This article originally appeared in the April 2018 issue of the Scotsman Guide (Commercial Edition).
For commercial property owners, investing in energy efficiency is increasingly moving from a nice-to-have perk to a must-deploy business tool.
As energy costs and estimates of energy use within the United States continue to rise, so, too, will the demand for energy-efficient buildings. In turn, commercial mortgage brokers and lenders should continue to address the ways in which green practices can be integrated into financing opportunities.
Americans spend $400 billion per year to heat, cool, and power commercial and industrial buildings, according to 2015 data from the U.S. Department of Energy, making energy use one of the largest operating expenses for businesses. Projections from the U.S. Energy Information Administration through 2050 show this pattern will continue, with energy consumption nationwide growing annually by about 0.5 percent.
Across the U.S., commercial mortgages are a popular finance vehicle through which owners can fund property purchases or renovations. According to the Mortgage Bankers Association, commercial and multifamily lenders closed nearly $491 billion in mortgage loans in 2016. Mortgages remain a prime example, however, of the untapped potential to invest in energy efficiency, something brokers should be aware of.
Until recently, building owners seeking more energy-efficient buildings had to seek out nontraditional financing and keep their energy upgrades separate from a traditional mortgage. Revolving loan funds and capital investment funds are two common internal financing options. External financing options are more numerous, but not all options are created equal and some are better fits than others for particular projects.
Energy-savings performance contracting, for example, allows property owners to hire an energy service company to complete a project, such as lighting retrofits, with little to no upfront cost. The repayment term can span up to 10 years or more in some cases, although commercial properties often have three-year repayment periods. Green bonds are another example of an external financing tool that allows owners to access large amounts of capital for complex energy-efficiency upgrades. These tax-exempt bonds accounted for more than $93 billion of investments worldwide in 2016, according to Moody’s.
Fannie Mae and Freddie Mac lead the multifamily housing market in energy-efficiency financing. Freddie Mac provided nearly $18 billion in financing during the first 16 months of its green loan program, which launched in 2016, while Fannie Mae issued about $31 billion in various green loan products during 2017. For owners of other commercial property types, however, there is no one entity similar to Fannie or Freddie that has as robust an energy efficiency portfolio.
“Until recently, building owners seeking more energy-efficient buildings have had to seek out nontraditional financing.”
Commercial Property Assessed Clean Energy, or C-PACE, financing removes the upfront costs of energy efficiency upgrades, tacking the payments onto property tax bills over several years, even if the building changes ownership. For smaller projects, such as replacing a heating, ventilation, and air conditioning (HVAC) unit or conducting a lighting retrofit, many utility companies offer incentives through which the customer can receive a rebate upon successful completion of a project.
Additionally, there are several smaller and nontraditional financial institutions, such as community development financial institutions (CDFIs) or the U.S. Small Business Administration (SBA), that offer alternative financing. One CDFI, the Community Preservation Corporation in New York City, has had success with underwriting financing for energy efficiency improvements straight into its traditional first-mortgage loans. Its financing, however, is only for multifamily properties. For small business commercial property types, the SBA’s CDC/504 loan program allows borrowers to qualify for a loan of up to $5.5 million if the upgrades result in energy consumption savings of at least 10 percent.
Each of the above financing options is worth exploring. None of them, however, allow for commercial building owners to truly have energy efficiency underwritten into their mortgage loans.
If energy efficiency is such a prime opportunity for cost savings and environmental benefits, what is delaying a larger market harmonization between these projects and commercial mortgage originations? One factor is complexity.
There are admittedly a number of players involved in a building’s life cycle that need to work together in order to successfully underwrite energy efficiency. A property owner must acknowledge the need for an energy-efficient building and request a professional evaluation, such as a property condition assessment or a physical needs assessment. In turn, these assessments must take the efficiency of a building into consideration and be performed by a trained professional who knows which components of a building impact its energy use.
Once the assessment has been completed, the building owner must then take that information to their lender—either a traditional bank or alternative financier—who has to be willing and able to use the data presented to underwrite a loan with energy efficiency as a top consideration.
To date, the overall commercial lending market has not been able to carry out this ideal scenario with the widespread success that Fannie Mae has had with multifamily properties. During the first half of 2017, Fannie Mae’s green-financing portfolio funded $10 billion in loans for multifamily properties that target an annual reduction of 20 percent or more in energy or water consumption. These loans may allow borrowers to receive a lower interest rate, increased loan proceeds, or a free energy audit, all of which translate into savings for both tenants and property owners.
“Simply put, the more energy efficient a building is, the less likely the underlying mortgage is to default.”
History is another factor behind market delays. Energy efficiency investments were once viewed as risky additions to a loan portfolio as lenders saw them as highly capital intensive. And, property owners may have associated them with lengthy or unknown payback periods, referring to the amount of time it takes to recoup the initial investment.
In 2017, Lawrence Berkeley National Laboratory (LBNL) published a study that found source energy-use intensity (EUI) correlates to mortgage default risk. Source EUI includes the amount of energy required to operate a building, including all production, transmission, and delivery losses. Simply put, the more energy efficient a building is, the less likely the underlying mortgage is to default.
The same is true when looking at residential properties. A 2013 study co-authored by the Institute for Market Transformation and the University of North Carolina at Chapel Hill Center for Community Capital found that, on average, mortgage default risks were 32 percent less for energy-efficient homes than comparable non-efficient homes. Increasingly, statistics and case studies are pointing toward energy efficiency investments as smart, viable additions to loan portfolios that have direct, positive impacts on parameters such as net operating income, return on investment—and even benefits such as increased tenant satisfaction, decreased tenant turnover, and higher rental prices.
Bentall Kennedy, a Canada-based asset-management company, commissioned a longitudinal study that found green buildings had occupancy rates that were 10 percent to 20 percent higher, and tenant-satisfaction scores that were 7 percent higher, compared to buildings without energy certifications. In this case, green buildings included those with certifications from the Building Owners and Managers Association (BOMA), the U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) program, or the U.S. Environmental Protection Agency’s ENERGY STAR program.
In order to overcome the green gap in the market, key players, including commercial mortgage brokers, must be aware of critical building components that affect energy efficiency—and be willing to integrate these details into their loan proposals. Mortgage brokers have a unique ability to impact loan amounts when successfully factoring in energy efficiency. Without knowledgeable brokers, this task becomes more difficult. Educated brokers, however, can incentivize and give direction to their clients on energy-related questions, which can produce more productive discussions about commercial mortgages.
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Increasing investment in high-performance buildings, creating a strong economy built on sustainability and financial longevity, and removing the unwarranted stigma of risk attached to investing in energy efficiency are all very real possibilities. In order to get there, mortgage brokers can help leverage all players in a building’s life cycle and acknowledge that investing in energy efficiency is both good for business and good for the environment.
To learn more about the value of energy efficiency for commercial mortgage brokers and lenders, view IMT’s training course with the U.S. Department of Energy’s Better Buildings Solutions Center, “The Business Case for High-Performance Buildings.”
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