Value Beyond Cost Savings - Green Building Finance Consortium

Value Beyond Cost Savings: How to Underwrite Sustainable Propertiesthe net operating income in year eleven capitalized to obtain a residual value. 71 Theresidual value is important because the difference between the original acquisition priceand the eleventh-year sales price captures the appreciation in value over the holdingperiod. Revenues and operating expenses will change over a ten-year holding period basedon the terms of new and existing leases, changing costs, varying occupancy levels, andother factors.The capitalization rate is a measure of investor demand that reflects the return required byinvestors to acquire the stream of net operating incomes from a property. Thecapitalization rate can significantly affect the rate of return of a property. If a sustainableproperty generates increased investor demand, its capitalization rate will be lower,increasing residual value and net sales proceeds. The financial impact of the residual salesprice is reduced because proceeds are received in the future and must be discounted backto the present, but is still typically significant in a real estate investment.The DCF model is used by the appraisal profession as one of their three approaches tovalue. The three approaches are the Income Approach (typically a DCF Model), the SalesComparison, or Market Approach, and the Cost Approach. To calculate value from theDCF model one selects a discount rate (based on market evidence) to apply to the streamof cash flows to determine the net present value. The discount rate is the rate of returnrequired by most likely buyers to invest in the subject property’s projected net operatingincome. Accordingly, the discount rate, similar to the capitalization rate, incorporates themarket’s perception of the risk of a subject investment. The discount rate is used totranslate cash flows received over the holding period to a present value. The higher thediscount rate, the more risk an investor perceives in the pro forma cash flows, and thelower the net present value will be.The financial performance (internal rate of return value) of a property is determined by allthe specific financial inputs shown in Exhibit V-7. Some assumptions, like rent,occupancy, or energy costs are very important, and others, like water costs, trash removalor insurance, are less important.Consequently, in assessing how, and how much, sustainable property outcomes (energyefficiency, certifications, etc.) will affect financial performance; it is critical to understandthe relative magnitude of the different financial model inputs for the specific subjectproperty being evaluated. Typically, rent and revenue related assumptions would be moresignificant than operating cost assumptions. Accordingly, traditional sustainabilityfinancial analyses that ignore revenues are often inappropriate or inaccurate measures offinancial performance.71 A simple ROI or Life Cycle Costing model are variations on discounted cash flow analysis that incorporate morelimited assumptions and varying life cycles. Discounted cash flow holding periods will also vary significantlydepending on the strategy of the investor, with three, five and seven year holding periods often considered as analternative, or in addition to a ten year time frame.124