The Value-Add of Energy Efficiency: Increased NOI and Cap Rates
The Capitalization Rate, or Cap Rate, is one of the most important financial metrics in the buying/selling of commercial real estate. The cap rate is often viewed differently depending on individual motives or incentives:
Buyers want a high cap rate. The higher the cap rate, the less expensive the property is given its earnings.
Sellers want a low cap rate. The lower the cap rate, the higher the sales price.
Lenders want a high cap rate, which is a good indicator of income and the ability to repay.
Appraisers often want to please the lenders they work for, and therefore conservatively come in with high cap rates which compute a lower valuation.
Regardless of situational self-interest, the Cap Rate is definitively calculated as:
Net Operating Income / Purchase Price = Cap Rate
So how does energy efficiency increase property value? By increasing the Net Operating Income (NOI), which is simply calculated as:
Income - Expenses = NOI
Energy efficiency projects increase the NOI by reducing operating (energy) expenses, known as the Energy Cost Index (ECI), which is an average of $2.30/SF for an office building in the Middle Atlantic.
With 100% project financing, another expense that is virtually eliminated is the need for capital reserves, money set aside for future projects such as necessary HVAC repairs/replacement, which can range as low as $0.40/SF or as high as $2.50/SF. (To read more, See #3 here: https://www.cap-eff.com/post/break-through-roadblocks-project-financing)
But sticking with reducing energy (operational) costs, let's provide some numbers as an example:
50,000 SF office building
Initially valued at $29,079,000 based on the average property value of $582/SF in Washington DC.
Initial energy cost of $115,000 based on the average $2.30/SF
Energy savings are found to be 40% (we've been able to identify energy cost savings of 93% with a building that had an Energy Star score of 95!)
Energy savings are $46,000 (40%)
Conservatively, estimate half those savings will go towards repaying the project financing, so overall the NOI increases by $23,000.
Generally, most commercial investment grade properties average between a 4-12% cap rate, so we'll compare using an 8% cap rate.
Again, the initial value is $29,079,000 at an 8% cap rate.
Using the same 8% cap rate, with an increase to NOI of $23,000, the new property value is calculated at $29,366,500 or an increase in value of $287,500.
So in this example, using the same 8% - which is decent enough to attract buyers, sellers can make an extra $287,500! All with no out-of-pocket expense utilizing 100% project financing.
Just like we are with our clients, we're transparent with our numbers. Take a look below: