Energy efficiency and performance of commercial real estate

Energy Efficiency and Performance of Commercial Real Estate Anil Kashyap, Jim Berry and Stanley McGreal, University of Ulster, UK

Abstract Buildings have a profound impact on the quality of our lives and the world around us. All types of buildings are a major source of greenhouse-gas emissions and account for over 40% of the European Union (EU) final energy demand. This makes energy efficiency as a key element of the European climate change strategy where buildings have a key role to play in driving environmental sustainability outcomes. The commercial buildings sector is one of the fastest growing energy consuming sectors. Green office buildings are good for the environment; provide healthier places to live and more productive places to work. Energy and emissions management helps buildings to manage their energy usage, improve their efficiency, drive down costs and reduce carbon emissions. Investors have been increasingly demanding in the disclosures that businesses are required to make concerning their greenhouse gas emissions. This paper examines the sustainability in commercial building from users’ and investors’ motivation perspective. Furthermore this paper identifies key barriers in achieving low carbon commercial buildings.

Introduction Global climate change is most important environmental challenge faced by our communities. The global energy industry is under pressure to find alternatives to the consumption of fossil fuels in order to reduce the amount of greenhouse gas (GHG) released. Rising energy prices have dominated the media over the past years, thereby increasing the public awareness of energy use and costs throughout the domestic, commercial and transport sectors. The International Panel on Climate Change (IPCC) suggests that buildings and the activities that occur within residential and commercial buildings produce more carbon than the transport or agricultural industries. Hence, reducing demand within existing commercial property assets have potential opportunities to drive the sustainability agenda forward. Commercial buildings include a wide variety of building types—offices, hospitals, schools, police stations, warehouses, hotels, libraries, shopping malls etc. of which office buildings have significantly higher energy use. According to the DOE’s Commercial Buildings Energy Consumption Survey (2003), commercial office buildings are the largest single consumer of energy among all buildings. For instance in the UK, commercial buildings are responsible for around 13% of total carbon emissions. Australian commercial property industry produces 8.8% of the national greenhouse emissions each year and forecasted to almost double its emissions between 1990 and 2010 (DEH, 2001). Given that buildings are responsible for carbon emissions, property sector will clearly have to take the lead to meet this objective. The UK government’s intentions were made clear in the Energy White Paper (2007) and the Green Paper (2007), setting the target to cut carbon emissions in buildings. The European Energy Performance for Buildings Directive (EPBD) 2006 and other policies and legislation brings sustainability as a major issue for all those across the industry, affecting planners, developers, occupiers and investors. This paper examines the sustainability in commercial building from users’ and investors’ motivation perspective and identifies key barriers in achieving low carbon commercial buildings.

Sustainability in Commercial Buildings There has been considerable debate throughout in property industry about the likely future impact of sustainability issues on the commercial property sector. Sustainability is now being considered much more than the design, construction and material choices in a property. It is also becoming recognised as a vital concern for those who are financial stakeholders in the whole building lifecycle, including the

front-end financing and the long-term management and operation of buildings. Increasing the energy efficiency of commercial buildings constitutes a significant step towards improving the environmental efficiency of property. However, energy efficiency is simply part of a much wider issue of achieving sustainability. Buildings account for almost 45 to 50 per cent of all energy consumed in the UK. In the United States also, buildings account for an estimated 39 percent of the country's energy consumption and 43 percent of its carbon dioxide emissions. Seventy-six percent of all electricity generated by US power plants goes to supply the Building Sector. Electricity and natural gas are the most common energy sources used in commercial buildings. Along with domestic buildings, sustainability is becoming an increasingly important issue for the commercial property industry. McKinsey Quarterly Report (2007) indicates that four of the five most cost effective methods of greenhouse gas abatement (being building insulation, lighting systems, air conditioning and water heating) are related to the commercial and residential buildings. With the soaring oil prices, the need to significantly reduce level of consumption and dependency on non-renewable energy is at the heart of drive towards sustainability. Therefore it is vital to make commercial buildings more energy efficient and acceptable. Recent advances in green design and technology create an opportunity as well as a responsibility to reduce its environmental impacts in the building sector. A sustainable commercial building can be defined as a building with planning, design, construction, operation and management practices that reduce the impact of development on the environment. A sustainable commercial building is also economically viable, and potentially enhances the social amenity of its occupants and the community. Ministry of Environment, New Zealand defines Sustainable buildings as buildings that are designed, built and operated with low environmental, social and economic impacts while enhancing the health, welfare and quality of life of the people that live and work in them. Green building also makes efficient use of resources, minimizes pollution and waste, and reduces overall environmental impact. Green buildings require less maintenance cost reduce short and longterm costs. They have better indoor air quality thus promoting good health among occupants and improve worker satisfaction. Green building demonstrates commitment to sustainability, gives a competitive advantage in the market, greater workforce productivity and even more significant effect on company profits. In addition to the satisfaction of contributing toward a better environment, a healthier workplace and an improved community, green commercial buildings often bring financial rewards in the form of cash reward from utility companies and tax incentive from Federal government (Green Building Initiative, 2008). Commercial buildings also use district energy system which is usually not common in residential buildings. In the case of buildings located closely like on a college campus or in a neighbourhood, it is sometimes more efficient to have a integrated central heating and cooling plant that distributes steam, hot water, or chilled water to all of the different buildings. This system can reduce equipment and maintenance costs, as well as save energy. The number of policies and legislation now emerging are designed to enhance the environmental performance of the sector. Arguably, the most crucial of these, once fully implemented, is the Energy Performance of Buildings European Directive (EPBD), in force from 2006. The European Energy Performance for Buildings Directive (EPBD) aims to reduce emissions through increased energy efficiency of the European Union (EU’s) 160 million buildings which generate more than 40% of total EU carbon emissions. By implementing the Directive, the EU could potentially reduce its carbon outputs by 45 million tonnes by 2010. Indeed, it is so important that the EC’s climate change and energy strategies are heavily dependent on its achievement.

Users' motivations and demand Sustainable commercial buildings are designed to use fewer resources such as energy and water, to operate them; thereby lowering operating costs. Hence it is important for occupiers of buildings to consider these issues with regards to the property they occupy. According to RICS Report (2007) and

National Real Estate Investor Research (2007), there has been a steady increase in level of demand for environmentally efficient commercial property over the last decade. Such demand is increasingly coming from all major stakeholders including government, institutional investors in property stocks, tenants and direct inventors in property. Leading corporate occupiers are also requesting energy efficient space although much of the impetus is still generated by occupiers themselves. This assertion is backed up by the results of the IPD UK Occupier Satisfaction Survey 2007 which indicates that environmental sustainability has become a critical issue for many occupiers. The occupation of property that is sensitive to the concept of sustainable development provides an ideal and tangible vehicle through which a company can exhibit its support of corporate social responsibility (CSR). Corporate Social Responsibility which normally embraces a commitment to ‘sustainable’ business practice is another key driver of current demand for ‘green’ offices. Companies, particularly those working in the financial and business services sector, are increasingly aware of the benefits of using a green space. These benefits include improved reputation and staff productivity as well as brand loyalty and recognition; all leading ultimately to greater profitability. Beyond simple enhancement of corporate image, there are other clear benefits associated with the occupation of green buildings. Arguably, the most tangible benefits are the financial savings associated with increased energy efficiency. According to JLLM estimates (2007), buildings with sustainable element can save up to 20% in total electricity cost thereby enhancing long-term building value and returns. Yu and Chow (2001) have identified as inverse relationship between building energy cost and size. In other words, the bigger the building, the smaller would be the energy cost per unit floor area. Many sustainable design features also have a positive impact on employee satisfaction, translating into increased productivity. Features such as natural lighting, air quality, worker-controlled temperature and ventilation can have many positive effects, leading to reduced illness, absenteeism and increased productivity of the workforce. Rocky Mountain Institute study (2005) identified productivity gains of 6-16% through energy efficient design, with decreased absenteeism and improved quality of work from employees. A detailed survey of 11,000 people in the USA found a 1 to 1.5% increase in productivity within a ‘green’ building. For a 4,000 sqm tenancy, on salaries alone that equates to more than $200 000 a year, or $50 per square metre. The property industry has been presented with numerous arguments to support the case for implementing ‘green’ initiatives, such as cost savings through energy management and potential value differential driven by occupier demand. It has also been established that green buildings are not only good for the environment, but also offer direct benefits to occupiers. To accelerate the creation of sustainable buildings and to transform markets, there is a need to determine, demonstrate and calibrate how sustainable buildings actually add value, to ensure that value is captured within the development process, and to ensure that fiscal incentives are provided where needed. Evidence on the economic advantages of sustainable property investments is needed to persuade business practices, to inform the public debate and to transform the markets for sustainable buildings. However, these benefits are undervalued under the current system, and the industry needs to incorporate them within property valuation. According to National Real Estate Investor Survey (NREI) 2007, corporations and developers are rising to meet the new demand for energy efficiency in US market. The focus on sustainable real estate is clearly on the rise with 84% of corporate users and 77% of developers expecting to own, manage or lease at least some green properties five years from now. This survey results support the premise that corporations and developers are embracing green building practices. Respondents expect that green building ownership and management will increase dramatically in just a few short years. Energy efficiency likely generates the most attention because it also produces the biggest payback on green design. The desire to cut energy costs is the main force pushing green building into the mainstream. Four in five respondents indicate energy efficiency is important to their company when selecting, acquiring or developing a green building. Colliers International's Canadian Office Tenant Survey, conducted in July 2007 demonstrates a high market demand for green leased space. 91 percent of tenants prefer green buildings, 90 percent of

respondents agree on the importance of landlords and developers greening their portfolios, 65 percent of tenants would pay a premium for greener leased space, and 62 percent would be prepared to pay net rent premiums given their utility consumption was lowered by 30 percent. Drivers that tenants ranked as most important for staff attraction and retention include proximity to public transportation, excellent indoor environmental air quality and thermal comfort and high level of natural light.

Investors' motivations and responses Rising public awareness will cause stakeholders of all types – tenants, employees, shareholders, investment analysts, and insurers to look closely at climate change practices within real estate industry as the public comes to understand the significant impact that the built environment has on energy consumption and consequently, green house gas emissions. The value of a building has essentially has two components – the rental income, and the investment yield. Both of these components have impact on competitive landscape of developers and investors. In a survey of large companies conducted by the British Council for Offices, 67% respondents stated that sustainability would be ‘very important’ in the future conduct of their organisation. Companies are recognising that a ‘green profile’ can enhance their corporate reputation among consumers and thereby bring commercial advantages, and systems are in place to encourage this. GVA Grimley Survey (2005) of office occupiers, carried out for Maple Grove Developments, states that only 24% of respondents stated that occupation of a green building would be unimportant to company image. Moreover, 17% and 25% respectively stated that it would be very important and fairly important to the corporate image of the company. Interest and enthusiasm for green building has never been higher in the building industry until building professionals have realised the commercial benefits of green buildings. Use of the Integrated Design Process to achieve the higher performance of green buildings keeps down construction costs. Moreover, green-building professionals in early in the design stage before key decisions are made could help maximizing the benefits of green design while minimizing costs. Global survey of corporate occupiers by Jones Lang LaSalle and the CoreNet Summits observed that many tenants would be willing to pay higher rental costs to occupy a ‘green’ building with a higher level of energy efficiency. This is highly favourable indicator for sustainable property going forward and encourages developers to accommodate any potential additional costs resulting from energy efficient design initiatives. Grubb & Ellis (April 2007) research highlights that commercial real estate investors and managers will be challenged to address new requirements for underwriting investments and operating their portfolios. There has been a widespread perception in the real-estate industry that green buildings are significantly more expensive than traditional methods of development. A 2003 study conducted for the California Sustainable Building Task Force shows that an initial increase in upfront costs of approximately 2% for green design will yield lifecycle savings of more than ten times the initial investment. A green building may cost more up front, but saves through lower operating costs over the life of the building. The green building approach applies a project life cycle cost analysis for determining the appropriate up-front expenditure. This analytical method calculates costs over the useful life of the asset. These and other cost savings can only be fully realized when they are incorporated at the project's conceptual design phase with the assistance of an integrated team of professionals. The integrated systems approach ensures that the building is designed as one system rather than a collection of stand-alone systems. Some benefits, such as improving occupant health, comfort, productivity, reducing pollution and landfill waste are not easily quantified. Consequently, they are not adequately considered in cost analysis. For this reason, consider setting aside a small portion of the building budget to cover differential costs associated with less tangible green building benefits or to cover the cost of researching and analyzing green building options. Harvard Business Review (March 2007) states that climate changes affects company’s competitive landscape and companies which manage and mitigate their exposure to climate change risks while seeking new opportunities for profit will generate a competitive advantage over rivals in carbonconstrained future. Jones Lang LaSalle (JLL) Research (2007) shows that sustainability issues drive

change in investment choices. 28% of Australian commercial property investors are now prepared to pay more for an investment with sustainability potential. An additional 58% of respondents agree that if all other things are equal, sustainability can sway their choice between alternative investments. The GVA Grimley survey (2006) reveal that efficient energy use was rated as the most important with 87% of respondents rating this as important or very important. The results are perhaps unsurprising, given that they bring the most tangible benefits to occupiers – in the form of cost savings through more efficient consumption. Accordingly, the fact that rather less importance was attributed to other sustainable features, such the use of sustainable materials in the construction process or locating on brown field land, is probably because they are not perceived to deliver tangible, day-to-day benefits. At the heart of the debate over the linkage between green buildings and asset value itself are the different notions of what constitutes ‘value’. According to RICS Green Value Report (2005), there are a number of alternative approaches to valuation, namely Triple Bottom Line, Full-Cost Accounting and Multiple Accounts Evaluation. All seek to model value more holistically by integrating environmental, societal, and community as well as strictly ‘financial’ concepts, and all have yet to achieve universal acceptance. Lifecycle cost analysis is needed to make the link between green building and asset value because much of a green building’s asset value may lie in its long-term lifecycle benefits. Better and more formalised life-cycle valuation will help to demonstrate the advantages of green buildings. The installation of environmental technologies in buildings is becoming more and more common with the increased market awareness, popularity, and client interest in green buildings and design. Organisational approach to sustainability can have significant influence over the perceived and real value of its intangible assets, and therefore can affect its market value. From an investor's perspective, sustainability in the commercial building sector is important as it is significant in determining the intangible and future value of the business and impacts on material risks and opportunities of the business. Major property developers are already incorporating more and more eco-friendly features in commercial buildings such as turbines to generate power for offices, solar thermal hot water heating, grass roofs to insulate buildings, laminated timber as an alternative to steel and using high efficiency lighting and enhanced skylights that increase natural light and reduce consumption of electrical power. Occupiers should be prepared to pay a higher rent for a more environmentally friendly building. Thus, a more sustainable building should have a higher rate of rental growth. An increase in costs related to low carbon construction is likely to affect either levels of rent, developer profitability or the price paid for land in the first instance. Research by Sarah Sayce, Louise Ellison (Kingston University, UK) and Philip Parnell (Drivers Jonas Chartered Surveyors, UK) surveying a cross-section of property investors, developers, consultants and bankers indicates that a notable shift is beginning to occur among property investors in the UK from a simple concern for environmental protection to a wider remit, encapsulating well-being and triple bottom line sustainability. The increasing emphasis on corporate social responsibility is becoming a driver in the property investment community. Rational behaviour by investors, developers and occupiers is linked to requirements for optimisation of return combined with risk containment. For current progress to be sustained and accelerated there is a need for both continued industry response informed by easily applied metrics and a need for government intervention in the form of fiscal incentives. Federal, state and local governments have been working to encourage sustainable development with programs ranging from tax rebates and grants to preferential zoning and fast-track development schedules. According to NREI Survey (2007), number of legislation, resolutions, ordinances, policies, and incentives can be found across the United States and Canada. The majority of corporate and developer respondents - 74% and 71% respectively - have noticed an increase in green building initiatives from local, state and federal government. Yet nearly three-fourths of respondents - 77% of corporate users and 72% of developers - have not taken advantage of government incentives for green building developments. Among respondents who have taken advantage of incentives, the most commonly used are tax breaks, fee waivers and a “fast-track” permitting process.

Despite the fact that an increasing number of corporate occupiers already have in place environmental and / or sustainability policies that express their commitment to such development, there is a considerable degree of inertia in the property industry about the costs and benefits associated with the construction, operation and use of sustainable buildings. Traditional property valuation and appraisal methods are not currently suitable to meet environmental or social requirements of sustainability. The GVA Grimley survey/CBI Survey asked occupiers their opinion on what factors were most likely to drive environmental change within the industry. Occupiers believe that both cost issues and legislation (both UK and European) will be of key importance in driving change. Conversely, respondents viewed pressure from employees and share holders as the least significant potential driver.

Barriers Previous studies have identified a ‘circle of blame’ in Figure 1 shows that developers and investors are waiting for occupiers to declare their demand for green property, and thus creating a defined market segment. Simultaneously, developers believe that there is no evidence that corporate occupiers are willing to pay increased rents or premium rent to compensate developers for extra cost incurred in the construction of sustainable buildings. The key to breaking the circle of blame is for the industry and valuation professionals to recognise the virtues of sustainable buildings and therefore include sustainable issues in market valuations and calculations of worth.

Figure 1: The Circle of Blame

The main barrier to the construction of sustainable commercial buildings directly relates to the different incentives that drive developers, investors and tenants. Developers want to build a commercial facility that will attract tenants and quickly sell to the investment market at a good profit. Meanwhile, investors want to own a building that will attract and keep tenants, while tenants want lowcost leasing arrangements. Therefore, a developer may have little interest in design and construction initiatives that can't be immediately valued by tenants and investors. Likewise, investors may resist paying for sustainability initiatives that tenants cannot immediately identify and value as part of their decision to lease.

In the context of commercial development cycles, requirements for enhanced sustainability which result in higher construction costs could delay a recovery. Secondly, developers strive to maximise the floor area of buildings by minimising the thickness of external wall construction. The adoption of a heavily-insulated wall construction could also impact on capital values and loss of net lettable floor area (and hence capital value) by 5 per cent (UK GBC, 2007). The investment yield reflects a whole host of factors such as risk, rental growth, obsolescence, investor perception of a particular market or sector, and more general investor demand. Therefore, investor demand for sustainable buildings is likely to rise relative to the market as a whole, which will have a positive impact on values for such buildings. Decision to invest in commercial offices is typically associated with the prospect of improved capital and rental growth. In addition, it is hoped that the investment asset will experience a low vulnerability to depreciation and obsolescence. The same principles hold true with investments in sustainable property, with the additional hope that any such asset may prove to be either cheaper, or at best cost neutral, compared to its non-green alternative, or at least provides an increase in value sufficient to offset any additional costs, such as higher plant costs. As green buildings typically incorporate the latest design principles, depreciation and obsolescence should have less of an impact than might be the case with a standard building. Given the urgency of greening buildings due to their greenhouse gas emissions and other environmental, social and economic impacts, removing barriers to rapid market transformation is necessary.

Conclusion The property industry is beginning to take the issue of environmental efficiency and sustainability very seriously. The discussion and survey undertaken by major property consultants and researchers indicates that ‘green issues’ will be a much more important consideration to occupiers in accommodation strategies in the coming years, as companies become increasingly committed the notions of corporate social responsibility. Sustainability is also an important issue from a property investment perspective, as it has impact on a building value. Legislation will drive change towards more sustainable property. The introduction of energy performance certificates will be crucial in raising awareness and thus promoting a market for more environmentally friendly buildings among occupiers and investors. Occupiers are receptive to greener buildings and that they may even be prepared to pay a higher rent in order to reap the benefits, in terms of corporate image, energy savings and productivity gains. The factors driving the interest and awareness of the various stakeholder groups are closely linked to the perception of demand. Investors and developers see the need to create energy-efficient buildings as driven by tenant-occupiers, coupled with developers’ perception that creating such buildings offers the potential to increase the liquidity of their property portfolio. For tenant-occupiers, the main incentives are the opportunity to reduce running costs and improve their brand image as good corporate citizens. Much of the occupier market is currently in infancy regarding use of sustainable buildings, although in the medium terms it is predicted that occupiers will increasingly want to occupy such buildings and that sustainability will move up the location in decision matrix. The challenge for valuers is to be able to take account and quantify any changes in stakeholder attitude. In other words, it is likely to become increasingly important to find effective ways to incorporate sustainability issues into their both valuation and appraisal processes.

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