A Vision of Green Building Economics for the Private Sector

A Vision of Green Building Economics for the Private Sector

Green building has rapidly been gaining momentum in the United States as a design protocol and measurement standard for building performance, quality and value. Though many precepts of the concept were established thousands of years ago, it has only been defined and integrated into the building industry over the past decade. Green building is rooted in buildings that minimize resource use, increase occupant health and productivity, and lessen the building's impact on the environment.

A more detailed definition of a green building is provided by the U.S. Green Building Council's "USGBC" LEED Green Building Rating System - the predominant standard in the country. LEED is a point based green building certification system with a total of 69 points available in six categories. LEED provides four award levels based on the number of environmentally related points achieved by a new building project. The four levels include: Certified (26-32 points) Silver (33-38 points), Gold (39-51 points) and Platinum (52-69 points). In essence, one could say that if a building is not LEED certified, it is not a green building. LEED's environmental categories and total possible points include:
  • Sustainable Sites (14 points)
  • Water Efficiency (5 points)
  • Energy & Atmosphere (17 points)
  • Materials & Resources (13 points)
  • Indoor Environmental Quality (15 points)
  • Innovation & Design Process (5 points)

The majority of green building activity has occurred in the public sector: federal, state and local government. Public entities can mandate green building for their own buildings. This is evidenced through dozens of new ordinances, guidelines, policies and demonstration buildings. The cost of funds for government bonds are low, and the time horizon for the average life of a public building is long - likely to be more than 50 years. The buildings are typically owned, financed, maintained and occupied by the governmental entity. Wearing these multiple hats makes it easier for governmental owners to design buildings to maximize their performance on a long-term perspective. Green building is also consistent with their mandate to maximize public health, safety and welfare.

Green building is lagging in the private sector. One reason is that it is more difficult to quantify the benefits. Also, many buildings are speculative, and not occupied by the building owner. Ongoing expenses are passed on to the tenants through their leases. The owner is not responsible for payment of the worker salaries, and therefore not directly compensated for building related benefits to worker health and productivity. These factors have contributed to a short-term owner orientation to building design, and therefore a slower adoption of green building principles.

There are many financial and other benefits to green building for the private sector. This paper sets forth a vision of the many benefits and identifies areas for further data collection and research to accelerate green building in the private sector. The discussion focuses on speculative private commercial office developments. Many of the items however apply to other private building types, such as retail developments. There is also some overlap with public facilities.

This paper follows the flow of a developer's proforma analysis. The components include:
  • Project Cost
  • Income & Expenses
  • Financing & Equity
  • Return on Equity/Project Valuation

Project Cost

There are three areas of project cost contributing to a project's total project cost: site acquisition, direct construction and indirect construction costs. There are green building related financial implications in each of these areas.

Site Acquisition Costs

It is important to purchase a property that will enhance the ability to create a high-level green building. LEED provides a point for proximity to public transportation: bus and metro. It also awards points for urban infill and reduced site disturbance. Solar access is important, as well as natural ventilation potential and good ambient air quality. Sensitivity to water quality and run off minimization issues is also critical. If demolition is required, it is important that a majority of the materials are diverted from the landfill. LEED also awards points for building reuse, as opposed to new construction. It gives a point for Brownfield redevelopment.

It is not established that a "green" site is more expensive than a non-green site. It is more a matter of inspection and thinking out the above issues when looking at prospective properties. There are case studies showing that diversion from the landfill can be more cost effective than sending all of the debris to the landfill (Portland Trailblazers project by Turner Construction).

Some jurisdictions, like Arlington County, Virginia, will provide a density bonus for agreement to create a green building. The extra FAR allowance can more than compensate for any extra cost of developing a green building.

Direct Construction Costs

There are numerous examples that a LEED Certified and even Silver building does not cost more for hard construction materials and labor. The new DPR Construction Sacramento building is slated to achieve a LEED Silver rating at an added cost of less than 1%. The cost increase was only $1.50 per square foot for the 52,300 square foot building. DPR estimates the payback period on the small added investment to be less than two years (Source: Neal Cordero, DPR Construction).

The City of Seattle has mandated a LEED Silver rating level for its buildings for the past several years. They originally allocated a 4% cost increase on total costs, but have found the cost coming down to about 1% given their increased knowledge in using LEED and incorporating sustainable building principles. (Source: Lucia Athens, Sustainable Building Coordinator, the City of Seattle).

The City of San Diego Ridgehaven Building achieved an energy efficiency improvement from Code of 53%. The incremental add was about 4 percent for the energy efficiency elements, however most of this increased cost was funded by the utility. The internal rate of return on the net investment was 57%. The building also incorporated many other green building measures. The net cost for green did not take into consideration significant downsizing of the mechanical system (about a 30% load reduction) and similar reductions in the quantity of lighting fixtures and reduced fixture sizes. Therefore, the overall net cost was zero.

The hard cost components include construction of the base building, parking facility and tenant improvements. Many green building elements can be incorporated at no extra first cost into all three of these areas. Other items, like more energy efficient systems, do cost more, but they have offsetting benefits, potentially yielding no overall cost increase up to the LEED Silver level. As one designs to a LEED Gold or Platinum level, first cost likely begins to increase, but life cycle cost benefits are also improved.

Indirect Construction Costs

As green building continues to expand, almost all architectural and engineering firms are embracing the field. The USGBC has 2500 total organizational members, with approximately 2000 of them comprising design professional firms. Included are both large and small organizations, including Gensler, SOM and HOK. Green building is rapidly becoming part of standard practice as indicated by this and other trends. Owners are increasingly requiring green building as part of the building's design. Over the past few years, design professionals have typically received a premium fee for providing green building services, such as energy modeling, materials research and LEED brainstorm facilitation. However, as the green building market grows, the fees for these services are declining and some firms are even offering them for free. One exception is the cost of LEED certification. There are fees due directly to the USGBC for project LEED registration and certification. The fees vary depending on building size and whether or not the building owner is a member of USGBC. The range is from a total of: $2,250 to $8,450. In addition, the owner must pay extra for the professional to manage the LEED certification documentation process. With the new version 2.1 of LEED, the cost of documentation is anticipated to come down by about fifty percent. The extra cost for professional fee time could be in the range of $10,000 to $30,000. Higher fees could be quoted if the work includes materials research, energy modeling or commissioning work. These items are outside of this estimate and could add up to a total of $25,000 to $75,000 or more depending on the size and complexity of the building. It is important to note that these extra "soft costs" can yield incredibly high returns on investment, typically paying back for themselves in the first year's energy savings.

Another indirect cost of construction is tenant lease-up contingency. It has been shown that a green building receives added publicity. Some projects, like New York's Four Times Square, attracted hundreds of articles and other media coverage. This can result in a higher level of attention and perceived building value. Education of brokers and their tenants on the merits of green building can result in a faster building lease-up period. The green emphasis can also aid in negotiations with local governments on building permit and use approval issues, lessening the land carry costs. Both items can result in financial savings far greater than any extra cost for going green.

The advertising costs can be reduced by relying on a greater amount of free articles and other media coverage on the property.

Income & Expenses

Income

Because green building is so new, sufficient data has not been collected to show that it can increase rental rates for a building. However, it is logical that a building is worth more if it has lower operating expenses for the tenants, enhanced daylighting, operable windows, improved occupant comfort and individual control, better air quality and dozens of other positive features. It is a matter of marketing by the owner and their broker to communicate this enhanced value to the marketplace. There is enormous precedent in other areas of the consumer paying more for a higher value. We do this every time we buy a car or appliance. Most of us don't buy the cheapest home possible to house our families. We pay more for comfort and quality. This is also true for office space. An "A" level building costs more than a "B" building. As green building is adopted into mainstream, it will become part of the definition of an "A" building. A LEED rated building may therefore command a higher rental rate. As mentioned earlier, it will also lease-up faster than the non-green building. In addition, it is possible that the owner is able to negotiate for higher annual increases to the base rent, as well as more frequent bumps in base rent over the lease duration.

Another income benefit associated with green building will be lower vacancy rates. Higher quality buildings historically have shown lower vacancy rates. Tenants prefer to renew their leases because they appreciate the enhanced comfort and health and productivity of the space for their employees. Proximity to public transportation is another benefits, as well as showers and bike racks. An underfloor air distribution system affords greater comfort and dramatically reduced the tenant's cost of churn - estimated at $2500 per incident. It also increased the tenant's flexibility and individual control of the space.

Expenses

It has been demonstrated that a green building's operating expenses are significantly lower. Energy can be reduced from 30 to 50 percent, yielding a savings of $0.50 to $1.25 per square foot annually. The amount of water consumed can be decreased by thirty percent or more, yielding greater savings. Repairs and maintenance can decrease, as well as landfill tipping fees associated with a lower level of waste generation.

Improved indoor air quality can lead to reduced owner liability. This can contribute to reduced expenses and even lower insurance premiums over the life of the new building. In addition, it is anticipated that insurance companies may soon provide an insurance cost reduction for green building. In time, they may also make LEED a prerequisite for building insurance.

The net result of higher income and lower expenses and cost of capital is improved net project cash flow over the life of the asset.

Financing & Equity

A higher building net operating income results in a higher building valuation. This can result in a higher loan amount as well as sales price. For example, a net operating income increase of $100,000 can yield $1.33 million in increased building value, using a 7.5% building capitalization rate [$100,000/0.075]. At a lender loan to value ratio of 75%, the owner can borrow an additional $1.0 million based on this higher valuation. This can substantially reduce the project equity requirement or result in tax-free proceeds upon refinance. Additional debt however does increase the owner's risk.

In time, it is envisioned that banks will offer green loans based on LEED; lowering the cost of capital and/or increasing the allowable loan to cost ratio. Once this becomes the norm, some banks may ultimately require the lowest LEED level in order to qualify for the loan. It would be analogous to the requirement for a Phase One property environmental assessment. The cost of LEED may similarly drop, as it becomes a commodity product - as we witnessed with Phase One assessments over the past two decades. The cost dropped from a high of about $30,000 in the 1980's, to under $1,000.

Some projects are beginning to attract investors who are interested in participating in a green building project. They understand the opportunity for improved financial return along with a social dividend. In times when it is difficult to attract equity for a project, green buildings may begin to have an advantage. Green buildings also offer the possibility of attracting new sources of equity, such as foundation assets and pension retirement funds, such as CalPERS. It is also likely that in the near future we see the emergence of green REIT's (Real Estate Investment Trusts) - raising funds from the public marketplace and trading stock on Wall Street. When this occurs, the access to one-hundred percent equity financing will become available - greatly accelerating the number of green buildings.

Green buildings can qualify for subsidies and tax credits. The State of New York passed the first green building tax credit. Building owners receive a tax credit of five percent of the cost of environmental technologies and materials. An additional two percent can be collected if tenants adopt environmental standards. Maryland and Oregon followed suit with their own tax credits for green building. California offers tax credits for solar, financing as much as fifty percent of the cost. Some utilities offer rebates and green building financing, such as Savings by Design in California, providing for as much as $150,000 in cash payment to the Landlord and another $50,000 for the design team.

Return on Equity/Project Valuation

The net result of increased income, lower expenses and any reductions in financing is a more profitable building. As property appraisers learn more about green building, they are likely to incorporate its relative greenness (i.e. LEED rating level) in the valuation. Buildings with a LEED rating will receive a superior capitalization rate than the non-green building. Even a 1/2 percent of capitalization rate improvement can equate to significantly higher building value upon sale or refinance. For example, a building with a net operating income of $350,000 has a value of $4.7 million at a 7.5 percent capitalization rate. However, a LEED Silver building may qualify for a better yield and therefore lower capitalization rate - say 7.0 percent. This equates to a value of $5 million. The value increase of this example is $300,000. Adding this amount to the increase associated with an improved net operating income can materially improve the overall project return on investment.

Conclusion

This paper presents a vision for the potential economic gains associated with green building. Some of the benefits have already been well established and documented, such as energy efficiency. Many of the other items such as increased rent and faster tenant lease-up still need to be proven. It is not hard to understand that a healthy, resource efficient and daylight building is better than one that is highly dependent on cheap power, is resource consumptive in its use of energy, water and materials and does not have optimal air quality. It is only a matter of time until banks, insurance companies and tenants better understand the benefits and value of green building; creating a shift in demand. When this occurs, owners who have embraced the principles will greatly benefit. And, even if this does not happen, they will still prosper through lower expenses, higher tenant satisfaction and the resulting enhanced financial yield.

When analyzing the decision to go green, the question should not be the impact on first cost, but the overall change to the building's return on investment. This is best reviewed as a projected net present value or internal rate of return over the life of the asset. Owners are encouraged to review the overall financial impact from this life cycle basis, as opposed to a simple payback period. The differential of this change of perspective and associated investment will be a higher return on one's portfolio value and the resulting boost in net worth. In addition, the owner will be providing better space to the tenant, and actively reducing the building's environmental impacts. There will also be social and political benefits - as solar and energy efficiency decrease our dependence on foreign oil. They also create local jobs and reduce pollution. Green building is an economic responsibility to our investors and a social one to society.

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David Gottfried is president of WorldBuild Technologies Inc., a Berkeley, Calif., consulting firm that has worked with many award-winning sustainable building organizations and development projects in the United States. He is also founder of the U.S. Green Building Council, and World Green Building Council.