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.

Getting Institutional Real Estate to Invest in Sustainable Buildings

In my work, the hot question from my sustainability friends is “how do we convince lenders and investors to allocate capital towards green real estate?” They are baffled about why institutional lenders and investors often nod their heads politely in meetings, but are still largely noncommittal about writing the checks for green real estate, despite all of the verified proof of its superior investment performance. You would think that such a crowd would automatically embrace the higher return and value story. So why is that not happening, yet?

A classic problem, really. The idea that people and companies will act to enlarge their own self-interest is accepted as conventional wisdom. Not true, says the Rockridge Institute's George Lakoff, people routinely make decisions and take actions, which are not in their self-interest. In Don’t Think of an Elephant, Lakoff explains that people’s actions are driven more by how the subject fits with their view of themselves in the world as opposed to their self-interests. This could help us understand the slow adoption by institutional real estate as well as hint the way forward to greater capital flows into sustainable buildings.

The sustainability community is focusing on this disconnect. Earlier this week, Joel Makower covered the LaFarge and United Technologies study which highlighted the fact that compartmentalized expertise within the real estate value chain, incorrect perceptions about sustainable real estate costs, plus many not-so-obvious complexities of building green combine into daunting challenges to widespread capitalizing of green real estate projects. Financiers and developers are specifically identified as the biggest barriers to more sustainable approaches in the building value chain.

Among eight recommendations on influencing decision makers about sustainable buildings, the study points to personal know how, business community acceptance, a supportive corporate environment and individual personal commitment as the four main barriers to “greater consideration and adoption” of sustainable building. Bring in Lakoff’s explanation about people acting according to their identity more than their self-interests and we have a more focused definition of the disconnect and how we can better advocate for greater investment in sustainable buildings:

• Know U.S. institutional real estate’s identity. This industry has been experiencing a long, successful economic cycle without having to differentiate assets in the way the sustainability requires. Sustainability doesn’t exist within the investment world view. And this world functions around highly compartmentalized expertise. Integration, a basic tenet of sustainable building, does not naturally exist between participants in the institutional real estate value chain. So it is difficult for already successful real estate executives to fully appreciate how their investments will benefit from concepts and processes which do not exist in their world.

• Talk in the language they understand. These days, interest rate increases are eroding financing proceeds and are expected to result in a drop in property valuations. Did I hear someone say, “decreased net asset value”? This is a good time to start presenting sustainable building’s financial benefits as a potential hedge against eroding values from interest rate increases and lower sales prices. It is also a problem within their world that they can understand. Lenders and investors could understand this as ‘cash flow preservation’ and/or ‘risk management due diligence’.

• Use a metaphor from their world. I like the Carrier Division’s way of borrowing tools and techniques from its aerospace division to lead real estate executives through the green building decision making process. Airplanes are a powerful metaphor to assist institutional real estate in its evaluation of risks, costs, tradeoffs and profits. Air travel is full of emotional decisionmaking. Airline travelers have a monetary, health and safety interest in the condition of a plane. Airlines must invest in updating their fleets in order to remain competitive. Most real estate executives are frequent business travelers. Their emotional stake in an airplane's safety and their innate understanding of the relationship between a new, state of the art fleet and an airline's reputation could be used to convey the important messages about the risks of not investing in sustainable building.