More on MOHURD Three Star System

Today I'm attaching another slideshow on MOHURD's Three Star green building rating system. This PPT was presented by Song Ling, head of MOHURD's Green Building Label Management Office, at the recent Canadian Embassy green building summit.

MOHURD Three Star System- How Does It Work?

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On slide 5, Ms. Song introduces the Green Building Design Label (GBDL), which serves as a form of pre-certification. Developers can submit their design plans and earn a GBDL, which confirms that the building was designed to meet the Three Star rating system. The developers can then use this pre-certification to market the sustainability of the building to potential occupants or investors. It's unclear, however, what mechanisms require the developer to actually build to the design.

The presentation then dives much more deeply into the nuts and bolts of the system and talks specifically about who actually rates the buildings for compliance. For buildings seeking 1- or 2-star ratings, they go through a local certification process that is run by the many universities and research institutes shown on slide 8. For buildings seeking 3-star, the rating must be approved by the Beijing office of MOHURD.

Lastly, Ms. Song presents a list of the 10 green building projects certified in 2008. The list is all in Chinese obviously, but some of the more important buildings include #1, Shanghai Research Institute of Building Sciences office; #3, the Shanghai 2010 World Expo Center; and #7, Shenzhen's Vanke City. All of these buildings achieved the highest 3-star rating. Also of note is #6, the Bank of China headquarters in Beijing, which received a 1-star rating. As more leading Chinese companies build green buildings, it will begin to drive market transformation. I wouldn't expect ICBC or China Construction Bank to be far behind.

Groundbreaking report: many barriers exist to building energy efficiency and carbon pricing alone is not enough

The World Business Council for Sustainable Development has just released a huge report on building energy efficiency called Transforming the Market. The report is the result of four years of hard work and a first of its kind computer model that attempts to incorporate how regulations, price signals and behavior change can affect global energy use in buildings. The report focused on buildings in the six largest building markets: Brazil, China, Europe, India, Japan, and the US.

The report reconfirms that buildings represent a vast source of low-cost investment opportunities to reduce CO2 emissions. However, much to my surprise, these investments will generally cost more than previously thought. I will come back to this point at the end of my post.
The report drives home the message that in order to capitalize on these carbon reduction opportunities, the building industry must start transforming itself TODAY.

The need for transformation
As the report notes, building energy efficiency isn’t a problem of technology. It’s a problem of scale:

Some very low-energy new homes already exist in many countries, demonstrating that our energy targets are technically achievable. But these examples show little sign of being scaled up globally. Low-energy buildings must become the norm rather than the novelty project.

The report identifies several key structural barriers that are preventing broad take-up and snowballing of energy efficiency solutions

• A lack of transparency about energy use and cost, resulting in a limited focus on energy costs by all those in the building value chain, with viable investment opportunities overlooked and installed technology not operating at optimal levels
• Public policies that fail to encourage the most energy-efficient approaches and practices, or actively discourage them
• Delays and poor enforcement of policies and building codes, which concerns all countries
• Complexity and fragmentation in the building value chain, which inhibits a holistic approach to building design and use (described in their first report)
• A lack of adequate offers today (affordable and quality energy-efficient solutions for new constructions and retrofitted works, adapted to local contexts)
• Split incentives between building owners and users, which mean that the returns on energy efficiency investments do not go to those making the investment
• Insufficient awareness and understanding of energy efficiency among building professionals – identified in EEB research published in the first report – which limits their involvement in sustainable building activity and results in poor installation of energy-related equipment.
  

I’ve come across these same barriers time and again in my China green building research, so it’s not surprising to me that the barriers are global.

The report also does an interesting case study of a multifamily housing unit in Northern China on Page 36. The authors model both a base case, where energy use triples between now and 2050, and a Transformation case, where an aggressive mix of policies and technology restricts the growth in energy use to 63%. Although the Transformation case still results in high growth of energy use, it results in a 50% reduction in emissions over the baseline case. But most importantly, this 50% energy use reduction over baseline pays for itself. The authors estimate this scenario will require an additional investment of $12bn per year, but will pay for itself with about $12bn of energy savings annually. So to me, the choice seems like a no-brainer: either aggressively implement policies that pay for themselves and result in 50% less CO2 emissions or do nothing and watch climate change rip the planet apart.

But as the report notes, it’s not a simple question of economics. Achieving the aggressive energy efficiency goal won’t be easy and will require a lot of strong policies, including:

1. Audit energy performance of apartment buildings; introduce labeling systems to provide transparency, and enforce increasingly strict building energy codes
2. Strengthen building codes and ensure adequate audit and enforcement capacity
3. Introduce heavy subsidies to achieve high performance in existing and new buildings, including significant feed-in tariffs for on-site generation
4. Require sub-metering, apartment level controls and charging according to use
5. Revise legal frameworks to overcome barriers to collective refurbishment of apartment buildings
6. Impose regulations to phase out low-performing buildings, including a requirement for zero net energy, new, low-rise buildings from 2020
7. Government authorities and other owners of social housing must act on their property portfolios
8. Initiate a mobilization campaign to motivate behavior change by owners, project developers, tenants and reinforce the message to fully establish a change in behavior
9. Educate and train developers, architects, engineers and the building trades to improve understanding of code requirements, illustrate the advantages of integrated design and alleviate concerns for higher costs
10. Promote energy service companies (ESCOs) as effective energy managers for building owners, especially public housing authorities
11. Promote onsite renewable generation for all new low-rise buildings
    

It’s not clear that China can find the political will to implement all these policies and get to the Transformation level. But at least this case study provides yet more evidence that he Chinese government should undertake these policies knowing that both the economic case is pretty solid. Again, the overall economics are not the problem; rather it is the many structural barriers listed above.

Building energy efficiency isn’t free
One of the more surprising conclusions of the report was this idea that building energy efficiency investments will cost more than many (me included) assume.

The authors divide the investment into three batches: those with paybacks of 5 years or less, those with paybacks of 5-10 years, and those with paybacks of more than 10 years. The authors suspect that there are about $150 billion worth of annual investments with paybacks of less than 5 years that will result in 40% carbon reductions by 2050. There is also about $150 billion worth of annual investments with paybacks of 5-10 years that will result in an additional 12% carbon reduction, totaling 52% below business as usual. The authors do not calculate a figure for investments with paybacks over ten years. As I’ve mentioned before, I have a problem with payback period, but this is still interesting to see so many good investment opportunities with less than 10-year paybacks. When energy savings are added to the ~$300bn in investment
shown above, this results in a net annual cost of about $250bn.

The authors also note that despite this relatively large cost number (1.5% of global GDP), building energy efficiency investments have much better economics than carbon reduction opportunities in other sectors. Building energy efficiency can also be implemented immediately and creates jobs, further lowering the net overall cost.

A carbon price alone won’t be nearly enough
As the report notes:

EEB modeling shows that increasing the price of energy or carbon will only slightly increase the implementation of energy-efficient options. In fact, reductions would only marginally increase from 52% at today’s energy prices to 55% with an incremental carbon cost of US $40/ton.

This fits very well with my earlier analysis showing that at current carbon prices, the CDM or other carbon price only gives a 20% sweetener to energy efficiency investments, probably not enough to make a whole lot of difference.

This unfortunate fact means that mere passage of a cap and trade bill will not be enough to get us to where we need to be. It also reinforces a statement made by Michael Hoexter, author of the indispensable Green Thoughts blog:

The premise of carbon pricing as a complete climate solution, as opposed to “command and control” regulation, is that regulators and the designers of a carbon pricing do not know the technological solutions to reducing carbon emissions, in keeping with the monetarist/free market tendency to view scientific knowledge as limited in scope and not generalizable. The market becomes a “black box” that produces innovation or favorable and/or efficient social results. In practical terms this could mean that designers of the policy are thought not to be cognizant of industry inside knowledge or that no one can know what the future will bring in terms of technological development. Entering into a carbon pricing system then means embarking on a technological and economic “voyage of discovery”.

If one believes that one knows or we know at least a portion of the technological solutions to reducing carbon emissions, carbon pricing would be in many instances a roundabout solution for supporting those solutions.

We know most of the solutions needed to drastically reduce building energy use and carbon emissions. I’ve blogged about many of them, including improved insulation, combined heat and power, and integrated design. Most of them are fairly mature technologies or processes and most are fairly low-cost. The issue is the many barriers to implementation listed above. Therefore, a carbon price alone will not be enough to access all of the emission reduction opportunities the built environment has to offer.

As the WBCSD says, “building professionals, owners and users do not grasp the urgency and remain unmotivated to act.” Governments and citizens need to start motivating these actors to achieve energy savings and emission reductions in the built environment.

More on Ministry of Construction’s Three Star Rating System

One of the hardest parts about studying green buildings in China has been the difficulty of finding accurate, publicly available information on green building policies. Nowhere has that been more true than with the Ministry of Construction/ Ministry of Housing and Urban Rural Development Green Building Evaluation Standard, or “Three Star System”.

I was lucky to get the English translation of the Three Star System that I previously posted. This has been my most popular post to date, so I’m following that up today with a presentation that should shed more light on the Three Star Rating System.

Gunnar Hubbard, a LEED expert and Principal at Fore Solutions, recently gave a great presentation at a green building event at the Canadian Embassy in Beijing detailing the differences between Three Star and LEED. I’ve embedded that presentation below.

Gunnar Hubbard- LEED vs Three Star Green Building Rating Systems

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On slide 22, Gunnar notes that the growth of LEED registered projects in China and Dubai far outpaces any other non-US country. China has nearly 150 LEED registered projects and about 20 LEED certified projects.

According to statistics from my advisor Borong Lin, associate professor in Tsinghua University’s Department of Building Sciences, China has only 10 buildings certified under the Three Star Rating System. But growth is strong: there are between 50-100 buildings going for certification this year.

Professor Lin says that the government is currently drafting a regulation that will require all new government buildings to achieve at least a 1-star rating. The government will also be drafting a list of incentives for developers who pursue certification. These incentives will include tax breaks, lower interest rates and preferential financing, and increased Floor-to-Area Ratio incentives. All of these incentives will bring down the upfront cost premium for Three Star buildings, currently about 2% for 1-Star all the way up to 10% for 3-Star. Both of these policies are expected to be unveiled next year. This is great news, and these steps are exactly what I advocated for in my Bottom Up Approach.

Pegging incentives and regulations to Three Star will be a huge driver for growth in the number of buildings seeking certification. One of the big reasons so many buildings in the US have pursued LEED is because municipalities and states have pegged their policies to LEED. As China increasingly pegs their policies to Three Star, expect to see more buildings pursuing this system. I would also expect that any Chinese building seeking LEED will also seek Three Star. This dual certification ensures the best of all worlds: an international, third-party certification that appeals to multinational tenants as well as a local certification that allows for accessing of green building incentives and helps drive market transformation.

Professor Lin captured the interplay between LEED and Three Star with a great metaphor: LEED and Three Star are like two climbers taking different paths to the top of a mountain. LEED already has already started trekking up the mountain, and Three Star has been able to learn what worked and what didn’t work by watching LEED's path. Both hope to get to the top, but it isn’t a race. There is room for everybody at the top, and hopefully they can help each other out on the way. The important thing is that they reach the top of the mountain. As Gunnar notes on Slide 5, the goal of ALL rating systems is market transformation. Hopefully the Three Star Rating System will reach the top of the mountain soon and achieve the goal of transforming the real estate market in China into a greener, healthier place.

Green jobs in China’s built environment

Green jobs are hot. The idea of green jobs - family-supporting jobs that contribute significantly to preserving or enhancing environmental quality - has gained significant traction in America over the last two years, culminating in President Obama’s appointment of green jobs guru Van Jones to Special Advisor for Green Jobs, Enterprise and Innovation.

While the concept hasn’t been as hot in China, the opportunity for green jobs is massive. This post will explore the opportunities for green jobs in China, particularly those in building energy efficiency.

Unemployment in China
Despite China’s strong growth over the last quarter century, many Chinese across the age and skill spectrum still have trouble finding good jobs. In this blog post, I will focus on two particular types of people having trouble securing good jobs, migrant workers and recent college graduates.

Migrant worker unemployment
The global economic crisis has hurt Chinese migrant workers particularly hard. 20 million migrant workers have lost their jobs since the start of the downturn, nearly 15% of the total migrant labor pool. Many of these migrant workers were employed in factories in the Pearl River Delta region or in the construction trades throughout the country. These migrant workers are generally untrained and have limited skills, with one study (PDF) indicating that less than 20% of migrant workers have received any type of training. The government is worried about the potential for these large numbers of unemployed migrant workers to cause social unrest.

Youth unemployment
But it’s not just low skilled migrant workers. youth in China also face severe employment pressure. In fact, youth account for a majority of the unemployed: over 70% of the unemployed are under 35, according to an academic study (PDF).

And while a college degree certainly improves the chance of finding a job, only 70% of college graduates find jobs upon graduating. This means that nearly 1.5 million college graduates failed to find jobs in 2008.

Greening the Built Environment
Greening the built environment is a huge opportunity to find employment for both of these groups and many others. As I’ve mentioned time and again in my blog, the Chinese built environment is extremely inefficient, but many low-cost solutions exist to make it much greener. Implementing these solutions will require significant manpower, particularly from migrant workers and college graduates. In this post I will profile two possible solutions, but many, many more opportunities exist for the creation of good green jobs that simultaneously lift Chinese people out of unemployment and poverty and result in a greener, healthier built environment.

Retrofitting poor insulation
As I noted in my post on China’s inefficient heating systems, Chinese buildings have extremely poor insulation:

As the results of the Asia Business Council expert interviews above show, the primary factor affecting a building’s heating load is the building envelope and the insulation it provides between the interior of a space and the outdoor environment. The worse the insulation, the more energy transfer between the indoor and outdoor environment. When it’s cold outside, this means the cold air comes in, and the hot air goes out, resulting in a lot of wasted energy as well as occupant discomfort. As the graph below shows, insulation in Beijing (and the rest of China) is significantly worse than the developed world’s, and allows much more heat (in the form of energy) to escape to the outside.

Graph based on data from Chinese Academy of Building Research

My anecdotal evidence backs this up: I can feel the cold when I put my finger against the glass of almost any window in Beijing, even in high-end apartment buildings. One major exception thus far was the Linked Hybrid, which as I mentioned here, focused on high-quality insulation. Investing in improved insulation is a win-win-win, resulting in higher thermal comfort for occupants, and less energy use and GHG emissions at low cost. Insulation works “year round”, in the sense that improved insulation reduces heating energy use in the winter, but also reduces cooling energy use in the summer. This is really important, since as we can infer from the LBL graph above, in addition to the southward creep of space heating units, there is also a northward creep of air conditioning units. Maybe the best part about investments in insulation is that they are also a win financially. As the McKinsey global GHG abatement cost curve below shows, investments in insulation are one of the lowest cost sources of carbon emission reductions available.



In that post, I also noted that improved insulation is a win-win-win: more thermal comfort; less energy use and CO2 emissions; and a low cost that quickly pays for itself. And because upgrading all that insulation requires significant hands-on labor, we can add yet another win: green jobs.

Improving insulation is straight out of Van Jones’s playback. He is well known for saying inner city youth should “put down those handguns and pick up those caulking guns” and start saving energy by improving insulation in buildings.

Putting some of the 20 million migrant workers (many of who were in construction trades before) into retrofitting building insulation would be a great way to simultaneously increase employment and reduce energy use and CO2 emissions.

Poor code compliance
As I described in my post on the Top Down Approach, compliance with Chinese building energy codes is dismal:

As the data shows (PDF), compliance with energy codes in China is poor throughout the country. The disparity between design and construction compliance also shows the willingness of developers to “cheat” when faced with the perception of increased costs. Given that many Chinese building dont even currently comply with mandatory building energy codes, it seems unlikely that these developers and owners will be willing to voluntarily take the jump to green buildings.

Therefore, the Chinese government must step in and force these laggard developers to improve their energy efficiency. The current mandatory building energy code, which mandates 50% savings over 1980 levels for new buildings, is a good start. But now the hard work of actually enforcing this code must begin. Several US groups, including NRDC and the US DOE Pacific Northwest National Laboratory,are working with Chinese government to help them develop the capacity needed to enforce the codes.

One of the big reasons buildings don’t often comply with building codes is that MOHURD (formerly MoC) doesn’t have enough employees to check every building. Certifying and establishing energy use levels for the millions and millions of Chinese buildings will require significant skilled manpower. As the NRDC notes in their recent strategy paper on US-China cooperation on climate change,

In China in particular, this new paradigm [stopping climate change] will also require heavy investment in effective environmental enforcement, including accurate environmental monitoring and reporting, well-trained environmental regulators and enforcement officials.

As part of this program, Kevin Mo, the director of NRDC’s China Sustainable Building program, will be lobbying the Chinese government to expand their hiring and training of building energy code certifiers. And who are the likely candidates to fill these jobs? Ideally, the many unemployed Chinese college graduates. Most will lack the specific skills needed for these jobs, but have the necessary capacity to learn these skills. The government will then provide the specific skills training and the jobs. In this way, young Chinese will be able to find good jobs and help reduce energy use in the built environment at the same time.

Efficiency is WIN-WIN
In addition to being the largest source of cheap carbon emission reductions, building energy efficiency is also the largest source of good green jobs. The UN’s International Labor Organization notes that:

The great majority of efficiency measures, especially in the building sector, show positive employment and economic effects. A study undertaken in 2000 by the British Government concluded that, for every $1.4 million (€1 million) invested in residential energy efficiency, 11.3–13.5 full-time equivalent (FTE) jobs were created. Half the economic potential for efficiency gains in buildings is located in developing countries, but no data on existing or potential jobs are available for that part of the world.

Given how inefficient Chinese buildings are, it will take a lot of manpower to fix them up. China should embrace the built environment as the best place to simultaneously reduce carbon emissions and create green jobs.

Green Building Economics 102: Affordable Green Housing

The key takeaways from my last post on green economics is that green building is more valuable and many people are willing to pay more for green buildings. This is great for the high-end of the market, but what does this mean for affordable housing? Obviously if green housing is more valuable, i.e. more expensive, this means green housing might be less affordable for potential buyers. How can we balance the need to keep green housing affordable with the green economics I presented last time? That is the focus of my post today.

(In this post, I will make the assumption that affordable housing is owned by the occupant. Of course, this is not always the case, but this simplifying assumption doesn’t actually change the underlying economics and makes it easier to write this post. If you are interested in how this would apply to renters, please email me and I would be happy to talk with you.)

Affordable housing in China
In China, as elsewhere, “affordable housing” usually means keeping upfront cost as low as possible. A pillar of China’s affordable housing program has been government subsidized development of affordable housing under the 经济适用房 or “Economical and Comfortable Housing” program. This program consists of a combination of subsidies in the form of land grants and reduced taxes and caps on developer profits to keep upfront prices low. For more info on this policy, see this Harvard Joint Center on Housing Study report (PDF). Although I am not an affordable housing expert, this program seems to have been pretty effective in creating affordable housing: in 2003, for example, Economical and Comfortable Housing accounted for nearly a quarter of all housing units sold in Beijing. Despite these successes, China still does not have enough affordable housing to satisfy its lower- and middle-class populations and the government is trying hard to fix this situation. The government is embarking on the construction of 7.5 million affordable urban homes between now and 2011, and an additional 2.4 million affordable rural homes.

On the surface, this approach of minimizing upfront costs makes sense. Certainly, those less well-off will have less ability to save and purchase homes. So subsidization means that more families are able to afford the down payments needed for these home. However, this narrow focus on upfront cost ignores any element of lifecycle costs. In many cases, the cheaper upfront option is actually much more expensive over its lifecycle, and in some cases, significantly more expensive.

In the case of this affordable housing program, I suspect that something like this happens: the developer designs the building one way and convinces the authorities to allocate his pre-determined profit margin based on those estimated costs. When it comes time for construction, the developer then has an incentive to cut as many corners as possible in order to reduce costs and max out profit. This is certainly a skeptical view, but given the compliance rates I showed in a recent post, this is unfortunately a likely reality.

The result? In most cases, the developer uses cheaper insulation and poorer insulating materials. The developer then sells off the property and washes his hands of any responsibility for the long-term operating costs of the building. The new owners, who were ostensibly buying this home because it was affordable, are now saddled with an energy inefficient home. Every year for the life of the building, the new owners will have to pay more in utility costs. Moreover, when it comes time to sell, what do you think will happen to the value of this home? That’s right, it will have depreciated greatly thanks to poor quality and high energy bills. So as we can see, even though this home was cheaper upfront, it carries a much larger lifetime cost. Who could call this affordable?

What does affordable really mean?

In order to properly define affordable, we must move beyond this narrow definition of affordability and consider total cost of ownership (TCO). TCO measures how much it costs to occupy a house or apartment annually, and includes everything from rent (or mortgage) to utilities, maintenance and taxes and can even include transit fees related to daily commute. Using this definition, homes with lower TCO are affordable, while homes with high TCO are not. After all, an avoided expense is just as good as money in the bank, in the sense that both increase a citizens ability to save and spend.

Total cost of ownership for green homes is lower

As I said in my post on green economics last week, it’s obvious that operating costs for green buildings are lower than comparable buildings. Therefore, it also makes sense that TCO for green homes should be lower than their energy-guzzling brown counterparts.

A recent study by Michelle Kuafmann, a green home guru in Northern California, confirms that TCO is lower for green homes. Even with a 3% cost premium for green features and the larger resulting mortgage, green homes still cost less, thanks to lower utility bills. Unfortunately, the increase in mortgage costs due to the green premium drowns out a lot of the utility bill savings, resulting in a pretty meager $2 in gross savings over the conventional building. (Note: Unlike the US, China does not have tax deductibility of mortgage interest, so ignore the net calculation here.)

But in fact, Kaufmann’s analysis understates the case for green building, at least in the US. As I mentioned before, insurance companies are offering lower insurance rates for green homes and some banks are offering lower interest rates. Most green homes focus on proximity to public transit, which means shorter commute times and less commuting expense compared to their sprawling brown counterparts. Furthermore, as energy and water prices rise in the future, this TCO case for green buildings will get even better.

How to get from here to there?

It’s clear that green homes have much lower TCO than their brown counterparts. But unfortunately, this doesn’t change the fact that green homes often cost more upfront. And although we should focus on TCO when analyzing affordability, this doesn’t mean we can totally ignore upfront cost. So how can we minimize TCO while keeping upfront cost low?

We can use two primary policy tools: incentive alignment and green financing.

First, government could and should require developers of affordable housing to have a long-term stake in the operating cost of the buildings. Government could set up a scheme whereby developers guaranteed some sort of typical level of energy costs for the residents. Any costs above this amount would be borne by the developer, and any savings below this amount would be split between the developer and the tenant. This would give the developer a big incentive not to cut corners and save energy over time. If government is interested in lowering TCO as they should be, this policy would be a useful lever to align the incentives of both developer and tenant.

Second, government should encourage banks to step up their green financing programs for customers to purchase green homes. Banks should offer a mix of lower interest rate “green loans” that will lower TCO further and also larger loans that will help reduce the upfront cost to purchasers. The mortgage is almost always the largest expense on a home and lower interest rates would further lower TCO. For example, let’s take another look at Michelle Kaufmann’s numbers. In the analysis below, I used the same figures but assumed the bank offered a 0.25% interest rate reduction for green homes. As you can see, this frees up significant savings, bringing the cost advantage for green from around $2 to nearly $87.

This type of green financing program is not unprecedented in China. The Chinese government has been using green loans to encourage other sectors to go green, but hasn’t done much for green financing of buildings, and nothing for green financing of affordable housing. Hopefully Chinese banks will expand this to individual customers, particular those in the lower- and middle-income brackets.

The future

Eventually, I think building a green home will actually cost less than building a conventional home. Zeta Communities, for example, is working on making pre-fabricated net-zero housing that costs less than standard brown housing. But until these cost breakthroughs occur and green buildings are superior on both total cost of ownership and upfront costs, government policy will have to help drive adoption.

Green Building Economics 101

As promised, today’s post will describe the economics of green building and why green buildings are so much more valuable than their brown counterparts. I will follow this up with a post describing how developers can use these economics to make affordable green housing work financially.

How to value real estate- DCF basics
The Discounted Cash Flow method and the Direct Capitalization method are the fundamental tools for valuing real estate investments and I will use that to inform the discussion today.

The Discounted Cash Flow (DCF) valuation method attempts to account for all future cash flows from an investment and discount them to a present value. So to make that more concrete, let’s say I buy a building today. I can assume I will get rent every year for the life of the building, and also assume that I will have to pay expenses over the same period. The difference of the rent income and the expenses is my profit. But as everyone knows, a dollar of profit today is a lot more valuable than a dollar of profit in the future, so we have to discount the future cash flows to today’s value using the time value of money. We also can’t be certain that we will continue to receive rent in the future, so we should also discount the future cash flows to reflect this uncertainty.

The DCF is the best theoretical way to value real estate, but it is somewhat more complex than the direct capitalization method I will focus on today. Direct capitalization generally captures nearly all of the important nuance of DCF, but does so in a much easier-to-understand formula. Therefore, I will focus on capitalization today. But if you want to understand more about the differences between capitalization and DCF, please see this article or email me.

The direct capitalization method involves taking the current net operating income (NOI) of a building and capitalizing (multiplying it by a large number- generally between 10 and 20) to reflect the face that this income will continue into the future
.
So the direct capialization valuation method works like this:

1. To calculate NOI, we simply add up all of the revenues (rent and other revenue) and then subtract all of the operating expenses (management fee, utilities, etc). It’s important to note that we only subtract operating expenses, so we don’t subtract things like taxes or interest payments. Although obviously important, these expenses don’t factor into NOI.



2. We then take the NOI and divide it by a capitalization rate. The capitalization rate is a percentage that takes into account 3 things: NOI will continue indefinitely into the future and in many cases grow over time; future NOI needs to be discounted to today’s value; future NOIs need to be discounted for risk and uncertainty. Capitalization rates are generally between 5 and 10%, but can be lower or higher depending on circumstances.
   

So then, the value of a building is roughly equal to:

Other valuation methods
Of course, DCF and direct capitalization are not the only valuation methodologies. Another extremely useful type of valuation tool is comparables. Comparables involves taking two or more similar assets and comparing their values. If, for example, we wanted to value Prosper Center, we could use the value of the neighboring Kerry Center as a proxy. For example, Prosper Center and Kerry Center should have similar capitalization rates. Of course we’d have to do slight tweaks to account for variations, for example, but their valuation should be in the same ballpark (although as I will show Prosper should have a lower cap rate since it's green and Kerry is not).
Comparables is a very good way of valuing marketable assets, but I will leave this valuation method aside and focus primarily on DCF today.

Another valuation method often used by real estate developers is simple payback period. Simple payback period measures how many years it takes to recoup an investment. One knock on many green systems is that they have a long payback period. Since many developers usually have a limit on their desired payback period, say 5 years, they often will not make investments that have longer investments.

While it may be true that some green building systems have long payback periods, this totally misses the point in my mind. Simple payback period makes no sense as a rigorous valuation tool for several reasons. First and most importantly, payback period has no concept of revenues. For example, imagine an investment that required $1 today, and then made no revenues for the first 5 years, but made $1,000,000 in the 6th year. If a developer were to strictly use the simple payback period with a 5 year limit, they would miss this clearly profitable investment. This may be an extreme example, but captures a serious flaw in the simple payback period method of valuation. For this reason, I do not consider the simple payback method to be a useful method of valuation. While it generally is true that investments with short paybacks have good returns, it is not necessarily true that investments with longer payback periods do not have good returns.
Therefore I will ignore simple payback entirely and focus instead on direct capitalization today.

How green building drives increased building value
One more time, direct capitalization works like this:

As we can see from this equation, in order to maximize value, we need to maximize revenue, minimize costs, and minimize the cap rate. Green building helps do all three of these things, and in turn increases building value.

(Note: for this discussion, I will assume that we are talking about an office building, where tenants rent the building on a gross lease, i.e. one monthly payment from the tenant to the landlord that covers utilities, maintenance, insurance, and taxes in addition to rent. Other lease structures, such as triple net, are more common, but the green valuation issues remain the same. Please email me or use the comments box for any questions that relate to different lease structures and I will be happy to respond.)

Reduced costs
The first way green buildings increase building value is through lower operating costs.
Obviously, a green building that uses less energy will have lower utility bills. Since LEED rated buildings on average use 33% less energy than regular buildings, this means utility costs are about 33% lower. Since utilities account for ~25 to 30% of an office building’s operating expenses, this adds up to big value. Smaller water and waste bills also make for better economics.

Green buildings can also lower other less-obvious expenses. For example, the Fireman’s Fund, a leading insurance company, offers lower insurance rates for LEED certified buildings. Other possible cost saving measures for green buildings include lower interest rates through green banks (although again this doesn’t affect NOI, only returns to the owner) and lower maintenance costs thanks to smaller systems and better commissioning processes.

The result is less operating expenses for green real estate, which means higher building value.

Increased revenues
Green buildings also benefit from higher revenue, primarily through increased rents.

Several recent surveys and studies show that green buildings command higher rents. A study by economists for the Berkeley Program on Housing and Urban Policy showed that green buildings on average rent for 2-6% more than their non-green counterparts, after controlling for other variables like location and building age. This green premium even exists in China, where a recent JLL report shows that nearly 70% of high-end real estate tenants are willing to pay more for green real estate.

Why do green buildings command these premium rents? Two reasons primarily. First, workers in green buildings are more productive than workers in brown buildings. Thanks to more daylighting, higher air ventilation rates, improved indoor air quality, and other attributes of green real estate, occupants of green buildings tend to be more comfortable and more productive. The US Green Building Council website links to numerous studies showing that productivity in green buildings is higher. Since green real estate space is more productive than regular brown space, tenants are willing to pay more for the productivity benefits. This productivity-driven rent premium for green buildings will continue, as brown buildings just cannot match the many productivity-boosting benefits of green buildings.

Second, the supply of green buildings is low relative to demand, meaning the large and growing number of companies who want to occupy green space need to pay a premium to get access to the limited supply. This likely will not persist much longer, since the supply of green buildings will expand dramatically. However, what we will see then is a switch, whereby brown buildings actually require a rent discount in order to lure tenants away from the abundant supply of green buildings. So this will also guarantee continuing premium rents over brown buildings.

Since higher rents means more NOI, higher rents therefore drive higher value for green buildings.

Lower cap rate
The capitalization rate is essentially a measure of the future outlook of the property. This includes both expected growth in NOI as well as the perceived risk of future NOI. On both accounts, green buildings do better and therefore should receive lower cap rates.

Let’s first look at expected growth of NOI. As more and more companies demand green real estate and are willing to pay more for the productivity benefits, I think it’s safe to say that we can expect rents and NOI at green buildings to grow faster than those at brown buildings. Or conversely, when green building becomes the norm, very few tenants will be willing to pay the same price for brown real estate, meaning negative rent growth for many brown properties. The result is still faster NOI growth for green buildings, and therefore lower cap rates.

Green buildings are also less risky than their brown counterparts. Since green buildings use more advanced building techniques and are more likely to satisfy the needs of tomorrow’s tenants, there is less risk of functional obsolescence for green buildings. Moreover, thanks to lower environmental impact, green buildings also face less regulatory risk. The result? Again, lower cap rates for green buildings.

Green buildings have higher value
So let’s take these results and run through a quick thought experiment. Let’s start with a hypothetical building with rent of $1,500,000, expenses of $500,000 and a cap rate of 10%. Now what happens when we take the same building but assume it’s green? Well now rents will be 2-6% higher, utilities will be 33% lower, and I'll assume the cap rate will be lower by 0.5 - 1%. As we can see from my calculations below, we get a big value increase.



At the low end, we should expect green buildings to be worth 12% more, and at the high end, green buildings could be worth as much as 25% more than their brown counterparts. Of course this is just a hypothetical example, but the takeaway is clear nonetheless: green buildings are more valuable.

What does this mean for developers and owners?
For developers, I think this means build green from the start. Even for developers who build to sell immediately upon completion, green building is still compelling. The purchaser of the building will have an interest in owning for the longer-term, and should be willing to pay more for green. So even if developers don’t believe the 12% valuation premium example that I laid out above, it seems they can easily get 5+% for all of the reasons I described. This means as long as that developers can hold the cost premium for green below this 5%, they will be making more money than they otherwise would by building brown. If a developer can build green at 5% but get a 10+% valuation increase, well, now the developer is really doing well financially (not to mention socially and environmentally). As more developers start to understand green building economics, I think building green will become increasingly more profitable and eventually become the only way to build.

For owners, I think this means retrofitting to green standards right now. As my hypothetical calculations showed, the benefits of retrofitting and getting green certification are huge. Not only will the building benefit from higher rent, lower operating costs, better corporate image, less risk, etc etc, but it will most likely pay for itself through immediately increased building value. For example, if a building owner could perform a large retrofit on a building for 10% of the building value, the investment would immediately pay for itself thanks to higher post-retrofit building value. Although increased building value isn’t exactly the same as cash in hand for the building owner, the increased building value provides significant security for this investment in energy efficiency and green features.

The bottom line is that green building makes sense for the bottom line. As more and more developers, owners and tenants realize this, I expect to see green building become the norm for those who can afford to pay for the green benefits, particularly those in Class A office buildings, luxury apartments and international quality industrial facilities. The trick then will be to figure out how to make green building economics translate into something that works for those other sectors of the market that I’ve been talking about so much recently. Stay tuned for my next post for some initial ideas on how to use these green building economics to make green building affordable- and widespread.

Upcoming green building events

Dear China Green Building watchers-

I just want to quickly alert to you a few great green building events that are taking place over the next few months.

First up is Scaling Up: From Green Buildings to Green Cities in the U.S. and China.
The event will be held on Friday, May 1st in San Francisco and is being sponsored by the Asia Society, who incidentally has been really making a move into the green China arena with their recent reports on climate change and water security.

Second is Green Building Summit: Greentech Media's Forum on the Future of Building. The event will be held on Thursday, June 11th in Menlo Park. Greentech Media is a great source of info for all news related to cleantech, and does some great coverage of Serious Materials and the other emerging green building cleantech companies.

Next is the China Eco-Expo, held June 18-20 in Beijing and sponsored by the Ministry of Construction (although it's interesting to note that the MoC no longer exists, having recently changed names to MOHURD- Ministry of Housing and Urban Rural Development.)

Last, but certainly not least, is GreenBuild Asia 2009. This event will be held July 7-9 in Hong Kong.

UPDATE: China Sustainable Building Summit 2009 to be held June 29- July 1 in Shanghai.

If there are any other green building events in Asia or the US, please let me know and I will be happy to add them to this blog post. Thanks!