Thursday, September 6, 2007

Is Subprime Lending Good for Green Real Estate?

One of my friends, a sustainability consultant, called me up and what she actually asked was, "What is the connection between subprime lending and green?" She went on to explain that her firm had an internal pow wow on how the credit crunch might be affecting their real estate customers. What a great question. I immediately saw its Freakonomics potential. We talked about it at length and afterwards, I even related it to one of my institutional clients. He also reacted immediately, so I knew that I was on to something. It is always good thing for a sustainability consultant get some independent validation by investor. These days, real estate investors sail choppy waters in the capital markets Some cruise in elegant ocean liners, other in make halting headway in rugged frigates, and a few are surviving with flimsy canoes. So the current market's impact really depends on the condition of your fleet. Bloomberg chronicled the mood of anticipatory doom that is swirling about institutional real estate, projecting a possible 15 percent drop in real estate sales prices and values in the coming year. I think they should have inserted one of those instant polls where people can vote on whether they were going to renew their antidepressant prescriptions. And as for the connection.

  • What goes down, must go up. The current events in the credit markets represent a reversion to the mean. For months, there have been mumblings in and out of real estate that the prior-go years of mega deals, and value increases have been fueled by cheap, "covenant light" debt. So from this perspective, interest rates were long overdue for increases back to historical averages. Subprime lending was a natural, timely trigger for for an observable market process that is critical to economic cycles.
  • Cash is King. The stronger sailers represent cashflowing assets in resilient markets with good, diversified employment fundamentals. Asset types with weaker cashflow prospects relative to lenders revised underwriting guidelines will be subject to the most volatile repricing. Lenders will not lend as much debt on these properties, the cost of any financing will be higher and investors will have to accept lower returns on their investments. Yes, even stronger cash flowing properties will be affected by lenders' tougher underwriting standards, however, they will obtain better credit terms relative to weaker assets and, just as important, higher sales prices.
  • Green is good for the Cashflow. In their 2006 update study, "The Cost of Green Revisited", Davis Langdon shows "no significant difference in average costs of green buildings compared to non-green buildings". On top of that, green buildings enjoy lower operating costs to boot. So let's do the math: same costs and more net operating income for a green asset. Which means, all other factors being equal, in today's tougher credit market, building and operating a green building is a quantifiable positive hedge of the asset's underwritten cash flow against market driven declines in value, sales prices and returns.
So the existence of subprime lending, as problematic as it is these days, is highlighting a strong common interest in cashflow that aligns more investors with the sustainability community and underscores investing in green buildings. Let's see what happens from here.

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