Value Beyond Cost Savings - Green Building Finance Consortium

Value Beyond Cost Savings: How to Underwrite Sustainable PropertiesThe key financial performance indicator from a DCF model is the internal rate of return(IRR). Technically, the IRR is calculated by determining the discount rate applied to thestream of cash flows from the property that would generate a zero net present value. 72Investors rely upon the internal rate of return, or related variations of the technique, formany real decisions, but then must fully consider whether the risks inherent in the proforma cash flow upon which the IRR is based are properly compensated by the internalrate of return that the property produces.Reduced risk is perhaps the most significant benefit of sustainable property investment. Tomeasure, or get a feel for the magnitude of value premiums due to potential risk reduction,one must evaluate how sustainable property investment influences discount andcapitalization rates. Practically, with few sales of sustainable buildings completed to date,and the difficult chore of separating out the effect of sustainability on sales prices,evaluating risk benefits relies more on a structured assessment of positive and negativerisks than a purely statistical or quantitative analysis. This will be discussed in more detailin Step 6: Risk Analysis and Presentation.Net operating income is not the end of the story in a DCF model. For investment decisionmakingpurposes, investors often need to consider leasing and capital items, debt servicecosts, and taxes. Importantly, sustainable properties can achieve favorable timing andreduced costs for capital expenses, tenant improvements and leasing commission costs,improving returns to investors.Prior to the last few years, low interest rates enabled debt to significantly increasefinancial performance. Essentially, investors could reduce their use of expensive equity,and replace it with low-cost debt, increasing their rates of return. Today, with debt servicecosts significantly higher, and loan to value and debt service coverage ratios lower, debt isless valuable than it used to be, but still cheaper than equity.2. Discounted Cash Flow Model InputsThe key financial model inputs for the discounted cash flow model are shown below inExhibit V-8. Those inputs shaded in yellow are some of the assumptions most influencedby sustainable property investment.72 In some cases, due to the reinvestment assumptions and other issues with the IRR calculation, a modified IRR or useof other measures—net present value, etc.—is warranted for decision-making126