The Challenges of Underwriting Green Improvements in Multifamily Properties

By Caitlin Jones
January 4, 2010 5 min read

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By David A. Smith, CAS Financial Advisory Services
     
Tax Credit Advisor, January 2010: When presented with a proposed green improvements program, those with fiscal decision responsibility – CFOs, property management heads, owners, and even regulators – find themselves reading the report much like restaurant diners presented with the antiquated “Ladies Menu” that lists dishes without prices. Everything’s tempting, but what does anything cost?

To underwrite green improvements in affordable multifamily rental housing properties, one must bridge two sets of quantitative estimates: physics and economics. As greening is intimately connected with energy (both production and consumption), most metrics of green improvements emphasize the physical: changes in gas, oil, and water consumption, BTU’s, R-factors, and air exchange rates. Yet financial decision-makers are not put in their roles to save the planet – their metrics must be economic: payback, net present value, internal rate of return. Without familiar and comparable yield standards, decision-makers will be reluctant to implement. While a CFO may take a below-market yield on some capital, she has to have some measure of economic return before making any recommendation.

For a Green Capital Needs Assessment to be underwritable, therefore, it must answer this two-part question:

Assuming the property funds this proposed improvement package, how much will it save, and what will be the return on incremental investment?

Because green and energy conservation measures are interactive, normally additive-oriented assessments will not do. As a result, green underwriting today is floundering because the established analytical products – green assessments, energy audits, and similar studies – have fallen into one or more traps that
renders their information useful for feeling good about one’s eco-consciousness but unequal to answering the CFO’s question.

The following principles are essential for selecting appropriate and cost-effective green improvements for a multifamily property:

1. There’s more to green than just energy savings. This includes resident-satisfaction measures like better indoor air-quality (paints and carpet dyes that off-gas less) and using more organic materials with better durability.
2. Energy production and energy consumption improvements are interactive, not additive.  Energy savings – the largest and most comprehensible set of improvements – divide into energy production (e.g., swap from electric heat to gas) and consumption (e.g., replacement of single-pane windows with polarized thermals). A tighter building envelope will reduce heating costs, as will installing a more efficient boiler – but the combined effect is less than the sum of doing each in isolation. Calculating combined impact requires comparing the Before and After states, which takes both energy expertise and suitable modeling software.
3. Existing financial metrics are crude and inapplicable to most financing decisions. Simple payback and savings-to-investment-ratio (SIR), commonly used on the engineering side, are unfamiliar to owners or lenders and awkward to interpret against cost of capital, target returns, or internal hurdle rates. Net Present Value (NPV) and its cousin Internal Rate of Return (IRR) are more easily understood, providing a clear picture of how much an improvement will save (or cost) over the life-cycle.
4. Proper comparisons must encompass full life-cycle costs. A product’s life-cycle costs include more than just purchase and installation – maintenance costs can be substantial. Further, new green improvements may have longer useful lives than conventional replacements, a benefit often overlooked. Life-cycle costing has to be flexible enough to embrace scenarios of varying interest rates, inflation rates, and discount rates.
5. Green improvements can be thwarted by resident behavioral changes. Put in a one-gallon toilet with inadequate bowl-cleansing power and the nine-year-old may flush it multiple times. Improvements should not lower the residents’ quality of life or they will be subverted.
6. The choice isn’t green versus do-nothing, but green versus conventional maintenance. You may blanch at the cost of high-conservation windows, yet your property’s windows will need replacement in a few years anyways. In the meantime, your building is enclosed in heat sieves.
7. Choices have a time domain: green versus conventional and now versus later. After identifying desirable products, you must then decide the best timing, which varies depending on the existing system’s remaining useful life. Some products waste energy relative to better technology and are worth replacing now, even if they have another 10 years left of expected life. Others should be left in place and upgraded only when they give out. A proper analysis tells you not only what to do today, but what to do when the time comes.
8. Greening is an ongoing process, not just an isolated event. For every existing property, no one ever retrofits every system all at once; instead, smart owners green over time through the normal replacement cycles, greening incrementally. Combining immediate improvements with a long-term green capital plan is essential for budgeting.

CFOs and corporate decision-makers will want a complete assessment that is predicated on an assumed green improvement package, which is then analyzed comprehensively regarding: up front installation; changes in energy production and consumption; changes in operating costs; revised life-cycles and replacement analysis; and effect on residual value.

The industry needs a comprehensive Green Capital Needs Assessment (Green CNA) that bridges between physics and economics with physically observable inputs and financially reliable outputs. Agreement on a standard, high-quality Green CNA tool will unleash the pent-up debt and equity capital eager to fund green improvements if they are presented as an underwritable proposition.

As it happens, we at CAS Financial Advisory Services have developed one.

David A. Smith is CEO of CAS Financial Advisory Services, a Boston-based firm that specializes in multifamily advisory, asset management, capital planning, and transaction services.  He may be contacted at 617-502-5913, [email protected].