A real estate investor owns a big office-building complex and decides he needs $10 million to invest in energy-efficient improvements. He goes to the bank, where the loan officer says, “Sorry, we don’t do that kind of thing.” When it comes to underwriting commercial real-estate loans, energy efficiency hasn’t been a part of the conversation – but it should be, according to Energy Efficiency and Commercial-Mortgage Valuation, by Nancy Wallace, Dwight Jaffee, and Richard Stanton. Watch the video.
A real estate investor owns a big office-building complex and decides he needs $10 million to invest in energy-efficient improvements. He goes to the bank, where the loan officer says, “Sorry, we don’t do that kind of thing.”
When it comes to underwriting commercial real-estate loans, energy efficiency hasn’t been a part of the conversation – but it should be, according to a new study, Energy Efficiency and Commercial-Mortgage Valuation, by Profs. Nancy Wallace, Dwight Jaffee, and Richard Stanton.
Backed by funding from the U.S. Department of Energy, the ongoing study develops loan models that would allow lenders to incorporate an office building’s projected energy costs into underwriting practices and commercial mortgage terms. The plan provides benefits for both buyers and banks by 1) providing incentive for building owners to make their buildings more energy efficient and 2) reducing the lenders’ exposure to risk. To create a way to measure a building’s value, Wallace, Stanton, and Jaffee studied a large database of recent commercial real estate transactions
“Buildings consume energy regardless of variability in tenancy. For example, lighting is often controlled by floor and the switch is either on or off regardless of actual demand. Energy isn’t really a variable cost for many commercial real estate assets in the U.S. and that is inefficient,” says Wallace, chair of the Haas Real Estate Group and co-chair of the Fisher Center for Real Estate and Urban Economics.
Traditional commercial underwriting relies on interest rates and building prices to establish terms. Stanton cites large fluctuations in energy usage that can cause a building to go into default as a reason such risk should no longer be ignored by lenders.
To consider the cost of energy risk, researchers deconstructed building prices into market rents minus total costs, including energy. The strategy considers the location of a building and the expected dynamics of electricity and gas prices.
“The challenge is to provide lenders with a tool with which they can incorporate four critical factors into their loan underwriting: (1) interest rates, (2) market rents (3) future electricity prices, and (4) future natural gas prices. While interest rates and market rents are already used, neither electricity nor natural gas prices have previously played any role in bank loan underwriting.”
Other than utility bills, currently there are no available metrics for lenders to measure the energy “risk” of a building and ensure accurate underwriting. The authors contend that using the information already available in a building’s engineering reports could be a first step in designing measures of energy efficiency relative to the building’s engineering systems and architectural features.
The research was inspired by obstacles encountered by scientists and engineers studying energy efficient technologies at the Lawrence Berkeley National Lab. Scientists discovered investors were not interested in retrofitting their buildings and wanted to know why.
“The lab engineers were perplexed as to why people were not making the available energy-saving investments and it became clear to them that this was an economic and financial issue,” says Jaffee, also co-chair of the Fisher Center for Real Estate and Urban Economics.
Wallace, Stanton, and Jaffee hope energy efficiency will be integrated into mortgage valuation in the near future, which among other benefits would help building owners meet the new mandates for energy efficiency in California.
“To do that, we may need both the U.S. and international capital markets. We need to reopen securitized bond markets to allow the capital to flow back into the United States and allow well-underwritten bonds to flow to investors internationally,” says Wallace.
Jaffee says if a few leading commercial banks begin incorporating energy efficiency into underwriting, other lenders will likely follow suit.