The Business Case for Sustainability
In this blog article, I will share one approach I have found to be effective while attempting to implement various sustainable strategies with commercial real estate developers. My approach measures expected operational cost savings like energy and/or water savings, and presents them as contributions to net operational income, often referred to as NOI. I then use the NOI associated with the operational cost savings that a project will produce in a ratio with the first cost premium associated with the sustainable design measures, including those that directly relate and contribute to the operational cost savings. This will yield an approximate capitalization rate for consideration.
Let's examine the concept of a capitalization rate (cap rate), or the ratio between NOI and a properties' original acquisition cost. Cap rates in cities across the US are used by real estate developers and investors as a form of benchmark for financial performance of an investment. If an area's average cap rate is 6.5%, and the investment can yield a cap rate at or higher than this average, generally, this investment is considered worthwhile.
To consider the financial merits of pursuing sustainable design strategies and projected energy savings with a new building design, I asked a client what cap rate they were using in their financial analysis, to which they responded 6.5%. I then evaluated various energy savings strategies and compared them against certain criteria such as the projected energy savings expected annually and the cost premium for the project's sustainable design measures. Once I had my data, I developed a few different scenarios to present to the client for consideration. An example of one of them looked like this:
- Annual Baseline Power Costs (assuming convention design): $200,000
- Annual Energy Savings (using strategies with a 35% energy savings): $70,000 (NOI)
- Purchase price: $719,225 (premium cost of all sustainable design measures)
- Cap Rate: $70,000/$719,225 = 9.73%
- Net gain above market Cap Rate: 9.73% - 6.5% = 3.23%
If the resulting cap rate is 6.5% or higher in this market, an investment such as the total cost of the project or acquisition cost makes sense-an investment made in sustainable strategies that results in a higher cap rate would surely be considered favorable. One trick is to compare costs for conventional design approaches and costs for incorporating energy savings strategies to determine a reasonable estimate of a premium. Another trick is to be careful with projections of energy savings, which need to be as accurate as possible to approximate a valid projection of energy savings. In the above example, the projected annual energy savings alone create an approximately 10-year payback period for 100% of all sustainable design strategies employed for the project.