Pulling Together the Value Streams for Building Retrofits

Pulling Together the Value Streams for Building Retrofits

"... Think of sustainability as a fabric. You pull a thread and everything comes together." -- Richard Locke, MIT Sloan

Richard Locke's metaphor evokes a beautiful image that emphasizes connectivity and purposefulness. It is fundamentally the future of sustainability.

As someone who helps organizations plan these futures, I'm excited about a more purposeful approach to the value streams surrounding retrofit. The approach, or thread, connects taxes, green design and owner portfolios. Why would owners think about these things in lieu of more tangible issues? Simply put, it will improve building performance and save them money.

Given energy cost saves, tax depreciation opportunities, carbon tax risks and portfolio reinvestments, this thread of green retrofit offers owners untapped opportunities for improved building performance. The link between the four variables offers the optimum opportunity for performance improvements and cost saves. But with purposefulness and the right tools, an informed owner can capitalize on initial investments and ensure the long-term performance of assets.

Imagine the following scenario: While green retrofit is increasingly emphasized, typically planning for tax depreciation is not part of that assessment. Likewise, tax planning for energy credits is often emphasized, but depreciation is not. These two distinct areas of expertise typically don't come together at the beginning of a project. Forecasting carbon tax risks also doesn't typically make the value engineering bottom line for a retrofit. Why? There is no individual carbon tax at this point.

Here is the crux of the opportunity: The combination of the three (retrofit, accelerated tax depreciation, and carbon tax risk analyses) needs to become an integrated part of a portfolio analysis. Whether a portfolio includes millions of square feet, or a series of small facilities, it invariably has untapped values in these areas. If investment decision-making includes these analyses, then owners will benefit -- immediately.

What are the analyses necessary for owners to benefit? Green retrofit, tax depreciation, cost segregation and carbon tax risk analysis.

Green Retrofit

The value of green retrofits is well-established. According to McGraw Hill, "today green building comprises 5 to 9 percent of retrofit and renovation market activity by value -- projected to grow to 20-30 percent in just five years" based on reduced new construction and the volume of existing buildings -- and that appears to be an averaged number. In major metropolitan areas, the market is far greater.

In New York City, PlaNYC refers to the fact that "85 percent of the buildings that will exist in 2030 are already here today." Representatives at PlaNYC further identify the importance of the retrofit of these facilities to meet energy reduction targets for the city of New York and the city's multi-step process to assure owners meet those targets. Of course savvy owners know that there is less risk in green retrofit as the performance indicators are already established.

For example, one company required an initial increased investment to achieve sustainability targets, but their self-report (on target after two years) demonstrated payback within five years of occupancy with full returns at twice the initial investment -- only over a 15-year lease. Given the return on investment that green market retrofits offer, the business case is clear. Smart owners know this and are moving in this direction.

So then what's missing? In my opinion, one missing link is the connection to tax depreciation.


Tax Depreciation

Tax depreciation analysis, leading to accelerate depreciation and more cash flow, complements energy saves. Unfortunately, the analysis for tax depreciation typically follows a retrofit project, or at best, is part of the construction document phase of the project. At worst, tax depreciation is an accounting exercise that frequently lacks the advantage of early design and planning input. How might owners benefit if design and accounting aligned early in the process to capture effective green retrofit opportunities that tap local, state, and Federal tax incentives? Cost segregation. Owners often have a limited understanding of tax depreciation in its most general terms and therefore fail to tap its specific opportunities, one of which is cost segregation.

Cost Segregation

Cost segregation "maximizes available depreciation benefits by segregating and documenting the cost of all short life property identified as part of the capitalized cost of the project or purchase … to reduce an owner's Federal income tax liability. A cost segregation analysis allocates construction and acquisition costs and allocates them to tangible personal property, land improvements and real property. Without a cost segregation study, it is difficult to separate all the personal property and land improvement costs, as well as indirect costs, from the total cost of the building. The result is that all such property may be subject to 39-year straight-line depreciation (27.5 years for residential real property) [Strickland, 2009].

In other words with the cost segregation, the depreciation timeline could drop to 15, seven, or even five years. This gives owners cash flow that may be used in other ways. Not to mention, cost segregation allows for the potential capture of previously missed depreciation from former tax years. But what does that mean for an owner?

For example, with accelerated depreciation, an owner may increase cash flow for green retrofit while also taking advantage of the recent tax law changes related to Section 179D that allow for further increased depreciation for investments in energy reduction. However, rarely are green retrofit ROI and early cost segregation planning correlated. Why not? Too often, ROI and cost segregation are positioned as performance indicators, not as planning variables. Imagine the difference if initial planning not only considered the retrofit return, but the means in which its construction and depreciation might contribute to other cash flows.

Carbon Tax

Tax risks further complicate the problem as building investments extend beyond the foreseeable future of carbon taxation. Current legislative action at the Federal level includes Representative John B. Larson's carbon-pricing bill, American's Energy Security Trust Fund Act of 2009. Representative Larson's basic premise is to establish "a national carbon tax rate of $15 per ton of carbon dioxide in 2012 … that would rise annually by $10/ton, with an alternate annual increment rate of $15/ton if required to meet emission reduction targets to be pre-established by U.S. EPA."

Current language targets these taxes at the high polluters such as oil refineries, coal facilities and import sites. Individual building owners are not directly impacted by such taxation, yet. However, numerous state and local governments have either taxes or incentive programs geared toward carbon reduction that do directly impact organizations.

For example, the State of California Employee Trip Reduction program taxes employers that have high volume traffic generation from their employee commutations. Maricopa County, Arizona shares a similar incentive. And the State of New Jersey is piloting a volunteer program to establish the same behaviors. While the stages of development and target audiences vary, the intent is clear. Owners will pay to pollute; the unknown extent is simply a matter of timing and degree of penalty. When owners have large portfolios that cross multiple geographies, and potentially therefore multiple local and state legislatures, both the complexity and the risk increase. Portfolio reinvestments offer owners the opportunity to optimize more by reusing existing building stock, thereby reducing initial capital expenditures and costs over time.

The Opportunity

Reuse isn't new. But imagine if every owner looked at green market retrofit, using the performance targets from green building, the tax advantages of cost segregation early in the planning process, and the risk analysis of carbon avoidance applied on a geographically distributed basis. We believe that there is untapped value in such assessment. It is not necessarily an easy equation, and larger property owners have increasing complexity, but the risk analysis against the potential return is well established. It is so well established that we have to ask a different question: why would owners not connect these variables and tap the embedded value in these connections, particularly in these exceedingly trying times? The potential outcomes include reduced energy and water consumption, accelerated cash flow, tax risk reduction and optimized incentive programs. We simply need to pull together these threads in order to tap the potential.

Janice Barnes, a PhD and LEED AP, is a principal and strategic planner with
Perkins+Will.

Image of the Equitable Building courtesy of the
St.Charles Town Company