Present Barriers and the Future of Energy Efficiency Financing

Event facilitated by Dr. Susan Wachter, Professor of Financial Management and Professor of Real Estate and Finance at University of Pennsylvania

Event Overview

On January 17, 2013, CBEI and the Penn Institute for Urban Research (Penn IUR) hosted a group of financial experts to review current trends and future opportunities for advanced energy retrofits (AERs) in commercial real estate. Their discussion centered on the 2011 publication undertaken by University of California, Berkeley, titled Energy Efficiency and Commercial Mortgage Valuation [1]. Using wholesale electricity market pricing, the authors argue that energy efficiency upgrades in commercial buildings help to mitigate the risk of energy price fluctuations inherent in these markets.

Matthew Kwatinetz, CBEI researcher, and Scott Muldavin, Executive Director, Green Buildings Finance Consortium kicked off the meeting with a review of the Berkeley work. Mr. Kwatinetz explained that the paper supports financing for energy efficiency upgrades in commercial buildings; it makes the case that energy efficient buildings are less exposed to the volatility of the energy market and that this reduced risk should be incorporated into loan valuation. Because existing loan practices provide no incentive for implementing energy efficiency measures in commercial buildings, the authors present a methodology for lenders that would explicitly include energy efficiency in risk evaluation and overall building valuation.

Mr. Muldavin disagreed with the Berkeley findings and the methodology. He argued that the risks of energy price fluctuation are not critical to financial decision-making, because they constitute such a small part of the broader risk assessment undertaken by underwriters. Mr. Muldavin also objected to the complexity of the model put forth by the authors, believing that the model was too abstract and too complicated to be of actual use to professionals in the lending field. He further noted that the data used in the model pre-dated the current financial crisis and that conclusions based upon this data would be compromised because of the radical shift in the lending and borrowing market since the early 2000s.

Both speakers acknowledged the achievements of the UC Berkeley research report, noting that with some modifications of the model and data set, this type of risk analysis could be a useful tool for the financial community.

Following the first presentation, Dr. Susan Wachter (Worley Professor of Finance at the Wharton School and Co-Director of Penn IUR) moderated a panel composed of Baxter Wasson (Director of Credit Structuring at Deutsche Bank), James Finlay (Vice President and Senior Commercial Real Estate Appraisal Manager at Wells Fargo), and Michael Meehan (CEO of Zerofootprint USA). The panelists provided a lively and informative discussion in which the viewpoints of different parties involved with energy efficiency financing were presented and debated.

Full event videos are included below. To read a summary of the panel’s comments read on.

Panelists Identify Barriers to Financing Energy Efficiency Retrofits for Commercial Real Estate

Panelists noted that, in their experience, no lender has financed a single energy efficiency retrofit loan.  They did note, however, the lending that includes energy efficiency provisions as part of a larger package. They identified the following five major barriers and recommendations for financing advanced energy retrofits:

1. The Diversity of Real Estate “Tribes”: Each property type (single family residential, multi-family residential, office/commercial, industrial, retail, institutional, land) has its own set of professional, service provider, tenant, and owner profiles that needs to be addressed specifically. Each type also experiences different issues related to the type of financing required, investor motivation, and energy efficiency.
2. The Small Problem: Financing energy efficiency measures for buildings having less than 75,000 square feet in floor space is difficult to secure; it calls for different approaches than that for larger buildings. One solution would be “rolling up” or bundling loans and finding a credit-worthy public entity with a vested interest in improving energy efficiency to act as a financing partner.
3. Banks versus Pension Funds: Banks do not have the capacity to handle the demand but could serve as intermediaries among well-capitalized lenders such as pension fund managers who control an estimated $2 trillion funds nationwide. Mr. Wasson pointed out that pension funds were more likely to be interested in investing in energy efficiency retrofits than banks or venture capital funds, given the time horizon and yield expectation.
4. Reversion and Payback Fallacy:  Potential investors’ current risk assessments rely on the largely unfavorable simple payback or return on investment (ROI) metrics. Calculation of net present value (NPV) better captures the expected benefits of energy efficiency measures.
5. Data: More quality data is needed for lenders to better assess lending risk and can be either culled from existing data or newly compiled.

The Lending Perspective

Deepening the discussion about the lack of data, Baxter Wasson (Director of Credit Structuring at Deutsche Bank) noted that while financing AERs for industrial and larger commercial spaces is common, the banking industry remains wary of making loans for smaller (under 7,500 square feet) buildings.  The industry’s wariness stems from the fact that lending for this type of activity is based solely on a company’s existing credit – the ability of the company to take on the additional debt, not the potential increased profitability of the building. Loan dispersals favor larger industrial or commercial entities with existing corporate credit.  Wasson discussed the lack of standardized methods for either verifying the potential energy savings of a project or for measuring the effect of energy savings on debt service and repayment.

As a consequence of the current credit climate, providing energy efficiency loans for small and diverse properties requires a credit overlay (or backing) from a municipality, utility or some other entity with a vested interest in achieving the energy savings. In other words, financing of energy efficiency measures for smaller buildings will need to be included under the umbrella of a larger organization with the necessary access to credit, at least until an adequate history of performance for smaller loans is available.

The Appraisal Perspective

James Finlay (Vice President and Senior Commercial Real Estate Appraisal Manager,  Wells Fargo) pointed out the numerous difficulties in providing accurate appraisals: the change between proposed building design and the stabilized operating building conditions; the varied risk culture, including acceptable levels of risk, among the different market actors – owners, bankers, appraisers, etc. – involved in energy efficiency; and the lack of experience in the appraisal community on valuation for energy efficiency. Finlay discussed the financial payback part of the retrofit calculation, arguing against the use of “simple payback,” or the time required for the return on an investment to “repay” the sum of the original investment, which by definition does not include reversion (the value of an investment at sale).

While many professionals in the retrofit industry tend to focus on advanced energy retrofits, or more holistic retrofits rather than smaller, discrete projects, Finlay held that the typical owner sets out smaller, more readily achievable goals and assesses her success before moving on to larger, more extensive projects. He suggested that a strategic approach of timing energy efficiency upgrades to correspond to capital expense investment cycles would allow individuals to balance design with already scheduled expenses. He also noted that advanced energy efficiency retrofits have benefits beyond appraised economic value, such as the effects on income, vacancy, expenses, reputation, and productivity, which are not currently valuated in appraisals.

Finley maintained that perception matters.  In a world increasingly aware of energy efficiency, investors do not want to be perceived as behind-the-times and that this market pressure can influence their investment decisions.  He cited New York City’s benchmarking legislation as having potential to move the market towards energy efficiency.

Finally, Finlay noted that historical precedents exist for solving complex credit problems like those facing the energy efficiency market, pointing to expert reporting – in this case, professional systematic appraisals – as a means of reducing lending risk, much like Phase 1 Environmental Assessments reduce the risk of toxic waste liabilities.

The Building Data Perspective

Michael Meehan (CEO, Zerofootprint USA), a building energy data management company, argued that while data related to building energy efficiency performance is available, quality data is  insufficient to support low-risk lending. Further, he called for rethinking the means of influencing consumers who ultimately will drive the market for energy efficient buildings.  Today, government entities and utilities seek to influence consumers through such indirect methods as federal rebate and incentive programs, approaches that are largely ineffective. He suggested shifting to more direct modes by using the growing amount of open-sourced energy data – EPA’s Energy Star Portfolio Manager and DOE’s Green Data – now becoming available to enable consumers to compare their buildings to others in the market.

CBEI’s Ongoing Involvement

CBEI will continue this important conversation and engage regional actors in the financing field to push forward lending mechanisms for energy efficient upgrades in commercial buildings.

References

[1] Jaffe, D., Stanton, R., & Wallace, N. (2011). Energy efficiency and commercial mortgage. Informally published manuscript, Haas School of Business, U.C. Berkeley, Berkeley, CA, Retrieved from http://faculty.haas.berkeley.edu/jaffee/Papers/DOE2913.pdf