutions for energy efficiency, we hope to see the development and expansion of even more options for building owners.

What motivates building owners? (Hint: $$$)

Barriers, barriers, barriers. Yes, there are many. And yes, they’re tricky to solve.

So let’s forget about barriers for a second. And just focus on why building owners do what they do.

Fundamentally, building owners are out to make money. And I don’t mean to insult, but building owners would basically do anything (legally of course) as long as the price is right.

So if we as the EE community think building retrofits are valuable, but building owners aren’t acting on retrofits for some reason, well then let’s pay them! Pay the owner some of the long run savings up front as a payment to get into the building. Or give them a cut of the profits. The point is, do something that speaks directly to the building owner’s wallet.

The analogy for what is going on here is solar. Land owners own land in the Mojave desert that has great solar resource potential. That resource potential has real value. So developers will come along and pay the land owner for the right to develop this resource.

Now consider buildings. Building owners are sitting on a property with great energy resource potential in the form of energy savings. Why can’t developers come and pay the building owner for the right to develop this resource?

While building owners would have all sorts of different prices around where they would sell the energy efficiency resource development rights in their building, it is our belief that enough building retrofit projects will have decent economics for both the developer AND the building owner such that the market can finally start to scale.

Why aren’t building owners scaling efficiency? It’s not just a lack of capital.

Efficiency advocates, ourselves included, believe that efficiency will benefit building owners. We believe this because we see a large amount of monetary and ‘soft’ value created by efficiency measures.

We have heard many times, and have often thought ourselves, that if there was just a mechanism to provide cheap capital, building owners would pursue the opportunity to retrofit their buildings.

This assumes a set of building owners is out there who are actively interested in retrofitting their buildings, but whose only barrier is access to capital.

But is that really true?

Let’s unpack the argument.

The logic makes fundamental sense. If energy efficiency is beneficial to building owners, and if the market can provide cheap loan capital, owners would use this capital to invest in energy efficiency measures at low cost. Owners wouldn’t have to pay significant sums out of pocket for the retrofit, the incremental cash flows would cover the debt service, and the project’s equity owner would maintain any upside of additional value that flows from the energy efficiency retrofit.

So does this type of building owner really exist?

You can split the world of building owners along two lines – those who have relatively strong access to capital and those who don’t. Those with access to capital are the Vornado’s of the world. These guys don’t need energy efficiency loans. They can self fund. (Now that doesn’t explain why they’re not doing retrofits en masse, but it indicates that capital is not the only barrier.)

The other type is the owner without ready access to capital. This could be because their buildings are fully-levered or over-levered or it could be that the property is struggling and can’t take on additional debt financing. For many commercial buildings, their mortgages contain covenants preventing additional debt from being assumed without first mortgage holder approval.  Spending incremental capital on energy efficiency is a barrier for this class of owners.

So now let’s introduce our cheap loan financing. What happens now? The building owners without previous access to capital will start doing efficiency en masse right?

Of course, if access to capital really is the only barrier, then great. Solving this problem is not trivial. For example, the energy efficiency community is still dealing with questions of how to achieve collateral and security interest in a retrofit project, issues of payment guarantees vs. performance risks, and the challenge of how to aggregate sufficient projects to meet thresholds for existing lenders. We are confident however, that with so many smart organizations (Carbon War Room, Clinton Climate Initiative, Hannon Armstrong, DOE, Serious Materials, and many other fantastic forward thinking organizations) working on this, someone will figure out how to make cheap loan capital work for retrofits.But what if capital is not the only barrier? After all, if we look at the well-capitalized part of the market, we don’t see deep retrofits happening all that much more frequently, which is one of the reasons that makes us believe capital isn’t the only thing holding retrofits back.

To further bolster this point, we suspect easy access to cheap capital is highly correlated with the class of the building – so most of those buildings with easy access to capital are the Class A buildings, while it is the Class B and C buildings that have less access to capital. Our hypothesis is that Class A tenants also care more about occupying energy efficient buildings. If that’s true, then building owners that lack access to capital are currently less likely to retrofit than those owners with easy access to capital, even after normalizing for access to capital.

Much of the energy efficiency community focuses near exclusively on access to capital issues, ourselves included (the name of the blog as Exhibit A).  This thought experiment indicates the need to expand our focus to the other potential levers we can pull to scale efficiency.

What does the Empire State Building retrofit mean for building energy efficiency?

Jake and I had the pleasure of taking a brief tour of the Empire State Building recently with Dana Schneider of Jones Lang LaSalle, the person responsible for shepherding the landmark building through its high profile retrofit.

Given the massive amount of articles that have been written about the building, we won’t recount all of the cool things being done to the building as part of the multi-million dollar makeover and retrofit. (Be sure to check out the building’s website, which has an amazing level of detail on the retrofit. They even posted a copy of the energy performance contract the ESB signed with Johnson Controls.)

However, we would be very remiss to not mention the various things the ESB can teach us about the current state of the retrofit market.

  1. Retrofits are cheap relative to renovations. Of the $500+ million spent on renovating the building, only a fraction – $13 million – was spent on the actual retrofitting and energy savings measures of the building. Now that really puts things into perspective, doesn’t it? When undergoing new construction or major renovation, it almost always makes financial sense to evaluate the opportunities and incremental capital needed for building energy efficiency.
  2. Self-funding makes sense for large owners. When a large, well-capitalized Class A office owner buys into the financial case for efficiency, the owner has not traditionally utilized an outside source of financing for the project. Johnson Controls, one of the largest ESCOs, was involved on this particular project, but played the role of a project manager for the retrofit and provided a performance guarantee.  In the MUSH market, the ESCO helps to arrange financing for the building through its performance guarantee backstopping the performance concerns of potential lenders to the project.  Notably, the retrofit did not utilize any outside capital. This is interesting, because as you’ll recall from the post on LBL’s report on ESCOs, ESCOs don’t currently play a large role in the commercial building market, and if it’s true that large owners are more interested in self-funding, this may not change anytime soon.
  3. The long tail problem is real. The Empire State Building retrofit really puts the scope of the long tail problem into perspective. This building, one of the largest in the world, cost only $13 million to retrofit. This further drives home the point that any individual building energy retrofit project is almost too small for many institutional sources of capital to approach individually, yet it does nothing to change the fact that in aggregate this market has massive potential. The key will be how to effectively aggregate a number of $5-$10 million projects into something that is useful for institutional investors who are most likely to drive the market to scale.
  4. Retrofits work. The ESB expects to save $4.4 million per year on the $13 million invested, which works out to a 30+% return on investment. It’s safe to say that most investors would be very pleased with that level of return.

Thanks again to Dana for a great tour of the property, and congratulations on all the hard work on this building paying off so handsomely.

The future of the retrofit business

A retrofit is the application of technology, engineering, and capital to real estate to improve building performance and value. The supplier is a project developer or perhaps an ESCO (let’s call this category of supplier an energy efficiency developer), and the customer is the building owner or in some cases the tenant. The fundamental interaction involves the supplier providing the customer with energy efficiency measures and the customer paying the supplier for the value of future energy savings.

Today, energy efficiency is a high margin, low volume business. Transactions are slow and complicated, and they take a lot of work to develop and sell. A deal could take many months to run feasibility and engineering studies and conduct negotiations before actual physical construction work on the retrofit project even begins. Often, building audits and engineering analyses appear very costly to building owners and can sometimes prove complicated, further slowing the process.

Because today’s retrofits take so much work and have high risk of non-completion, developers demand high returns from the project to cover their time and initial expenses, which makes the project very expensive from the customer’s perspective. Further complicating the situation, the capital needed to fund retrofits tends to be costly, as capital providers still struggle to price the risk inherent in retrofit projects.

From a building owner’s perspective – and again the building owner is the customer in this transaction – a retrofit is an expensive, complicated product that takes a lot of time and effort to complete successfully. 

Even though the building owner often doesn’t have to come out of pocket to pay for this product, the retrofit is not free. The building owner knows they will have to cede a significant portion of the value of future energy savings to the supplier to compensate the developer for the time and effort and risk they put into the project, but at today’s economics, many buildings owners don’t think it’s a good deal.  The future value paid to the developer also doesn’t capture the significant amount of time that the building owner will have to put into upfront negotiations and related closing tasks. Building owners aren’t jumping at the current energy efficiency product offerings because in many cases they don’t meet the owner’s needs as a customer.

What will have to change in order to make energy efficiency easy?  What will increase the number of retrofit projects in the market and help achieve the scale that the energy efficiency market has the potential to deliver?

Fundamentally, suppliers will have to provide something that building owners – the customers – demand and value.  As we described in the post on What is an Energy Efficiency Retrofit:

 “Without real estate, structurally, there is no retrofit project. By definition, a retrofit must be “of a building.” Therefore, retrofits must be useful to real estate owners and operators, ON THEIR TERMS.”

 Suppliers will have to cater to building owners, the customer, the party with the most leverage in the transaction, in order to grow volume and scale the market. How will they do this?

First, energy efficiency suppliers will have to make it far easier for customers (building owners) to purchase the product. This means the product will have to get better. Energy audits will be easier and cheaper and likely entirely funded by the supplier. Time to complete both the deal and construction will likely be dramatically shorter.  Service and support such as post-retrofit continuous commissioning will likely become standard.

Marketing of the product will also improve. Benefits of the retrofit will be explained more comprehensibly, in language that is native and applicable to the customer. By extension, the benefits will also need to be explained to the many specific sub-departments that have a say in a building’s purchasing decisions, from the facilities guys to the finance department. Accounting is different than legal is different than asset management is different than tenant services, and the best energy efficiency suppliers will understand these differences and cater to them.  Data will be used to quantify and support claims, with specific reference to client building types, local market dynamics, and other building specific drivers.

These changes will also drive improved branding for retrofitted buildings, which will allow building owners to market the benefit of the retrofits to current and future tenants in order to increase occupancy and rental rates. Eventually a retrofitted building, and all the high performance attributes that go with it, will be a “must have” for real estate.

Second, margins for “off-the-shelf” retrofits will compress. Building owners are smart economic actors.  It’s not a stretch for them to realize that if someone else is willing to invest significant capital in reducing energy costs in their building and get paid purely by the savings, those returns must be attractive relative to the risks. This is one of the reasons why the best-capitalized real estate leaders all currently say they self-fund efficiency (Vornado, Related, and Tishman Speyer come to mind). 

To say it another way, standard retrofits will get cheaper for building owners. A larger portion of the savings will accrue to building owners, and retrofit suppliers will take a smaller cut. On the surface, this margin compression appears to be negative for retrofit suppliers. The reality is that the corresponding increase in volume will be the driver of scale and maturity for the industry.  A few large retrofit service providers will emerge who have national scale and scope to do low-margin retrofits and still generate huge profits despite moderation in margins.  The cost of capital supporting the retrofit providers will decrease, allowing further savings to be passed to the customer.  Efficiencies of scale and best practices will drive costs even lower still.

 Lower margins in standard retrofit projects will also open the possibility for higher-margin specialty retrofit products, like deep retrofits and eventually zero net energy retrofits.  Developers and building owners utilizing cutting-edge technology to re-retrofit will also maintain high margins by leading the industry and providing valuable produces to building owners.

 The bottom line is that the energy efficiency business at scale will look dramatically different than it looks today. Suppliers of building energy efficiency would do well to keep that in mind, as this transition is already under way.

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