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A Simple Framework for Evaluating Green Real Estate Properties:

Note prepared for the Argentina Green Building Council


Copyright © March 2009 by Meng Li. All Rights Reserved.
E-mail: mli@energyefficient-power.com

General idea:

When properly designed and constructed, green properties use less energy, less water and require less
maintenance expenses than conventional properties of similar sizes and functionalities. In this note we
develop a simple framework that allows us to quantitatively measure the economic benefits of green
developments from an investor/financier's point of view.

In a nutshell, we choose a conventional property design as the design base case and then measure the
green building case against the baseline case in terms of energy, water, maintenance savings, as
illustrated in the following graph.

Conventional Building
without green features

Expenses

Green Building

Time in years
5
Two Basic Concepts:

The discount factor:

The discount factor r is usually obtained via the CAPM (Capital Asset Pricing Model)1:

r=rf+Bi (Mrh-rf)+ SCM-Mrh+SCR (1)


where

rf is the risk-free interest rate


B represents the beta or covariance of commercial real estate sector. It makes more sense to use
the beta for green real estate sector only. Currently this is not yet feasible however, due to the very
limited number of green projects that have been undertaken as of right now.
Mrh represents the historical expected return in the market for the S&P 500: this figure has been
fluctuating between 11% and 14% until the current stock market crash. As such, new projects being
undertaken right now likely face a hurdle that is significantly lower than 11%
SCM represents the historical return in the market for micro-cap stocks, this too has been
discounted heavily for new projects
SCR represents specific company risks in comparison to micro-cap firms

The discount factor's importance derives from the fact that it represents a concrete measure of the
opportunity cost of money.

Net Present Value (NPV):

With the discount factor, we can determine the net present value for a given project:

1. See Campbell Harvey's annual survey of CFOs for testimony of the popularity of the CAPM for major U.S corporations.
The version of CAPM presented here is the formulation commonly adopted for practical as opposed to academic purposes.
For more information, see Appendix C of The Handbook of Financing Growth, John Wiley & Sons, 2005.
FV t
n
−FV o
NPV = (2)
∑ 1r  t

t =1

The NPV is the most widely used tool to determine the feasibility of projects. For an investment to be
worthwhile, the NPV must be positive. It is popular because it provides a concrete measure of the time
value of money. When it comes to investments, time is money. The NPV quantifies this idea.

It is evident that, the higher the discount factor, the lower the NPV, other things being equal.

Let's define the NPV for a green property development project to be:

FV tg
NPVg= n
−FV og (3)
∑ 1r g  t

t =1

The single most important challenge of Green Building is to minimize or eliminate the so-called
“Green Premium”. In other words, our goal is to incorporate green features into a building without
adding any additional cost to its design or construction process.

This can be accomplished via a rigorous approach toward project budgeting. It is important to maintain
clear communications among project team members to make sure that everyone involved in the project,
from project architects to engineers to the general contractor and sub-contractors, is thoroughly familiar
with the green measures that would be incorporated into the project from the get-go.

Green building elements are incorporated seamlessly into the overall design and construction process.
To eliminate the green premium, it is important to:

• Lock down a definitive budget for the project before construction commences
and then
• Stick to this budge throughout the course of the construction by all means
Value Engineering (VE) process is instrumental in achieving the latter goal. In particular, a good way to
economize the development process and prevent cost overrun is by incorporating an experienced cost
estimator into the project team early on during the schematic design phase.

The goal of no Green-Premium means that Fvgo=FVo (4)

FV tg
n
−FV o
therefore NPVg= (5)
∑ 1r g  t

t =1

While life-cycle cost saving estimates are the best way to measure the effectiveness of energy
efficiency measures, in practice developers often sell the property within 5 years of having completed
the development. To reflect this tendency, we will consider an investment payback period of only 5
years or t=5. Therefore, the difference in NPV between a green property and the baseline property is:

FV tg FV t
∣NPV g −NPV ∣=
∣ 5

∑ 1r g t ∑ 1r t
t=1
− 5

t=1
∣ (6)

In addition, every year the green features allow the property to save:

FV tg FV t
∣1r g  t

1r t ∣ (7)

Taken together, (6) y (7) form the framework within which we can readily analyze the economic
benefits of green design solutions.

It is reasonable to believe that: r g ≤r (8)

This is so because green building projects are looked up favorably by investors for several reasons, in
addition to the substantial savings that can be achieved. These reasons include reputation and public
relations benefits, government policies that favor green, environmentally friendly projects as well as
regulatory regimes that impose a cost on carbon emissions, such as the Cap and Trade system currently
proposed by U.S President Barack Obama.

Furthermore, attaining prestigious Green Build recognitions such as the LEED certifications help a
property distinguish from its peers in competitive and fragmented markets such as the hospitality
industry.

Based on (8), we obtain the following inequality:

FV tg −FV t
NPV g− NPV ≥ 5
(9)
∑ 1r g t
t=1

An Example:
Consider a building that manages to save 5% of operating cost per annum thanks to its energy and
water efficiency measures. This translates into a corresponding 5% increase in the property's before tax
net operating income, other things being equal.

so FV tg =1.05FV t

5 5
and ∑ FV tg−FV t =∑ 1.05FV t −FV t =.05 FV t
t =1 t=1

so long as there is no green premium and equality (4) holds.

Based on these data, it is straightforward though algebraically tedious to calculate the project's Internal
Rate of Returns (IRR) by setting the sums of the project's present values equal to its forward value:

FV tg
n
=FV o (10)
∑ 1r g  t

t =1
Knowing that FV tg =1.05FV t , we can solve for rg, which represents the equivalent compound
interest rate on this green project.

Caution:
At the end of the day, the project has to be viable and well-planned in the first place. Incorporating
green building elements per se will not turn a ill-thought out and ill-executed project into a good one.
Methods of Green Build, as specified in the LEED standards, can add significant values to a promising
project. However, these improvements are predicated upon other relevant factors in the design and
architecture, engineering and construction process.