In this paper we explore linkages between energy-efficient building performanceand property value. We contend that financial markets might be more inclinedto recognize the asset value of energy-efficient building features if claimsof expected energy savings were supported by diagnostics, maintenance, andrigorous documentation. Recognition of this value, in turn, could yieldpowerful financial incentives for the building owner, including higher resalevalue and expanded borrowing privileges.
Our goal is to initiate a dialogue about these ideas among appraisers, commercial investors, building owners, and providers of energy services. We would like to familiarize appraisers and investors with current practices in performance assessment, continuous commissioning, and energy accounting. We hope to elicit suggestions from appraisers and financial institutionson how energy performance information could be gathered, analyzed, and presented for convenient and credible use in property valuation. Ultimately, through discussions with assorted stakeholders, we will seek to facilitate the establishment of standard criteria for energy-performance documentation for use by financialmarkets.1
The value of energy efficiency
The value of energy-efficiency measures for a property owner, aside from any aesthetic or comfort amenity they might provide, is the discounted difference between future levels of energy use and baseline levels over the lifetime of the measures. This value is a function of expected magnitude and duration of savings. It also depends o n discount rate, which reflects the rate of return that an investor would require to make the investment, based on expectedperformance and risk relative to other investment opportunities.
Note that in the context of this paper, we use the term "value" in its relatively limited sense as present asset value recognized by financial markets. In today's marketplace, the financial benefits of energy efficiencyare felt by owners only gradually, as operating savings are achieved month by month and year by year. Because financial markets are not sensitive to the asset value of these operating savings, it is generally not possible for an owner to capitalize immediately on an expected stream of future savings - neither through direct sale nor through collateralization for expanded borrowing. Our key goal is to spur the market to treat expected energy savings as a component of a property's asset value, to be recognized at resale orused as leverage for other investments.
Barriers to recognition of the asset value of energy efficiency
Energy efficiency may resist complete and accurate market valuation forat least three major reasons: difficulty in counting and measuring savings;failure or lagging performance of energy-efficient measures over time; and absence of mechanisms to deliver information to appraisers and investors.
Measurement, calculation, and counting of savings.
Unlike other investments,whose revenue streams are easily counted (for example, rent from income property or interest on loans), energy efficiency offers value that is vexingly difficult to quantify. Both efficient and baseline levels of energy use can be defined in myriad ways, and both carry significant uncertainty. Toaddress this problem, the U.S. Department of Energy is leading a collaborative effort to develop the International Performance Measurement and Verification Protocol (IPMVP), which establishes standard methodologies for measuring and verifying energy savings. We expect that any successful system of performance documentation for financial markets will use the IPMVP in quantifying energysavings and avoided energy cost.
Savings reliability.
Financial markets may hesitate to assign value to expected energy savings because of doubt about savings reliability. Programs of continuous commissioning and building diagnostics might lift this doubt by identifying and rapidly redressing problems, thus reducing the risk offailed savings and increasing the reliability of payback. Utilities, energy service companies, controls firms, and others are now offering a burgeoning variety of services to assure lasting efficient performance in buildings. We envision that any or all of these services could help to demonstrate savings reliability to appraisers and financial markets.
Documentation of energy-efficient building performance.
Our inquiries have revealed that appraisers do seek to take energy efficiency into account in determining property values. The problem, many say, is that they lack detailed information on various energy-efficient building features, and have no specific idea how much energy and money these features might be expected to save. Utility records offer little conclusive insight, because confounding factors like weather and occupant behavior can affect energyconsumption as much as the characteristics of the building itself. In the absence of specific information, appraisers often use simple rules of thumb or average regional data to estimate the building's operating costs, and assign no value at all to savings from installed energy-efficient features.
Appraisers suggest that a simple but well-substantiated document showing the savings associated with specific building features, as well as a normalized index of whole-building performance - much like home energy rating certificates in the residential sector - would be a desirable tool for commercial property appraisal. In the following section, we elaborate how such documentationmight affect a commercial appraisal.
Use of performance documentation in property appraisals
Appraisers use various methods to assess the value of a property, including comparison with similar properties and estimation of deterioration and replacement costs. One of the most common and widely accepted approaches for commercial real estate, the income capitalization approach, considers the property as a source of income for the owner. Operating costs are subtracted from projected gross revenues, yielding net operating income figures. The discounted stream of total present and future net operating income equals the value of the property.
Efficient use of energy lowers a building's operating costs and, where energy costs are not passed on to tenants, raises net operating income for the building owner.2 We believe that this increase in operating income, especially when documented reliably over time, could serve as the basis for an increase in the appraised value of the property.
We envision that the performance record of the building might show, in as much detail as deemed necessary by appraisers and investors, any or all of the following information:
This information would be delivered in printed or electronic form to an appraiser. Using the income capitalization approach - either for the property on the whole, or, if applicable and desired, for the energy-efficient features of the building separately - an appraiser would assess the cash flow from energy savings, determine the discount rate associated with savings reliability, and calculate the present value of the expected avoided energycost. This savings value, combined with any non-energy value such as comfort or convenience, would equal the value of the energy-efficient features of the building.
The possible bottom-line stakes for building owners: a hypothetical case
The incremental value that energy efficiency could bring to a propertyis significant. Let us imagine, for example, a commercial building with 100,000 square feet of leasable area, and average yearly operating costs of $4 per square foot. These operating costs are about average for the regio nand building type, and are paid by the owner, not passed on to tenants. An array of energy-saving measures is installed (a new cooling plant, efficient lighting, occupancy sensors, and advanced controls, for example) at a costof $5 per square foot, a conservatively high estimate based on our experience. The building owner also engages a reputable energy service company to maintain and document the performance of the installed measures.
After four years of operation, the performance record shows that the new yearly operating costs of the building consistently average $3 per square foot. (This estimate is quite consistent with the technical possibilities of the installed measures.) A normalization algorithm, working with measured data imputs, verifies that the savings have arisen from the installed measures, not weather or occupancy changes. Thus the building owner is reliably saving $100,000 per year as a result of the initial investment.
The building owner decides to sell, and an appraiser is summoned to assign a value to the property. The appraiser receives the verified information from the performance document and determines that operating expenses may indeed be expected to continue at current (post-retrofit) levels. If the capitalization rate for the building is 0.10, then the value added to the building by the energy-efficiency measures is $1,000,000 - or twice the original cost of the improvements. Alternatively, the appraiser may decide to assign a higher cap rate to the efficiency measures, reflective of some remaining uncertainty about future savings streams; even so, one could still expect that the efficiency measures would have significant value.
Even if the building were not up for sale, the owner could still benefit from the inclusion of energy performance in the appraisal. The incrementof value from energy efficiency could serve as the basis for expanded credit through collateralization of the property. In this case, the extra $1,000,000 in appraised property value might be leveraged through a loan at 80% of its value - the owner would have an extra $800,000 in cash flow.
Necessary conditions for successful implementation
A number of factors will have to fall into proper alignment if this hypothetical case, with its considerable market-transformation implications, is to be realized. Most importantly, if appraisers and lenders are to accept performance documentation as a basis for boosting the value of energy-efficient properties, they will require some reassurance about the quality of data and the legitimacyof data analysis tools. Financial markets may require some standardization of procedures, in order that energy-efficiency value might be comparable across different properties. Appraisers may also need some formal protection from liability in the event of "lost" value through use of errant performance data.
Assurance of data quality through consensus specifications.
Data qualitydepends on numerous factors: types of data; accuracy and precision of measuring instruments; installation and calibration of instruments; frequency of data collection; reliability of data recording and archiving; and so on. Available service packages of continuous commissioning and diagnostics cover quite a broad range of these variables. Moreover, there exist several analytic methods for transforming collected data into normalized performance indices. We hope to catalyze movement toward consensus specifications for data collection and analysis, to reassure financial markets about using performance data to assess energy-efficiency value.
Certification of service providers and their methods.
Protocols for data collection and analysis will probably require some degree of formal certification if added energy-efficiency value is to be recognized in the marketplace. In addition, providers of performance documentation, whether building managers or outside energy-service contractors, may themselves need to have their qualifications certified in some manner. We imagine that providers might apply for listing in an official registry, much as home energy raters do.
Standardization.
Though financial markets may tolerate some variety in service packages and documentation methods, standardization could hold several advantages. It would facilitate comparisons among different buildings with different energy-saving features. Standardization would also help breed familiarity with performance documents, limit confusion among different systems, and help to lighten the load of training and added work for appraisers and service providers.
Regulation.
Taken to their logical conclusion, specifications, certification,and standardization of performance-documentation practices may fit together in a regulatory scheme of third-party oversight. A government agency (for example, an office of the California Energy Commission) would receive a legislative mandate to approve procedures, register and certify providers, issue standards, address grievances, and levy sanctions as necessary. Such an arrangement could help to raise market confidence in the legitimacy of energy performance documentation. It could also shield appraisers and service providers from liability claims, by giving them clearly defined rules and regulations with which to comply. Funding for regulatory oversight could be collected through licensing fees, filing fees, or other mechanisms.
Next steps
We have received encouraging support for these initial ideas from a broadrange of stakeholders - government agencies, utilities, energy service companies,appraisers, national laboratories, and others - across the United States.We are now planning a series of discussions to bring appraisers, investors, building owners, and energy service providers together, and to begin to build concrete plans and specifications for applied programs. These meetings are planned for the last three months of 1997, and will take place in California and the Pacific Northwest, and possibly in Washington, DC, Texas, and other locations as well. We hope that we will have laid a solid foundation for an actual working system by September 1998. Meanwhile, we welcome further comments.
Acknowledgements
We gratefully acknowledge the Atmospheric Pollution Prevention Division of the U. S. Environmental Protection Agency for providing grant support for this work. Paul Jacobs of the California Association of Real Estate Appraisers, Margo Wright and Lisa Estes of the Appraisal Institute, and Don E. Boyson, SRA, MAI have provided useful guidance and insights. We thank them for their contributions.
1 Though the issues we address could apply to residential properties as well, we focus on commercial buildings in this paper and in our program efforts. Two factors have prompted this choice of direction. First, commercial property markets are much more purely responsive to bottom-line issues of revenues and costs (in which energy use plays a significant role), whereas residential property value tends to depend heavily on subjective factors such as styling and charm. Second, home energy ratings, which are well established throughout the United States, already embody some of the key concepts we have in mind; indeed, in certain respects, our efforts may be viewed as an attempt to create an analogous rating system for commercial buildings.
2 It is possible that building owners might see a mild incentive to track and record the value of energy efficiency, even if utility bills are passed on in whole or in part to tenants. Tenants might be encouraged to examine all of the costs of occupancy, including utilities as well as rent; a performance document showing reliable savings over time might boost the confidence of would-be lessors, and might therefore allow owners to charge higher rent to compensate for expected lower energy bills.
Energy Efficiency and Property Valuation by Appraisers and Financial Markets page 2 of 6
M. Chao and D. Goldstein, September 1997