Net Zero Isn’t Just Good for the Environment — It’s Also a Value-Add Strategy

As the global real estate industry increasingly acknowledges its role in addressing climate change, three CRE industry veterans from the industrial, multifamily and office sectors convened at ULI’s Spring Meeting in Toronto in May to discuss their hands-on experience generating value though energy-efficiency retrofits of existing buildings.

All three panelists agreed: thoughtfully planned, energy-efficient retrofits not only minimized the carbon footprint of their existing assets, but also helped significantly reduce their utility and maintenance costs and differentiated their offerings in a competitive marketplace, leading to higher rents, lower capitalization rates and added value.

Moderator Beth Eckenrode, co-founder of Pittsburgh-based Auros Group and author of “The Power of Existing Buildings,” described the objective of the discussion as “really bringing this down to value” to encourage owners of all stripes to consider energy efficiency as part of a competitive business strategy, regardless of what their views on climate change may be.

Panelist Kevin Bates, president and founder of Sharp Development, put it this way: “If you’re a building owner and you have existing building stock that’s fully leased, you may think you can’t add any more value to it. But by driving it to carbon neutrality, it can be done.”

Peter Merrigan, CEO and managing partner of Taurus Investments, echoed Bates’ point, saying that pushing toward net zero energy consumption “is not something we’re doing just to save the world, although that’s a nice benefit associated with it. This is something that we’re doing as a line of business. Every single thing that we do is meant to be financially accretive.”

Merrigan also spoke of the importance in the CRE world of providing tangible proof of concept, particularly when straying from tried-and-true methods of generating value, “because no one will believe you otherwise.”

“The solutions have to be real, they have to be measurable and you have to be able to document them,” Merrigan said. “You have to track the energy consumption of the user, to show the before and the after.”

He gave the example of South Winds Apartments in Fall River, Massachusetts, a 404-unit, garden-style, three-story walkup built in 1972, which was retrofitted by RENU Communities, one of two Taurus Investment subsidiaries that focus on carbon neutral real estate.

The first thing the company addressed was the building’s envelope, replacing all windows, doors and roofing systems. It then tackled the infrastructure of the facilities by replacing electric baseboard heating and sleeve AC units with air-source heat-pumps. Next, it installed energy-efficient appliances, low-water flow toilets and LED lighting. After making the building envelope and interior as efficient as possible, RENU installed solar panels capable of generating 1.37 megawatts (MW) of electricity on the roof to supply the remaining energy consumption for the property.

“What was interesting about it as a case study was that it was on a master meter,” Merrigan said. “So, we were able to measure the impact of all the interventions that we did and actually document what occurred.”

Merrigan said the retrofit resulted in an 80.5% reduction in energy consumption, representing 3,803 tons of reduced CO2 emissions. Moreover, it also led to an $800,000 increase in net operating income on the property through savings in energy costs and capital reserves for HVAC maintenance. On a net spend of $10 million after incentives, those savings represent an 8% return on cost and an increase of 200 to 300 basis points to the property’s internal rate of return.

Merrigan said Taurus is now preparing to exit the investment and he’s looking forward to seeing how the upgrades will impact value. “The broker opinions are that this will probably trade in roughly the 4-cap range,” he said. Applying a 4% cap rate to the above-mentioned $800,000 of increased NOI results in up to $20 million in added value.

“And this is a 1972 vintage workforce housing project,” Merrigan said. “So, that’s something that’s interesting to see.”

On the industrial side, Sharp’s Bates gave the example of a manufacturing building that Sharp acquired in 2011. After doing a conventional renovation including new HVAC units, securing a manufacturing tenant for a 12-year lease term and putting a 10-year permanent loan in place, “we were done adding value conventionally,” Bates said.

Then, in 2017, the company drove the building to net-zero energy consumption before selling it in 2021. “So, we know exactly what the value was before we did the energy efficiency upgrades, we know what we sold it for and we know what the cost to get from A to B was,” Bates said.

After a net spend of $1.96 million, the energy-efficiency retrofits reduced the tenant’s energy load by $403,543 per year, representing a 20.57% rate of return on cost. Meanwhile, Sharp only increased rent by $348,144 per year, effectively saving the tenant $55,399 a year after the first year of occupancy.

Bates explained how reducing the tenant’s operating costs by driving the building down to a net-zero energy bill ended up also driving down the risk profile of the occupancy, which in turn affected the cap rate and increased the exit value of the asset.

At the time of sale, Bates said, the tenant was paying $1.51 per square foot per month on a triple net lease. Meanwhile, the energy-efficiency retrofit was generating the equivalent of $0.51 per square foot per month of electricity. The result, Bates said, was that “we’ve got a very sticky tenant now, because they’re not going to leave a building where they’re getting $2 per square foot of benefit for only $1.51 and go to another building where they’re going to have to pay more.”

By reducing the risk of the tenancy, Bates said, the property’s cap rate was compressed from 6.25% to 5.15%. “That’s how much it dropped because of the energy efficiency, because now the tenant can’t leave,” Bates said.

He explained that the energy-efficiency retrofit is set to remove the equivalent of 32,000 metric tons of carbon from the air over a 20-year period. Meanwhile, after recovering all the costs of driving the building to net zero energy in under five years, the company ended up selling the building for an additional $126 per square foot thanks to the rent increase and cap rate compression.

Michael Izzo, senior vice president for environmental strategy at Hines, agreed with Merrigan and Bates that energy efficiency retrofits are a risk worth taking.

“We think about it in risk-adjusted returns,” Izzo said. “We put capital into buildings all the time: in rooftops, lobbies, by repositioning a building from class-B to class-A or value-add to core. Do we know exactly what value that’s going to drive and how much rent we’re going to get? No. But we believe that the market is going to pay us for it.”

Izzo used the example of 345 Hudson, a 1931 masonry office building owned and operated by Hudson Square Properties (HSP) — a joint venture of Hines, Trinity Church Wall Street and Norges Bank — that occupies the entire block between King and Charlton Streets in New York’s former printing district.

When the idea arose of retrofitting 345 Hudson, HSP had just completed a new development next door at 555 Greenwich, featuring cutting-edge energy-efficient design such as geothermal piles and radiant slabs. “We built one of the most progressive buildings that we had right next to one of our worst buildings in the Hudson Square portfolio,” Izzo said. “So, we said, ‘we can do it in a new building, but no one’s going to believe that we can do it in an old building.’”

Using a Nordic-inspired, circular systems approach that sees heat not as something to be ejected in summer and supplied in winter, but as a resource to be shared among different spaces year-round, HSP devised a water-source heat pump system that moves energy from floor to floor, and even from building to building, according to different occupancies and use types.

“The cheapest form of energy is the energy that we’ve already created,” Izzo said. “So, we look for opportunities to recycle and upcycle energy within the building, because it’s energy that you’ve already paid for. Then we look to onsite and offsite renewable strategies.”

Although Izzo did not get into specifics of the costs and returns of the retrofit, he emphasized that the results were overwhelmingly positive. “Just from a capex/opex perspective, it was less than a 10-year return [on investment],” he said. “And then getting the tax incentives was even more accretive.”

All three panelists agreed that tax incentives put in place as part of the Inflation Reduction Act (IRA) of 2022 have made retrofits much more financially viable, particularly given the current state of the economy.

“We all know that things aren’t penciling the way they were, so what gets cut are optional items,” Merrigan said. “Sometimes the incentives do make it work, especially in low energy-cost markets.” He added that “one of the key components of the IRA is transferability, so now [tax credits] can be sold easily. That’s a game-changer.”

Bates was even more enthusiastic about the impact tax incentives can have on a project. “Right now, with the IRA in place, I don’t think the incentives will ever be this strong again,” he said. “It really makes sense to push your building stock in that direction today while the government is paying for 30% to 50% of it.”

Yet Bates also stressed that energy-efficiency retrofits make economic sense even without tax credits. “If you’re doing it the right way, using an integrative design mentality and being very thoughtful about the envelope, you really shouldn’t need those incentives,” he said. He added that in the case of Sharp’s manufacturing facility retrofit, incentives “sent the returns through the roof.”

Hines’ Izzo said that a major motivating factor for retrofitting office buildings is that it helps secure high-quality tenants in an increasingly competitive market.

“Our tenants are looking at net-zero space for targets that they’re coming up against, especially tech tenants,” Izzo said. “We’re realizing that there’s a shortage of supply and we can meet that demand with this type of offering, even in a 1930s building.”

Bates agreed that making space attractive to potential tenants by reducing energy consumption is a key method for generating value, particularly in markets where real estate plays a significant role in employee retention.

“In Silicon Valley, the cost of labor is so much greater relative to the cost of real estate that if [energy efficiency] can attract higher quality labor, tenants are all in to pay for it,” Bates said.

Bates also mentioned provisions in executive order 14057 stipulating that by September of 2030, buildings in which the U.S. General Services Administration (GSA) occupies over 25,000 square feet and at least 75% of leasable space will be required to be carbon neutral.

“What that means is a lot of the large building owners in the country that want GSA as a tenant — which in a downturn are probably the best tenant you can have in the country — are already starting to move their building stock toward carbon neutrality,” Bates said. “So, if you’ve got a class-A building, it’s going to become an A-minus or B-plus if it’s not carbon neutral.”

Referring to the energy performance certificate (EPC) system in place in the United Kingdom, Taurus’ Merrigan said that it is creating positive demand for office space that complies with EPC requirements.

“In 2030, you won’t be able to lease certain buildings, they’ll basically be taken out of the rental stock if they’re not compliant,” he said. “So, it’s a major issue in London, [and] it’s changing the dynamic of the marketplace there.”

Merrigan also spoke of demand for energy-efficient properties from capital markets. “There are many institutions, particularly the ones from Europe, that can’t acquire or invest in your asset if your business plan doesn’t bring you over 20 years onto a CRREM [Carbon Risk Real Estate Monitor] global decarbonization pathway,” he said.

“It’s really about future-proofing your asset and having it become institutional-quality in the long term,” Merrigan said. “You’re going to have an investment-obsolete building if you don’t make these kinds of interventions.”