As in fashion, where every season's “it” color is dubbed as the “new black,” for private equity real estate firms, “green” has become the new black. But unlike in fashion, where each season's hot-ticket concept lasts for a fleeting few months, sustainable real estate investing represents more than just a fad. In fact, say many industry professionals, it is a long-term trend and one that we can expect as the standard going forward.
Soaring energy costs and increasing consumer demand make investing in sustainable real estate developments of increasing necessity. For private equity real estate firms the initial costs of incorporating green designs into buildings will be more than recovered in the long-term through energy savings and other economic benefits.
A study done earlier this year by real estate research firm CoStar Group on the financial benefits of building “green” found that sustainable buildings outperform their peers when it comes to rental and sales values. LEED-certified buildings (the US rating system) command rent premiums of $11.33 per square foot over non-LEED buildings, according to the report, entitled Commercial Real Estate and the Environment, and have 4.1 percent higher occupancy. LEED-certified buildings also command sale prices of $171 more per square foot than non-LEED buildings, while Energy Star buildings sold for an average of $61 more per square foot than their peers.
Starwood Capital Group's $200 million development of a “green” condo-hotel in Vancouver Island, British Columbia is just the latest in a host of real estate projects underway being developed to LEED (Leadership in Energy and Environmental Design) certification – a measure established in 1999 by the US Green Building Council. Other firms such as GE Real Estate and Canyon Capital Realty Advisors have hired sustainability gurus to “green” their real estate investments.
“A 15 or 18 percent savings in energy means one thing today, but as we see energy prices double nominally that's a much larger number. The incorporation of sustainable design makes sense at today's numbers. And as we project out into the future, there's acceleration in the recovery of that investment.”
Sustainability has become “a trend and not a fad, which is what a lot in the business were saying a couple years ago and some are still saying today,” says Steve Spaeder, president of BPG Development Company, an affiliate of Philadelphiabased private equity real estate firm BPG Properties.
For any private equity real estate firm, green developments carry their own costs-benefits analysis. In the short-term, there is the initial capital outlay to incorporate sustainable or “green” features into real estate investments. It may cost a little more at the time a firm initially constructs a project using sustainable design, says Spaeder.
The costs can be attributed to two factors: the additional architectural or engineering costs involved, and the nominally higher construction and materials costs. “Frankly, the materials costs is not that great,” says Spaeder. “Early on in the ‘green’ movement the belief was that it would add significantly to the cost of construction.”
Over the long-term, however, there are many economic benefits to be accrued. One obvious benefit is the energy savings in the long run – a point of increasing focus with the continued escalation in energy prices.
As energy costs become more and more expensive, says Spaeder, a “15 or 18 percent savings in energy means one thing today, but as we see energy prices double nominally that's a much larger number. The incorporation of sustainable design makes sense at today's numbers. And as we project out into the future, there's acceleration in the recovery of that investment.”
For real estate investors, the trend toward building green is based on three factors, says Charles Woollam, a director at global real estate adviser DTZ – it is partly about compliance, partly about risk management and partly about opportunity.
On the corporate compliance side, companies need to comply with their own environmental policies, which is in many places influencing leasing decisions. This also links in to the risk management side. Buildings not particularly sustainable may “suffer from accelerated obsolescence,” says Woollam, an issue that is affected by different factors including the availability of better buildings, strength of demand and the volume of development.
In some places, such as in financial districts where there is a concentration of public sector organizations or publicly-owned companies, it is likely to become an issue fairly quickly: “Investors left with portfolios that are non-compliant with current occupiers requirements could find that they suffer from both a reduction in rental value, as there is less demand, and a reduction in investor sentiment because the investments aren't future-proofed,” Woollam adds.
But for real estate GPs, the opportunity angle is of particular interest. Sustainability is still a relatively recent consideration in the real estate market, says Woollam. “There is a lot of mispricing and therefore opportunities to buy under-priced assets that may have considerable alpha performance built in. That's exciting to many property investors, particularly those that are chasing relative returns.”
In the construction and engineering of sustainable developments, real estate investors are marrying the use of green materials with current technology to create new LEED-certified developments.
Ingredients can range from recycled materials used in the development of properties, to recycled concrete in parking lots and in buildings, to low VOCs (Volatile Organic Compounds) in carpet glues, says Spaeder. Property developments are also incorporating features from low-flow toilets to the orientation of the building to harvest the greatest amount of natural light. More advanced technology, which can be found in prime, and often high-tech, office complexes, include the use of CO2 sensors which detect and regulate fresh air in the building.
Private equity real estate firms may find it is easier to build “green” than to redevelop existing buildings to incorporate green elements. They could run into cost-prohibitive design features with older buildings. It may be impractical, for example, to replace the whole heating, ventilation and air conditioning (HVAC) system for high-efficiency ones.
“It's difficult to retrofit old buildings and make them green. There's a whole industry doing that, but you're obviously burdened by the way things were insulated or constructed or planned,” says Alan Worden, founder and chief executive officer of New York-based Scout Real Estate Capital.
There are also certain risks involved in greening real estate developments. Some sustainable features could be disproportionately costly in relation to the environmental benefits they bring, says Woollam. There could be new designs that do not actually work, or that fail, as in the case of chilled beam air-conditioning systems, a new way of circulating air around buildings, a few years ago. There were so many installed that failed to work properly that it actually became a “value suppressor,” rather than one that added value, says Woollam. Likewise, there may be green technology that will “fall in the same bracket.”
But the benefits to be accrued through sustainable investments go beyond long-run energy savings. The benefits could emerge in both rental values – where the rental value of the least sustainable buildings may decline and the rental values of the most sustainable buildings may increase – and, in cash-flow terms, sustainable buildings may lease quicker. They will have fewer “non-rent producing” periods, says Woollam, and may take longer-term leases.
In the US, Seattle has a very high demand for green buildings. “It's becoming business as usual in Seattle to do green buildings,” says Margaret Montgomery, a sustainable adviser at architecture and design firm NBBJ. “We have zoning bonuses that are predicated upon doing LEED-silver buildings, for instance, in the downtown core. Since that zoning ordinance went in place, even the developers who were not interested before are suddenly considering that they need to build green in order to reach their pro forma goals.”
Seeds of change
One of the challenges in the sustainability story is that there is no international measure for sustainability. The LEED standard exists in the US and the equivalent BREEAM certification is used in the UK. Other European countries have their own systems of measurement, however there is no uniformity in measures.
The percentage of existing properties that are currently LEED-certified is also pretty low, says Woollam. It is limited in terms of standing stock. But there are opportunities to invest in properties that are capable of being upgraded to meet better standards as well as new development opportunities.
“I think you'd find it difficult to invest in just standing stock. The proportion of new development in relation to the whole built environment is quite small. There's not much development activity so the real issue – and the real challenge – is what happens to existing buildings and how they can be improved. That's where many of the opportunities are too because of the mispricing,” Woollam adds.
According to the US Green Building Council, the value of green building construction is projected to increase to $60 billion by 2010. The green building products market is also projected to be worth $30 billion to $40 billion annually by 2010.
“It's about future-proofing property portfolios against the negative effects of what is a growing trend. It's always going to be difficult to point to sustainability generally, or any individual aspect of it, and say that's going to add x percent to the rental value or y percent to the capital value. What it does do is eliminate the possibility of unexpected liability to comply with future legislation and improves the overall perception of quality of the property.”
The increasing focus on green investments could also have a positive impact on fundraising, says Woollam. For LPs, such as pension funds, the people they represent are increasingly demanding environmentally responsible investments. “We've seen with ethical equities funds and sustainable equities funds that there's been a huge increase in funds under management over the last three or four years. And the same would happen with real estate,” explains Woollam.
Going forward, “green” properties will be a trend we can expect to gain momentum in the coming years, especially in light of growing consumer demand and increasing government regulations for environmentally-conscious investments. Private equity real estate firms will do well to take heed of that fact, says Woollam. “It's about future-proofing property portfolios against the negative effects of what is a growing trend. It's always going to be difficult to point to sustainability generally, or any individual aspect of it, and say that's going to add x percent to the rental value or y percent to the capital value. What it does do is eliminate the possibility of unexpected liability to comply with future legislation and improves the overall perception of quality of the property.”
“Sustainability isn't going to go away,” adds Montgomery. “What we're seeing is a transformation of what is considered best practice. It's becoming the new baseline.”
Developments in the hospitality sector are increasingly taking up green designs, driven largely by consumer demand.
Consumer demand for a greener lifestyle is growing. According to a recent Deloitte survey, US business travelers are increasingly making daily choices to reduce their environmental impact. The survey revealed that around 34 percent of travelers seek out hotels that are environmentally friendly. Moreover, 28 percent said they would be willing to pay 10 percent more to stay in a green hotel. Green investing has become “front and center” on the agenda of real estate investors in the hospitality arena, says Adam Weissenberg, head of Deloitte's US tourism, hospitality and leisure practice. Rising energy costs have pushed many to pursue sustainable practices to target cost-savings. Firms that are not incorporating green features in their real estate investments could lose market share going forward, says Weissenberg.
Starwood Capital Group's green condo-hotel development, at the Wyndansea Oceanfront Golf Resort in Vancouver Island, British Columbia, will be part of its 1 Hotel brand – launched in 2006 in a bid to show that green principles could “coexist” with luxury hospitality projects. The development – which will comprise 180 hotel-condominium suites and 95 beach and golf villas – will also have an eco-conscious spa, fitness facility and salt water pools. The hotel is expected to use renewable energy systems such as seawater geo-thermal exchange, tidal power and photo-voltaic energy.
“The expectation of what you get when you go to rent space, or buy a home, or stay in a hotel – the standards are definitely including green priorities,” says Margaret Montgomery, a sustainable adviser at architecture and design firm NBBJ.
For real estate investors, sustainable hotel projects can go a long way in terms of economic benefits, adds Alan Worden, founder and chief executive officer of New York-based hospitality development and investment company Scout Real Estate Capital. “We could heat a pool in one of our hotels with a massive oil furnace or we could put up solar panels and heat pools with solar energy – that's going to save us money. It's also going to make us money because our hotels are a differentiated product, which will make them more attractive and which will fuel the absorption of condo hotel units and related residences. We think absorption will be faster by using a sustainability framework.”
Such sustainable developments need to happen on a project-by-project basis, says Worden: “In Bermuda, for example, where energy costs 37 cents/kwh, it's incredibly high, that's three times what it is on Nantucket (Massachusetts). Solar or wind power might work really well in Bermuda but it might work less well on Martha's Vineyard. You really need to be project specific. The key is to approach sustainability from day one.”