One common metric used by energy consultants, engineers, and contractors in the energy efficiency field is “payback.” As a CRE executive, “payback” has probably never been a metric used to analyze your real estate investments. Buildings are not bought or built based on how many years it would take to be “paid back.” A simple translation to CRE financial terms would be Return on Investment (ROI) and in comparison, a ten-year payback is analogous to a 10% unleveraged ROI.
A CRE executive’s primary focus is enhancing the returns generated for investors, typically expressed either by, Internal Rate of Return (“IRR”) or a “Multiple” of equity investment returned. Capital is always constrained, so allocating limited capital is prioritized based on the impact to your investor’s IRR or Multiple.
A simple ROI hurdle would work as follows; if the annual contribution to Net Operating Income (NOI), divided by the capital investment, is greater than your exit cap rate, the project should be considered. Assume a $1M CapEx investment, OpEx savings resulting in a $100k increase in NOI, in a building valued at a 6% Cap Rate. The 10% annual ROI will be accretive to investor returns because the $100k of NOI capped at 6% results in $1.67M of added value, net of the $1M investment adds $670k of net proceeds to investors. This is, of course, an unleveraged look at ROI, imagine the impact to investor IRR when the efficiency CapEx is funded, possibly 100%, through creative financing options such as rebates, incentives, and/or low cost “green” financing programs.
Misconceptions on Timing
Many energy consultants hear objections to projects based on the owner’s hold period ending prior to a payback. A clear financial argument can be made that the opposite is true, owners can improve investor IRR more impactfully by investing in projects just prior to selling for the following reasons:
- Increased NOI and deployed capital is quickly turned into higher net proceeds at the sale increasing investor IRR.
- Physical asset characteristics are improved, avoiding a price deduction from buyers for deferred maintenance.
- State-of-the-art physical characteristics justify a lower cap rate due to improved quality, reduced or deferred maintenance risk and increased tenant satisfaction, and extended lease terms.
- Improved, up-to-date, physical characteristics and sustainable attributes increase the buyer pool to include institutional buyers, not comfortable with value-add projects and looking to check the ESG box.
Prioritizing Capital
When comparing efficiency CapEx to other uses, i.e. a lobby renovation or other cosmetics in preparation for a sale, the certainty of the efficiency project ROI is quantifiable and should have measurable NOI improvements in the months leading up to a sale. The best way to prioritize capital is to not use your own. There are many public/private incentives, rebates, and creative financing opportunities in the energy efficiency space.
- Energy savings impact to NOI can be quantified and proven prior to a sale, cosmetic improvements are emotionally attractive and often cover up defects but are unquantifiable.
- In a NNN leased multi-tenant building, for a landlord to capture energy savings per lease terms, there must be a transparent negotiation with tenants to restructure the leases with a simple amendment. This will always provide the opportunity for the landlord to require lease extensions to justify the investment.
Cautions
Be conscious of the “useful” life of the equipment, efficiency projects that produce annual returns for decades are certainly more valuable and add more to the asset value. If limited capital forces you to contract with third-party providers for a lease or financing, make sure termination rights minimize prepayment penalties. Always consider the project’s potential financial burden on prospective buyers. The energy environment is very dynamic and complex, maintain flexibility, monitor performance, and use consultants experienced in all phases of an energy management strategy.
Final Thoughts
In conclusion, energy efficiency projects should be analyzed from a real estate finance perspective as compared to commonly used payback metrics. As the energy sector is going through dynamic changes it is prudent for CRE executives to always consider energy strategy that will boost returns for their investors. As far as timing, the energy strategy should be analyzed prior to the acquisition, annually during your hold period (budget meetings should always include energy strategy), and prior to executing an exit strategy.[/vc_column_text][vc_empty_space][vc_cta h2=”EEP is focused on supporting the Commercial Real Estate industry.”]Our management team is very familiar with CRE practices and how our offerings can support the industry. Contact the team at EEP today for a detailed discussion on how your CRE portfolio can benefit from our Sustainable Energy Management programs.