Seeing the Greenbacks in a Green Retrofit: Key Issues in Securing Financing for a Green Retrofit

Empire State BuildingSavvy building owners and operators recognize the commercial rental market’s growing awareness of energy efficiency and sustainability issues. Driven by state and local government mandates and a desire for healthier working environments, builders and architects are constructing new green buildings nationwide. However, for every new green building constructed, there are thousands of existing commercial buildings that remain energy inefficient–consuming water, electricity and gas in excess and spending a premium in bloated operating expenses. Renovating these relics of bygone days of carefree consumption to incorporate green concepts is a burgeoning industry. Even the Empire State Building in New York is undergoing a $20 Million green retrofit that is expected to save over $4.4 Million in annual energy costs and reduce the building’s overall energy consumption by close to 40%. Because investing the initial capital in a green retrofit can be expensive, especially for building owners in a down economy, many have turned to traditional lenders for financing. The majority of established lenders, however, have not yet developed a consistent approach for underwriting a green retrofit. In trying to secure financing for your green retrofit, how do you make your lender see the greenbacks in greening your building?

The underwriting process for a green retrofit is not drastically different from that of any other renovation project. The borrower’s creditworthiness, resources and financial track record remain of paramount importance. What separates financing a green retrofit from any other refurbishment is simply the lender’s ability to understand and underwrite the value of the green improvements. In financing a green retrofit, the lender will often require a third party rating standard for the retrofit (LEED, for example, has a certification program for green retrofits) and will verify the property’s meeting this criteria through an independent architect or third party consultant. Often, there will be ongoing loan obligations after the completion of the retrofit for the property to retain the certification standard or at least operate at the same level of energy efficiency as created upon the completion of the retrofit. Lenders are also particularly interested in the existing leases of the property and the owner’s future lease form. The terms and provisions of the leases, especially all pass-throughs and capital expenditure provisions, are essential in determining how much value can be retained from the green improvements at the ownership level and how much of the initial costs, if any, can be recouped from the tenants.

Capturing the value of a green retrofit is not always a simple endeavor. If your building is currently occupied by tenants under existing leases, there are several issues that may impact your ability to secure financing for a green retrofit. Restricted landlord rights of entry, inability to temporarily relocate tenants and limits on the pass-through of capital improvements in existing leases can all be problematic in refurbishing existing buildings. Without negotiated rights of entry and the ability to relocate tenants during construction, there may be serious practical difficulties in pursuing a green retrofit. Building owners should also pay particular attention to how operating expenses and capital expenditures of the property are handled in the leases. What, if any, costs of the green retrofit can be passed through to the tenants? Standard lease forms often limit the landlord’s ability to recoup any capital expenditures from the tenant, especially during the final years of a lease. And, what, if any, savings in operating costs and expenses can be retained at the ownership level? In a triple net lease where the base year was established prior to the retrofit, the savings in operating expenses and utilities may pass through to the tenant, despite the owner’s funding of these improvements. Conversely, in a gross lease, the building owner is more likely to retain these savings in operating expenses and be able to use them to ultimately offset the costs of the green improvements. Of course, the more value a building owner can capture from a green retrofit, the better the chances of securing a loan.

When negotiating the terms of new leases or modifying existing leases, building owners should impose green obligations on tenants in order assure the property meets ongoing certification or efficiency requirements. For example, leases that require separate metering of utilities, occupancy sensors for lighting, operational limits for heating and air conditioning and limitations on water and electric consumption enable the owner to better capture the value of the green retrofit and maintain the efficiency of the property. Because the net present value of green improvements is most directly affected by the lease terms, lenders closely scrutinizes leases when underwriting a retrofit. Therefore, before embarking on green retrofit, it is imperative for building owners to examine the existing lease provisions to develop a “green” lease form with ongoing obligations for future tenants.

Although appraisers and underwriters struggle to develop a model to determine the net present value of green improvements, recent studies have shown that the value in green improvements is real and can be monetized. In a November 2009 study, CB Richard Ellis and the University of San Diego found that green buildings have higher occupancy rates, demand higher rentals and increase the productivity of their occupants. With 3.5% lower vacancy rates and 13% higher rental rates than comparable buildings, the study shows that it pays to go green. Green buildings also deliver lower operating costs for electricity, natural gas and other utilities, especially where there is separate metering for tenants. By lowering a building’s operating costs and catering to a tenant-friendly market eager for healthier and more sustainable work environments, there is money to be found in a green retrofit. Building owners, however, must show lenders that they can capture this value and safeguard it for their loan payments.