LBNL Report Number
The commercial real estate mortgage market is enormous, with almost half a trillion dollars in deals originated in 2015. Relative to other energy efficiency financing mechanisms, very little attention has been paid to the potential of commercial mortgages as a channel for promoting energy efficiency investments. The valuation and underwriting elements of the business are largely driven by the “net operating income” (NOI) metric – essentially, rents minus expenses. While NOI ostensibly includes all expenses, energy factors are in several ways given short shrift in the underwriting process. This is particularly interesting when juxtaposed upon a not insignificant body of research revealing that there are in fact tangible benefits (such as higher valuations and lower vacancy and default rates) for energy-efficient and “green” commercial buildings.
This scoping report characterizes the current status and potential interventions to promote greater inclusion of energy factors in the commercial mortgage process. It includes the results of a literature review and extensive stakeholder discussions with 40 lenders, owners, service providers, advocacy organizations and others.
We present the following key findings related to current status of energy factors in the mortgage process:
- Energy efficiency is generally not a motivating factor for lenders. It is typically considered a very small piece of the overall risk profile. Furthermore, the commercial mortgage loan process involves high stakes, which creates a disincentive to do anything that deviates from the shortest path to “getting the deal done”.
- Although energy costs are part of the NOI calculation, there is currently very limited awareness and analysis of their impacts in underwriting.
- Underwriting is not standardized across the industry and lenders have considerable discretion in underwriting practices.
- The Property Condition Assessment (PCA), a detailed engineering report that lenders usually require, generally does not include information on energy performance. Furthermore PCAs are often ordered too late to influence the basic mortgage terms.
- Most appraisals do not consider existing or planned energy efficiency features in property valuation, and have limited if any access to this information.
- There have been several studies claiming a positive impact of energy factors on building value, but many owners have not been able to discern this in their own portfolios.
- Context matters: all real estate is local. The impact of energy factors on valuation vary significantly by location, building type, quality, and current market conditions.
Overall, current commercial mortgage practices do not fully account for the risks and opportunities that may be associated with the energy-use of buildings. As a consequence, energy efficiency is not properly valued and energy risks are not properly assessed and mitigated. Commercial mortgages are a large lever and could be a significant channel for 2 scaling energy efficiency investments. We present seven potential interventions to properly account for energy factors in the commercial mortgage lending process:
- Demonstrate to lenders how and where energy factors “move the needle” on the key underwriting metrics, such as default risk, NOI (and thus, implicitly, valuation, LTV and DSCR), and economic or functional obsolescence.
- If intervention #1 is successful, provide simple, seamless ways to incorporate energy factors into underwriting - ideally as simple as a score to characterize energy factor risks.
- Include energy performance in the PCA and move it up in the process. If PCAs included investment-grade information on energy efficiency opportunities, they could be used to facilitate funding for improvements through the mortgage loan.
- Owners need to demand consideration of energy performance by appraisers and lenders and provide the data.
- Include energy metrics more explicitly in ARGUS software. Given ARGUS’s widespread use in the real estate industry - it’s a de facto standard - a possible intervention would be to introduce more explicit energy metrics into its analytics package.
- Get appraisers to properly value energy factors. There are already several efforts under way on this front, including DOE’s Appraisal Working Group.
- Consider interventions in ancillary products and services such as mortgage insurance premium discounts for energy efficient buildings.
These interventions are technically feasible and could have significant impacts, with benefits to lenders and owners. However, it is also true that the nature of the mortgage lending process – with multiple stakeholders, high stakes and risk aversion – does not lend itself easily to changes. Therefore, these interventions will need to be piloted carefully and modestly with highly motivated early adopters. Wider deployment will likely require aggressive education/awareness efforts and stakeholder engagement and support through relevant industry organizations.