by Paul L. Jones, CPA, LEED Green Associate, Principal,
Emerald Skyline Corporation
Regardless of whether you are building your ark and waiting for the sea level to rise or if you are a climate-change denier, the writing is on the wall: sooner or later, you will need to modernize your building to improve its sustainability and resiliency. Accounting for almost 40% of the world’s energy consumption and greenhouse gas emissions, buildings are considered a high-impact sector for urgent mitigation action on climate change.
Accordingly, building owners, managers and tenants need to assess the opportunities and possibilities for improving sustainability in order to optimize the benefits realized – both physically through reduced consumption and waste and financially through proper planning, budgeting and financing.
Let’s begin by recognizing that there is a robust business case for investing in sustainability and resiliency measures (see the Sustainable Benefits article “Welcome to Sustainable Benefits – Let’s begin with the benefits of doing a commercial building sustainable retrofit….”) which enables the stakeholders to improves profits, saves the planet and be socially responsible corporate citizen (the “Triple Bottom Line”).
The first step in creating a sustainable retrofit program is to benchmark the property. According to Ms. Clare Broderick in her article, Creating an Energy Efficient Plan – One Step at a Time, (GlobeSt.com, 3/4/2015), “There is much truth to the adage, “whatever you measure improves”. Whether you are responsible for one building or a portfolio of properties you need to know your starting point in order to gather quantifiable results.”
Another step to facilitate the cooperation and sharing of costs and benefits between the landlord and the tenant is to align the interests through a Green Lease (for more on Green Leases, see the Sustainable Benefits article “Overcome Obstacles to Going Green with Green Leases“). Systematically including sustainability clauses at lease creation or renewal facilitates energy efficiency, sustainability and resiliency retrofit projects.
Sustainability and resiliency measures are not all capital-intensive. Many relate to building operations – like aligning operating hours with actual building occupancy or changing the time when cleaning crews work. Conventional wisdom states that the best way to start a sustainability program is to begin with free or low-cost measures which creates an environment where people who work or visit a building start thinking about reducing, reusing and recycling. (see the Sustainable Benefits article “Going green – Fifty free or low cost ways for commercial property owners, managers and tenants to begin.”).
While low cost measures and the replacement of energy-inefficient lighting and equipment occurs at the time of natural replacement as part of the annual capital budgeting process for property maintenance, the timing for a significant building sustainable retrofit is usually determined by the investment or occupancy cycle of the building:
- To attract a new tenant or retain an existing one;
- As part of the process to prepare a property for sale; and
- Upon acquisition as part of a value-enhancement business plan.
Maximizing the benefits from investing in the modernization (sustainability) and risk-reduction (resiliency) of a building utilizes a capital budgeting approach and requires the diagnostic review of the building which provides an understanding of the current equipment in use and an assessment of the improvements that can be made to accomplish your sustainability goals and objectives. The key to stakeholder action is to use capital budgeting based on forward-looking investment plans that facilitates the decision-making process.
In addition to planned equipment replacement upgrades, the first type of upgrade which is typically analyzed and approved as part of the annual management plan involves low-impact initiatives which generally have a short payback and can be implemented in currently occupied/leased buildings. These measures include commissioning an energy audit, replacing lighting and installing occupancy sensors and mid-level building energy management and control systems with interval energy data monitoring among other programs. In the case of these types of improvements, the capital budgeting decision can be limited to the relevant costs and benefits as hereinafter described.
The second is referred to as a “deep refurbishment” or “deep retrofit” project that aim to achieve high energy performance of the whole building which may include upgrading the building envelope, replacing the base building lighting systems, installing next generation smart building automation systems, adding solar or other renewable energy systems that require significant capital investment that cannot be recovered solely through the energy savings of the first few years, and the financial analysis of investment opportunities needs to include the impact on asset values.
Simple capital budgeting measures that are commonly used by engineers and contractors in proposals are the Payback Period and the Return on Investment:
- The Payback Period in capital budgeting is the amount of time necessary to recapture the investment in a retrofit project, or to reach the break-even point. For example, the cost to upgrade lighting to LED is $25,000 which is forecasted to generate $14,000 in energy and maintenance savings would have a 1.79 year payback period (Cost divided by annual savings or earnings).
- The Return on Investment is the inverse of the Payback Period and calculates the percentage return on an investment relative to the investment’s cost. In our example, the Return on Investment would be 56% (annual savings or earnings divided by cost).
While both the Payback Period and Return on Investment provide a quick way to evaluate and compare capital projects, the next level of analysis is multi-year and involves the time value of money which are commonly used in analyzing real estate investments. They are the Discounted Cash Flow, Internal Rate of Return. Another method is the Profitability Index and, finally, the method that is recommended in evaluating alternative investments is Life Cycle Costing. For all of these measures, it is important to forecast anticipated savings, earnings and costs over the investment horizon (typically, the life of the equipment):
- The Discounted Cash Flow (“DCF”) method “discounts” the estimates of future savings, earnings and costs using the cost of capital or other investment threshold to arrive at a present value estimate. The cost of the project is then deducted from the present value to arrive at the Net Present Value (“NPV”). The project is acceptable if the NPV is greater than zero. It can also then be used to compare to other projects.
- The Internal Rate of Return (IRR) is the rate at which the NPV of cash flows of a project is zero (i. e, the rate at which the present value of the future cash flows equals the initial investment). This is a yield calculation and the project is acceptable if the project IRR is greater than the Cost of Capital or other investment return threshold.
- The Profitability Index (“PI”) is calculated by dividing the present value of the project’s future savings, earnings and costs by the initial investment. A PI greater than 1.0 indicates that the profitability is positive while a PI of less than 1.0 indicates that the project will lose money (the NPV would be less than zero). It is a useful tool for ranking alternative projects because it allows for the quantification of the value created per unit of investment. Most of the time the PI will be consistent with the NPV methodology; however, they may be in conflict due to different project scale or different pattern of cash flows. Conventional wisdom is to use the NPV when the PI is in conflict with it.
In each of the NPV, IRR and PI, the future savings are determined using the difference in future consumption/expenditures based on the economy of the new equipment or process over the anticipated costs of continuing use of the existing equipment.
- Life Cycle Costing (“LCC”) is a tool to determine the most cost-effective option among different competing alternatives to purchase, own, operate, maintain and, finally, dispose of an investment in property, plant, equipment or process. According to BusinessDictionary.com, it is the “Sum of all recurring and one-time (non-recurring) costs over the full life span or a specified period of a good, service, structure or system. It includes purchase price, installation cost, operating costs, maintenance and upgrade costs, and remaining (residual or salvage) value at the end of ownership or its useful life.”
Consider the following example in the selection between two air handling units (from “Sustainability/LEED and Life Cycle Costing – Their Role in Value Based Design and Decision-Making” by Stephen Kirk, PhD, and Alphonse J. Dell’Isola, PE, date unknown):
Consider the selection between two air handling units. A 10% discount rate, a 24-year life cycle and a differential energy rate escalation of 2% per year are assumed. Other relevant data (NOTE: For all capital budgeting decisions, only incremental cash flows are included. Accordingly, sunk costs – those costs that have already been incurred – cannot be a part of the incremental cash flows used in the financial analysis of a capital project.) are:
|Type of Cost||Alternative 1||Alternative 2|
|Useful life||12 years||8 years|
The solution begins by converting all annual or recurring costs to the present time. Using the present worth annuity factor, the recurring costs of maintenance would be:
Alternative One: maintenance (present worth) = $500 x (8.985) = $4,492
Alternative Two: maintenance (present worth) = $800 x (8.985) = $7,188
According to the discount rate tables, the present worth of the energy costs for each alternative would be:
Alternative One: energy (escal. @ 2%) = $1800 x (10.668) = $19,202
Alternative Two: energy (escal. @ 2%) = $2200 x (10.668) = $23,470
Replacement or nonrecurring costs are considered next. When one or more alternatives has a shorter or longer life than the life cycle specified, an adjustment for the unequal life is necessary. If the life of an alternative is shorter than the project’s life cycle, the item continues to be replaced until the life cycle is reached. On the other hand, if the item life is longer than the specified life cycle, then a terminal or salvage value for the item is recognized at the end of the life cycle. This treatment using the present value factors is illustrated as follows:
Alternative Two: replacement (n = 8) = $10,000 x (0.4665) = $4,665
Alternative One: replacement (n = 12) = $15,000 x (0.3186) = $4,779
Alternative Two: replacement (n = 16) = $10,000 x (0.2176) = $2,176
The salvage value for both systems equals zero since they both complete replacement cycles at the end of the twenty-four year life cycle. A summary of present worth life cycle costs follows:
|Type of Cost||Alternative 1||Alternative 2|
|Maintenance (recurring) cost||4,492||7,188|
|Energy (recurring) cost||19,202||23,470|
|Replacement (nonrecurring), year 8||0||4,665|
|Replacement (nonrecurring), year 12||4,779||0|
|Replacement (nonrecurring), year 16||0||2,176|
|Salvage, year 24||0||0|
|Total present worth life cycle costs||$43,473||$47,499|
The first alternative would be selected on the basis of this LCC analysis.
Of course, any analysis should reflect the rebates that are available from manufacturers, utilities and governmental agencies.
As you can tell, the simple Payback Period and ROI analyses may be appropriate for small projects, like replacing the lighting, but using the DCF, IRR and PI methods provide better information while Life Cycle Costing Analysis provides the best basis for evaluating a project, or alternatives among projects, in making the capital budgeting decision.
As a CPA, I know that these analyses require time and skill to accurately prepare, but making sound capital budgeting decisions when improving a property using these techniques is the lynchpin of profitability. Emerald Skyline Corporation is uniquely qualified to be your advocate in planning, analyzing and executing your sustainable and resilient retrofit project.
In my next article, I will present the investment analysis of a “Deep Retrofit” as pioneered by Rocky Mountain Institute.