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Principles of Building Renewal

For real estate investments, we often rely on rules of thumb or generalized investment principles to accelerate decision making and quickly assess options. Whether based on market momentum, availability of capital, regulatory environment, tenant demands or the timing of leases, we often utilize investment principles to frame and orient our day-to-day work. Likewise, successful Building Renewal (BR) projects require a set of fundamental ideas to filter and guide decisions.

Consider the following list of Building Renewal Principles as you explore and implement your project:

BR is a Value Creation Strategy

Building Renewals are best understood as a value-enhancement real estate strategy, not just an energy efficiency (or cost reduction) strategy. Your objective should extend beyond that of cost savings to that of increasing the market appeal of a property. While energy costs are the largest controllable operating expense in an office building they are always trumped by an increase in asset value. The cost savings are real, but given current technology levels and depending on your time horizon, it can be hard to justify a project on reduced energy savings alone.

Nor should you…few real estate projects are ever analyzed solely on a cost reduction basis. How do you calculate the simple payback period on a cosmetic lobby upgrade? Fixing a leaking roof? We invest in buildings to make them more competitive, to address limitations, and to attract greater interest from tenants and buyers. Let’s be honest – there is a significant degree of subjectivity here. Will a tenant pay more if the lobby looks nicer? Can I sell the building if the roof leaks? There are no payback calculations to be made here - these are fundamental real estate decisions.

Beyond the simple payback analysis of Building Renewals there are additional benefits that aren’t always factored into the equation. Many of the strategies of Building Renewals, coupled with the integrated design approach, allow you to take advantage of synergies between the interior and exterior of your building. For example, re-designing the building envelope can allow for new day lighting strategies, which necessitate more open office space layouts, which in turn can lead to the re-configuring of the building’s floor plates to optimize the rentable floor area.

A Building Renewal is a real estate investment. You are seeking to transform the market perception of a property and reduce costs by leveraging energy efficiency and sustainability.

The Commonwealth Building

Building Renewal Snapshot

Unico Properties bought Portland’s Commonwealth Building in 2007, and turned what might be viewed as a liability into an asset. At the time of acquisition, the Commonwealth Building was approximately 50 percent vacant. Recognizing a unique opportunity, the Unico team implemented a series of energy efficiency upgrades as part of a larger repositioning of the property. With some modest tenant “re-stacking”, improvements were quickly made to the building’s HVAC systems that would have proven more difficult if occupied. Additionally, the design team removed suspended ceilings and improved common areas to increase the property’s appeal to local businesses. Certified with the ENERGY STAR® designation in 2010, the Commonwealth story demonstrates dramatic success in both energy efficiency as well as creating a compelling product in the market.

Think Holistically

At a high level, any renovation project can be broken down into various areas of emphasis, each relating to and impacting the other. We have organized these into four key dimensions, defined in the table below:

Markets: The local market conditions faced by your building, market fundamentals such as rental rates, vacancy rates, demographic shifts, the presence and nature of competitors, and regulatory environment. 

Tenants: Current and future tenants of your building. The timing, leasing issues, motivations, business models, sophistication, location, and size of tenants critical to the success of the Building Renewal. 

Finances: The sources, terms, and conditions of funds used to implement your renovation. 

Systems & Structures: The physical equipment, architecture, and operations of your building as they relate to the needs of the tenants, their energy use, and your ability to alter them to achieve energy savings.

No renovation is feasible in a commercial property without engaging with each of these, and successfully navigating the interrelations between them. For example, local vacancy rates can determine how many choices tenants have, either strengthening or weakening your competitive position. Likewise, your ability to upgrade equipment is tied to the funds you have available, which in turn is linked back to the market rents and existing lease structures. For Building Renewals it becomes even more critical to parse each area and draw up a cohesive game plan. Throughout the Building Renewal process utilize this framework to orient decisions and ensure that all of the real estate implications are considered and addressed.

Early decisions determine options

Building Renewals are an excellent opening move for a real estate investment. To a certain extent, any construction project undertaken on a building “locks-in” that building’s performance over time. A new chiller is a 20-30 year investment, one that cannot be easily undone. Glazing and envelope improvements have even longer time horizons. To maximize the value of a property you need to evaluate what the future market needs of that property will look like and design any renovations in a manner that keeps the most options on the table.

The influence of sustainability and energy efficiency on building value is only going to increase. Regulatory, market, environmental, and cultural changes are all putting pressure on our building stock to reduce its impact. As an initial strategy, a Building Renewal can mitigate the risk of a building losing its market appeal and keep multiple options viable over the long-term. 

The following table details ways that Building Renewals can “future-proof” a building and serve as a smart first move for your property:

Regulatory shocks

A building with a significantly lower energy profile than its market competitors may be insulated from:

  • More stringent energy code or performance requirements  
  • Impacts due to building energy disclosure ordinances 
  • Local and regional regulations related to carbon reduction

Supply & demand shocks

A revitalized building including a Building Renewal will likely compete more effectively against any new construction project coming online by:

  • Articulating a more compelling environmental narrative 
  • Maintaining a lower cost structure 
  • Retaining tenants who were engaged and motivated through the Building Renewal 

Price shocks

Building Renewal buildings may prove to be less impacted by: 

  • Energy price increases 
  • Material and construction cost spikes 

Liquidity

Building Renewals position the asset for quick sale by:

  • Positioning the building for future ENERGY STAR®and LEED® certifications 
  • Stabilizing tenant relationships and lease terms 
  • Appealing to institutional investors submitting environmental performance data to groups such as the Carbon Disclosure Project, GRESB, or the Greenprint Foundation 
  • “Future-proofing” the building against future regulatory shifts and environmental requirements

Market preference shifts

Building Renewals enhance the appeal to future tenants through: 

  • Appealing to millennial and Gen-Y preferences towards sustainability in the workplace 
  • Aligning with corporate and governmental leasing policies and environmental platforms 
  • Increasing occupant comfort and productivity via potential day lighting and improved ventilation strategies 
  • Maintaining a lower cost structure

Building Renewals complement any investment strategy

Real estate investors typically analyze a given property through two-dimensions: risk and return. What return might the purchase of a property yield? What is the risk that a building will lose a major tenant? How stable are the cash flows and over what time horizon? Each of these questions requires market knowledge and a defined investment strategy through which to conduct the analysis.

At a basic level, most real estate investments either focus on generating cash flows (what institutional investors might call "core") or to increase property values for a future sale ("non-core".)  Building Renewals – given their unique nature – can align well with each of these investment approaches.  Because Building Renewals focus on energy efficiency and the associated cost reductions, net cash flows can be enhanced.  Likewise, Building Renewals often result in higher property values, as the revitalized building is more cost competitive, attractive to tenants and has a lower risk profile.  When planned thoughtfully, Building Renewals can complement and even magnify the investment objectives of the building owner in almost every scenario.

The specific manner in which a Building Renewal can enhance a given investment strategy will depend on a range of factors such as local market conditions, hold periods, degree of leverage and more. Ultimately, determining the impact of Building Renewals on the investment strategy will require a property- specific financial model with operating assumptions tied to market realities.

Energy efficiency is the cornerstone of sustainability

While a broader range of sustainability considerations will follow suit, energy efficiency drives Building Renewals. Water efficiency, carbon emissions, renewables, indoor air quality, and other “green” features will inevitably play a role in your project. But energy should remain the core focus.

Put bluntly, no energy efficiency, no sustainability. As detailed on the Architecture 2030 website, buildings consume more energy than any other sector and are the largest contributor to climate change. Seventy-seven percent of all the energy produced in the United States is used to operate buildings. In terms of operating costs, energy is the largest controllable expense in a typical office building. From both an environmental and financial standpoint, energy efficiency trumps many alternative sustainability strategies.

Energy also factors heavily into most sustainability rating systems. Whether LEED, ENERGY STAR, Net-Zero, or Living Buildings – virtually every certification program addresses a building’s energy performance. With the increasing sophistication of tenants, institutional investors, and regulators interpreting and analyzing building performance, marketing a building as “sustainable” or “green” without quantifiable energy savings may backfire.

The Christman

The Christman is one of the few Triple Leadership in Energy and Environment (LEED) Platinum buildings designated by the U.S. Green Building Council. Its Energy Star score of 81 out of 100 puts it in the top 20% in the U.S. for energy performance.

Sequences are critical

Real estate can be a surprisingly complex choreographed sequence of actions, with one tactic depending on the proper execution of multiple other actions. Any real estate renovation relies on careful timing and execution, but Building Renewals in particular rely on proper sequences of actions, both technically and financially.

Conceptually, one idea dominates the technical approach to a Building Renewal: reduce loads first and then upgrade equipment. Building Renewals are made possible through integration, sequencing and cohesiveness. The interdependent nature of energy use, systems, occupants, and envelope all require recognition that decisions in one aspect of the project have obvious – and not so obvious – implications on other parts of the project.

The following three phases of implementation provide a way to organize which upgrades and investments need to happen in which order:

Phase 1 Load Reduction (General)

Reducing energy loads as much as possible through lighting upgrades, envelope improvements, plug-load reduction, natural ventilation and lighting strategies, adjusting occupant schedules, and optimizing space layout and use.

Phase 2 Load Reduction (HVAC)

Reducing loads through HVAC optimization, including heat recovery, controls strategies, improving fan efficiencies and other building operations techniques.

Phase 3 Upgrade & Downsize

Replace chillers, duct work, and HVAC infrastructure with the intent to migrate to smaller equipment sizes – or eliminate equipment entirely – due to the reduced loads from Phases 1 and 2.

By adhering to this sequence through an integrated design process you can more likely schedule and implement different energy efficiency upgrades in either a staged or bundled scenario. This allows for more flexibility to match up with tenant movements and lease terms, but only if the project is carried through to completion. Whether you implement all phases in one year, or across five, the energy savings will more likely be obtained if the integrated design approach is kept intact and properly sequenced.

Location and velocity drive success

"Location, Location, Location."  Real estate always boils down to the reality of where your building is located. Is it in the downtown core? The suburbs? Are you surrounded by buildings with high vacancy rates? What infrastructure and amenities nearby are appealing and available to tenants? Each of these questions helps determine the competitive environment for your property.

Sustainability considerations may never outweigh location as a driver of real estate value, but it can act as a powerful supplement. When competing against properties within a similar location, the focus shifts to that of bringing new features and amenities to distinguish your building. Sustainability offers one such edge when locational differences are minor. Increasingly, significant numbers of premium tenants are seeking sustainable, green office space. In a May 2011 report, 93 percent of businesses stated that sustainability is important for business and the future, over 130 Fortune 500 companies have high-level corporate sustainability officers, and 80 percent publish sustainability reports. Whether through corporate sustainability policies, employee recruitment and retention ambitions, productivity standards, or cost mitigation, the most attractive tenants in large and small markets are adding environmental performance to their leasing checklists.

The mechanism to capture this value is “velocity.” Put simply, velocity is the speed at which your building renovation attracts and secures tenants – in relation to competing buildings. High velocity situations are those where tenants are very interested in your building, quick to sign leases and claim their space within the “next, new thing.” The power of high velocity is that it gives you pricing advantage, the ability to negotiate from a position of strength. Conversely, low velocity implies low interest, softening the demand for space and limiting your negotiating power. If your building is average, you will be forced to accept average market rents.

You can’t change your location, but you can change your velocity. Building Renewals offer a tactic to accelerate leasing velocity by generating “buzz” about your building, reinvigorating interest and causing brokers and tenants to take a second look. By marketing the unique nature of your Building Renewal – shaping its “brand” and introducing a new consideration into leasing discussions - you have a unique opportunity to alter the narrative. You can tell the story that this building is different. The last thing you want is to become a commodity. You need to highlight that your renovation will yield a totally unique product and craft the messaging that brokers and local media convey about the project, generating that velocity – that speed - that will give you a winning edge.

Master your Market

Your building is almost always at the mercy of the local market. Market regulations, local preferences, competitor strengths, investor pools, financial institutions, and economic conditions all interact to define the nature of the market. The dynamics of the market determine what options are viable, what opportunities may be unexploited and what strategies most likely will lead to a successful project.

In his book "Value Beyond Cost Savings: Underwriting Sustainable Properties" Scott Muldavin discusses how linking sustainability performance can only be tied to financial performance through “assessing the response of the market.” Muldavin articulates the logic necessary to conduct this type of investigation as follows:

Evaluate the market demand for sustainable property by regulators, occupants, and investors; 

Assess whether brokers, appraisers, and lenders in your market recognize this demand; 

Determine the key financial model/evaluation inputs, factoring in both sustainable and traditional issues into cash projections.

This analytical sequence equally applies to Building Renewals. Without clearly mapping the market demand and likely response to a Building Renewal, the project may never get financed or implemented. To counter this begin with an examination of your market, seeking to understand if Building Renewals can generate positive reactions: 

Tenants: Will the Building Renewal appeal to the local tenant base? Are there clean-tech tenants or environmentally-oriented tenants to target? What specific leases in the market are coming due and can you synchronize the Building Renewal to coincide? What tenants have external environmental or carbon tracking policies? Which tenants are concerned with recruiting young talent?

Investors: Who will eventually buy this building? What criteria do they use? Are they a local investor, an institutional fund, an international investor? How can you link the Building Renewal to their needs? Do they report environmental performance across their portfolio? Are they subject to local or national political pressures?

Regulators: What entitlement and tax policies are linked with energy performance or green buildings? What neighborhood planning and zoning issues will this building be subject to? Are there other public policy areas that a Building Renewal can alleviate or mitigate? What does the political future look like, and can a Building Renewal generate public goodwill for your project?

With each of these target audiences you are identifying market needs and demands through which you can better argue for funding, investment and regulatory approvals. This type of analysis is integral to most real estate decisions and a successful Building Renewal will require predicting how the market will react, and how that reaction will translate into financial performance.

This is not anything new. Real estate developers understand that they are essentially predicting demand in the future, anticipating a favorable market response to a new building or renovation. Yet by definition, you can’t prove a prediction before it happens.

That’s why sometimes you have to “set the market.” If you can’t prove that there is demand, sometimes you have to create the demand. This can be a risky strategy, but one that many real estate professionals are familiar with. Often the best method to raise the value of a property is to enhance the neighborhood around it by building infrastructure and services that bring renewed interest. Another way to set the market is to simply offer something new and innovative. As Steve Jobs once said “…people don’t know what they want until you show it to them.” Cultivate the playing field, or even change it altogether. For Building Renewals, three approaches to consider are:

Secure first-mover advantage – In marketing terms, the first-mover is the product or firm that secures competitive advantages by introducing a new concept to the market ahead of others. In terms of real estate, first-mover advantage exists for buildings that are the first to renew a property, locking up premier tenants most attracted to green buildings, generating press and media interest, and establishing a reputation for innovation.

Build the market’s capabilities – Building Renewals require coordination and communication across many disciplines. Engineers, architects, lenders, contractors, government officials all bring necessary skills and resources to a project. But given the challenge of a Building Renewal, you may find that some skills or technical knowledge is lacking. You may run into code or policies of traditional design and construction practices that prevent a Building Renewal’s success. When faced with these issues you may need to import skills, educate stakeholders and lobby to change the established patterns of development. In doing so, early adopters have often gained a reputation for re-engineering the market and tilting the playing field to their advantage, establishing themselves as a market leader and innovator. By cultivating new skills among your team and altering the competitive landscape in a direction that you choose, you lock-in long-term advantage for the second Building Renewal, and the third, and so on.

Highlight the risk of inaction – Sometimes the fear of losing something is more compelling than the hope of gaining something. Social scientists call this “loss-aversion.” When selling the concept of Building Renewals to project stakeholders, it may prove more powerful to focus on the negative consequences of NOT proceeding. What if we lose our main tenant to the new LEED® Gold or Platinum building across the street? What if energy prices double over the next 5 years? What if the city passes the building energy disclosure policy? What if we can’t sell the building because it’s too outdated? Highlighting these risks with lenders, investors and other stakeholders can change the dynamic of the conversation and force a more honest market- based assessment of the value and potential need for a Building Renewal.