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Aug 24, 2019

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Green building has fundamentally altered commercial real estate market dynamics over the past few years. The market trends are clear: tenants (because of hiring directives from HR) are demanding greener, more energy-efficient facilities; and governments are now strongly encouraging the move to greener buildings through financial and planning incentives, and increasingly strong mandates. Developers have begun to embrace this shift and are reacting to it by delivering LEED (Leadership in Energy and Environmental Design) certified and Energy Star compliant product to market. Unlike other recent technological innovations in building materials and systems, the greater tangibility of today’s sustainable design features are driving tenant appeals for greener buildings, and as a result we have experienced a kind of redefinition of what constitutes “institutional-quality” real estate.

Although green building financial performance data is still skimpy, the best evidence for new construction paints a compelling investment picture: green buildings can cost little more to build than conventional buildings but yield substantial operating cost savings and other tangible and intangible benefits for tenants – which seem to translate into higher rents, lower vacancies, and more rapid absorption. But what about the business case for achieving LEED certification through building retrofits and full-scale building renovation?

As an alternative to new construction, developers and landlords have increasingly targeted existing office properties in advantageous urban locations for complete renovations in order to deliver a seemingly new Class-A product while saving time and money by utilizing the existing structure to the greatest extent possible. Under current market conditions, such a decision can make good financial sense simply due to the funding constraints that exist for any project involving all-new construction and the rising investor interest for green product. Like LEED for New Construction though, examination of LEED for Existing Buildings, Operations and Maintenance seems to go beyond a simple cost-benefit sort of financial analysis. Instead, the set of evaluation criteria must include the micro-economic analysis of local market supply and demand factors, the architectural and engineering opportunities afforded by the existing asset, the particular asset’s location, and the remaining duration of existing tenant leases.

Ideal candidates for full building renovation must be unoccupied or possess a tenant roster whose leases expire within a reasonably short time period. Otherwise, landlords will spend years and significant financial resources negotiating their way out of leases in order to make way for construction. Buildings must also ideally be free-standing properties with a healthy building skeleton, below-grade parking and advantageous floor plates – all of which are prerequisites for constructing an end product suitable for any Class-A tenant. The building must also be located in a dense urban area, close to public transportation in order to achieve the basic LEED rating points awarded for having workers that ride the subway, bus, or a bike to work. Furthermore before evaluating the case for converting an existing asset, the location must be evaluated on a supply and demand basis to determine the number of existing LEED buildings in the area as compared to the tenant demand for such assets. Where new construction opportunities are sparse and LEED demand is high, the opportunity for green retrofit and/or renovation is strong. Finally from a stricter cost/benefit analysis perspective, the opportunity to achieve LEED certification in conjunction with such a renovation should only be considered if the incremental infrastructure and construction costs are justified by the short and long-term value added to the specific project, the potential source of which is often higher rental rates, higher occupancy rates, lower operating expenses, and/or exit cap-rate premiums.

The reality in most circumstances is that it makes business sense to invest the most effort and resources into the building improvements which achieve both greener status and significant energy savings. Foremost, achieving LEED certification ensures the first set of previously mentioned concerns (in terms of higher per square foot tenant rates and lower vacancy), while the Energy Star component remains just as essential from the perspective of operating cost savings of the building – particularly if those savings can be effectively translated to triple-net tenants in the form of correspondingly higher rental rates to the landlord, or if a gross lease can be negotiated.

In the long-run, the country’s urban buildings will unequivocally require this kind of conversion in order to meet aggressive demands from government programs to cap and reduce the nation’s global warming producing carbon emissions. To facilitate this, we may see increased levels of subsidies available to greener buildings – and penalties imposed upon less efficient buildings – thereby offering more favorable returns. But in fact the case already exists for many urban-office buildings that achieving LEED rating in conjunction with tangible, quantifiable energy savings can result in much higher value from the tenant perspective, and moreover improved net operating income from the landlord perspective.

About the Author

This article was written by Richard Ayres '09.