CUSTOMER BENEFITS. buildingrenewal.org

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1 SPARK VALUATION CAPABILITIES BUILDING RENEWAL PROJECT ASSESSMENT CONTENTS ll Introducing Spark ll Customer Benefits ll How Spark Works ll Value Creation ll Valuation Methodology ll Inputs ll Sensitivity Analysis ll Reporting INTRODUCING SPARK Through its BetterBricks program, the Northwest Energy Efficiency Alliance (NEEA) and its utility partners pioneered building renewal and developed Spark, a business case tool, that provides strategic, technical, and economic guidance for real estate investors, developers, and design professionals who wish to revitalize commercial office buildings. Spark s analysis and reports are also intended to inform customer decisions regarding building renewal projects and by doing so, accelerate the adoption of deep energy retrofits in leased commercial office space across the Northwest. This document describes Spark s economic analysis methodology, basic technical capabilities, customer benefits, and some of the resources upon which the building renewal tool was built. Spark has been designed to assess the value creation potential from deep energy retrofit and renewal and repositioning of commercial office buildings: ll Providing a building renewal/deep energy retrofit project scope as an integrated package of energy efficiency measures; ll Facilitating quick comparison of different project scenarios, including sensitivity analysis of project economics; ll Estimating project cost and energy and energy expense savings; and ll Assessing the value created by building renewal and repositioning. Spark delivers a simple, user-friendly analysis of the building in the form of project scenarios. The scenarios are defined by the user s answers to fewer than 60 questions about major building characteristics, economics, and preferences among potential project options.

2 Spark estimates the value created through deep energy retrofit projects undertaken to modernize and reposition the building. Spark s value calculations are built upon the economic leverage of energy and operations and maintenance (O&M) savings, plus the impact of building renewal and asset repositioning on tenant perception. The initial version of Spark has been developed for commercial office buildings, rented or leased to generate income. Historically this has been a complicated market segment for energy efficiency due to lease structures that require capital investment by owners, with operational savings flowing primarily to tenants. Spark recognizes the value premise in modernizing and repositioning older buildings. Investments made to renew, modernize and reposition older buildings provide significant opportunities to increase both operating cash flows and asset value through enhanced lease rates, tenant retention and risk reduction. CUSTOMER BENEFITS Spark is easily accessible. A complete, initial pass through the questions in the user interface should take no more than an hour (assuming utility billing and energy use information is compiled beforehand). It is relatively easy to explore different building renewal scenarios. The answer fields for some of Spark s questions are pre-populated with hints; if you are not sure of the answer, entering the value suggested by the hint will allow for a quick initial run that can be refined and fine-tuned as additional project team members are invited to the Spark project and more detailed information is obtained. In the absence of full information, Spark users are encouraged to answer questions with their best guesses. It is easy to go back into the Spark user interface and make adjustments to fine-tune the results. Spark will save time and money. The potential for deep retrofit savings and project costs can be quickly evaluated before investing time and fees on building audits, energy studies, and energy models. After Spark has demonstrated there is sufficient potential, a project team should be formed to deliver the additional assessment needed to support a final investment decision. Spark highlights market opportunities. By enhancing customers understanding of how energy efficiency fits into an overall real estate investment strategy, Spark places energy efficiency within a business context. Unique opportunities are highlighted and benefits comprehensively evaluated rather than as standalone project drivers.

3 HOW SPARK WORKS For each project, users can run an unlimited number of scenarios, and for each scenario, Spark users receive the following analysis: l Summary of existing building characteristics and energy use l Building- and project-specific integrated package of energy efficiency measures, based upon building characteristics and user choices l An alternative integrated package of measures providing enhanced energy savings l Estimate of project costs for both measure packages l Annual electricity and gas savings estimates, in both energy units and dollars An Analysis page provides Spark users with options to conduct sensitivity analysis of project financial returns. Users can modify scenarios to explore the combination of factors that influence project returns and to determine project areas for further analysis. From the analysis page a user selects a scenario either the Selected Measures or Enhanced Savings for reporting purposes (capturing any sensitivity analysis adjustments). Spark produces a scenario specific report that summarizes the following: l Project economics summary including returns, energy cost savings, implementation cost, and non-energy benefits. l Detailed efficiency measure descriptions, including measure intent, performance criteria, design and construction implications. l Detailed descriptions of relevant best practices, including measurement and verification, commissioning, operations and maintenance, and tenant procurement protocols; to support getting started with low cost-no cost energy improvements, and to help ensure that post-renewal energy performance is achieved or exceeded. Spark s energy analysis is built upon the capabilities of US Department of Energy s (DOE) EnergyPlus, a sophisticated hour-by-hour energy modeling tool, including the OpenStudio Application Suite [see sidebar description]. Typical Meteorological Year ( TMY ) Weather Data for the building location is used. Spark does not develop and run a full energy model of each building; rather, a full energy model of a prototype office building is run. Spark matches the user s building and retrofit characteristics with the characteristics of an office building prototype, developed from NEEA s demonstration projects. By comparing the actual energy use information of a user s building to the results of the prototype energy model, a customized order-of-magnitude energy savings estimate is developed. Measure cost indices, also derived from the demonstration projects, are used to estimate an overall project cost. Within the Spark user interface, structured in a survey format, users answer questions about building characteristics, and the value creation opportunity from building renewal. The number of these questions varies depending on the answers and relevant heating, ventilation, and air-conditioning (HVAC) systems but will not exceed 58 questions. The questions are organized into categories, so that a user s ordered responses suggest appropriate opportunities for load reduction and smaller (down-sized) plant and HVAC equipment. With this streamlined approach, Spark delivers important elements of energy modeling, without requiring consideration of the hundreds of criteria that need to be addressed to build a detailed, calibrated energy model.

4 Spark presents questions in nine categories: l Building age, size, location, etc. l Utility-related questions about annual electricity and fossil fuel use and expense l Building envelope questions, addressing windows, insulation, and leakage l Lighting and plug load control l Distributed HVAC systems l Where applicable, chillers and chilled water distribution l Where applicable, boilers and heating water distribution l Where applicable, VAV or Constant volume systems l Questions that further inform Spark s business analysis and valuation components VALUE CREATION A deep energy retrofit project can spark renewal in an older building, creating the opportunity through modernization to update and reposition and capture additional value. Integral to the Spark Tool is the recognition that these types of building improvements create far more value than energy savings alone. The integrated improvements breathe new life into an aging building: a more comfortable and productive interior environment, a building that is significantly more energyefficient and one better positioned to compete effectively with newer properties. Tenant experience: Increased Comfort l Higher quality light distribution l Improved visual comfort and control l Enhanced thermal comfort Based on the answers to these questions, Spark assembles one or more packages of improvements that make sense for a given building. For these packages, calculated energy savings and project cost estimates are developed. These savings and costs are combined with information provided in answers to the business profile questions to calculate the internal rate of return and present values of costs, expenses and other market benefits. These financial results are reported by the Spark Tool, to summarize the overall value creation potential. Increased Efficiency l At least 35% more energy efficient l Daylight responsive dimming l Comprehensive controls Renewed Look And Feel Capabilities for sensitivity analysis are built into Spark and are accessible via Spark s Analysis page immediately after a scenario is processed. Projected energy savings, estimated project cost, and the amount of project incentives can each be adjusted higher or lower with the impact of these adjustments seen in real time.

5 Owners achieve: Enhanced Strategic Positioning l Renewal and repositioning through modernization of the asset l Superior tenant retention l Increased tenant reach quality and quantity 1 l Hedge against energy price increases and volatility l Avoidance of both functional and economic obsolescence Increased Asset Value l Increased net operating income l Enhanced monitoring & measurement of performance l Risk reduction 2 l Durable income stream l Value capture on sale or refinance 1 Many government and corporate tenants require properties they lease to reach a minimum ENERGY STAR rating or LEED certification before they can even be considered. Through a building renewal project, a property can enhance its standing in one or both rating systems, thereby increasing the pool of tenants and credit quality of those tenants. 2 The risk profile of the asset is impacted by increased operating expense predictability, reduced exposure to energy price increases and volatility, reduced maintenance expense, and the addition of enhanced tenant credit quality. VALUATION METHODOLOGY Spark employs the most commonly utilized valuation methodology to evaluate investment returns in commercial real estate, the income approach to value, or discounted cash flow ( DCF ) 3. Organizations use a variety of measures and metrics to assess investment performance and returns. The starting point for most, is to look at an unleveraged pre-tax assessment, to get a sense of basic project economics, prior to consideration of tax implications and the relative benefits of financing alternatives. Many financial decisions on sustainability or energy efficiency are calculated and justified on a ROI or simple payback basis. However, this offers a limited view of the financial performance of the investment, especially when elevating the analysis to the property level. Underperformance is projected because these metrics focus on recovering cost, not what happens to cash flow improvements beyond the cost recovery period. Risks of project underperformance and benefits of over performance are also not accounted for in these scenarios. When developing Spark, NEEA assumed that an organization intrigued with the potential for building renewal would recognize the value added potential of the investment and ultimately turn to their established analytical methodologies and tools. Therefore, Spark s analysis calculates two of the most commonly used investment performance metrics, internal rate of return ( IRR ) 4 and net present 3 Discounted Cash Flow DCF - The procedure in which a discount rate is applied to a set of projected income streams and a reversion. The analyst specifies the quantity, variability, timing, and duration of the income streams as well as the quantity and timing of the reversion and discounts each to its present value at a specified yield rate. DCF analysis can by applied with any yield capitalization technique and may be performed on either a lease-by-lease or aggregate basis. 4 Internal Rate of Return IRR - The annualized rate of return on capital that is generated or is capable of being generated internally within an investment or portfolio during the period of ownership. The internal rate of return (IRR) is similar to the equity yield rate and is often used as a measure of profitability after income taxes. The IRR is the rate of discount that makes the net present value of the investment equal zero.

6 value ( NPV ) 5, on a pre-tax, unleveraged basis. The analysis uses the typical investment standard a 10-year project term with asset appreciation (reversionary value 6 ) calculated at the end of the tenth year. The analysis also isolates the cost and estimated returns associated with the improvements to provide an incremental assessment of the value of the renewal project investment. Spark provides an organization exploring building renewal with enough initial analysis to quickly see if further investigation and analysis is warranted. Internal Rate of Return ( IRR ) The IRR can be used to compare several prospective projects. The project with the highest IRR would generally be considered the best allocation of capital and be undertaken first. IRR is calculated using the net project cost (full cost less incentives) and ten years of pre-tax cash flows, with the calculated reversionary project value added to year ten. Net Present Value ( NPV ) Spark calculates the project s NPV by first calculating the present value of ten years of pretax cash flows including energy expense and operation and maintenance savings, plus the increase in rent (at the year of tenant turnover) using the project discount rate 7 and incorporating the reversion value of the project into the end of year ten. The net project cost is deducted from the discounted cash flows, to arrive at a net present value. The reversion value of the asset reflects the benefits of the anticipated cash flow that continue 5 NPV is the difference between the present value of the cash inflows and the present value of the cash outflows. These cash flows are discounted back to the present time at an interest rate that takes into account the time value of money and the risk or uncertainty around these anticipated future cash flows. 6 Reversionary project value The reversionary project value is the incremental asset value added by the building renewal project. It is calculated by dividing the net operating income at year 10 by the reversionary (or terminal ) cap rate. The terminal cap rate is used to estimate the resale value of a property at the end of the holding period. 7 Discount rate - The discount rate is the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate takes into account the time value of money plus the risk or uncertainty of future cash flows. The greater the uncertainty of future cash flows, the higher the discount rate. beyond the 10-year time horizon. To calculate reversionary value, NOI in year ten is divided by the estimated reversionary capitalization rate. This amount is added to the year 10 operating cash flows and discounted to the present, to represent the increase in asset value. Project Returns Six key factors combine to drive overall returns. l The all-in cost l Net Operating Income l Non-operational or limited benefits (incentives, tax credits, etc) l Location, market dynamics and competitive position l Management expertise l Ultimate exit value (value captured through sale or refinance) The economic environment, intended hold period, competitive landscape, regulatory horizon, tenant/occupant dynamics, operating expenses and cost of capital all play a roll as does the perceived risk profile of the asset. A multi-faceted analysis incorporates the risks and rewards of the sustainable components and capitalizes on operational efficiencies, revenue premiums, and government incentives to achieve a competitive advantage. A comprehensive property analysis depends on accurate information relative to current market conditions. We must understand a property s market position, as well as its competitive advantages and disadvantages to accurately assess value.

7 INPUTS SENSITIVITY ANALYSIS Spark s valuation process poses five business analysis questions for tool users to answer. l What is the building s current vacancy (as a percentage of rentable square feet)? l What is the building s stabilized vacancy percentage? 8 l What does your current rent roll look like (lease rollover percentages or rentable square footage in each year over the next 10 years)? l What is the building s average annual lease rate per rentable square foot/year? l What is the appropriate capitalization rate 9 for the property? 10 In addition to these five questions, Spark s economic analysis incorporates basic building information captured in the general questions section of the tool and then integrates the results of the technical analysis including project costs and energy savings. Spark has been designed with ample detail for its calculations to provide sufficient information in its reports for users to quickly assess rough orders of magnitude of project performance and returns. It encourages users to explore the impact of relatively broad changes to key project assumptions to test various assumptions and scenarios. These capabilities are built into the sensitivity analysis features of Spark s Analysis page located below the Proposed Scenario. While Spark has been designed to take into consideration specific regional market differences, it is understood each market and project is unique. Accordingly, Spark enables the user to make adjustments in a number of key areas through specific overrides, or via on-screen slider controls, allowing the User to modify the base Scenario and test a variety of assumptions. The sensitivity analysis sliders relative to the initial scenario assumptions include: l Project cost +/-20% l Energy savings +/-20% l Rent differential impact from $0.00/s.f. to $5.00/s.f. The sensitivity analysis text boxes include: l Capitalization rate l Discount rate l Incentives 8 This question is asked to avoid overestimating the positive impact of a building modernization rent differential. On average, most commercial office buildings are less than 100% leased. If you do not know this number for your building, or generally base valuation assuming zero vacancy, enter zero as the stabilized vacancy percentage. 9 The capitalization rate (CAP Rate) is the rate of return expected on a real estate. CAP Rate is calculated in a simple fashion as follows: investment, calculated as the annual income the property will generate (after fixed costs and variable costs), divided by the market value of the property. CAP Rate = annual net operating income /market value. 10 Spark will enter a default value for the first analytical run based on the property zip code. The user can override this default value on the Scenario page before a scenario report is generated. As a group, they provide an opportunity to overwrite the values used for these metrics in the initial scenario calculation, and allow the user to: assess the impact of a different capitalization rate than Spark s default; risk adjust the rate of return, based upon the type of project(s), the measures involved, and market based assumptions such as the ability to earn the full rent differential that is being assumed; and the relative impact of different incentive amounts upon project returns.

8 Because of the wide-open nature of the text boxes, a user can push the analysis a fair amount, to investigate the impact upon investment returns and the relative attractiveness of broad changes to project valuation assumptions. Project Costs Spark s project cost estimates represent the full project cost to design and install an integrated energy efficiency measure package, including hard costs, general contractor mark up, and soft costs. Cost data has been derived from NEEA demonstration projects in Boise, Missoula, Portland and Seattle. Working with a cost estimator to fully price the projects, the demonstration project hard costs have been converted to square foot averages, to calculate the rough order of magnitude of total project cost. (For the purposes of Spark s analysis, it is assumed that all project costs are incurred in year zero. However, a building renewal project may well be implemented in phases, with capital expenditures and the initial cash benefits from those expenditures spread out over as many as ten years. The timing of those expenditures and benefits can only be determined after detailed considerations that are beyond the scope of an earlyproject analytical tool such as Spark.) Project Incentives Project incentives vary by regional location, utility focus and the specific project improvements. They are often time limited and evolve depending on desired outcomes. Incentives for building renewal projects may be available in the form of utility incentives, tax benefits, or development agency incentives 11. l Hard costs include all materials and labor required to install the various energy efficiency measures. l General contractor mark up includes general conditions, payment and performance bond fees, estimating and design contingencies, general liability insurance, the general contractor s fee, and in Washington business and occupation tax. l Soft costs include project management, architecture and engineering services, construction administration, commissioning, permitting fees, owner s construction contingency (5%), builder s risk insurance and, in Washington State, sales tax. To allow users to make adjustments, on-screen slider controls allow up to a +/- 20% change io capture locational differences, in-house expertise, differences in soft costs and contractor markups and/or more detailed knowledge about renovation costs for a particular building. This allows the user and to quickly explore price sensitivity on investment returns. Spark does not automatically incorporate these incentives, due to the distinct nature of each market and the tax exposure unique to each property owner. However, it does allow the user to directly input their estimate of total available incentives. At the bottom of the Analysis page, below the proposed scenario, is a text box that allows the user to input a single aggregate number for all combined incentives. This total might include utility incentives or rebates, local government green building or sustainability development incentives, and federal and state tax credits. For utilities working directly with customers, the Spark report provides an opportunity to inform and broaden discussion of incentives. Through the list of integrated energy efficiency measures, an estimate of whole building energy savings, and a rough order of estimate of project cost the utility can provide information about applicable incentive 11 An actively maintained list for all states may be found at: Database of State Incentives for Renewables & Efficiency - www. dsireusa.org. Other sources include: The Oregon Department of Energy - business/incentives/pages/index.aspx The Energy Trust of Oregon - Seattle City Light - Washington State Energy Department - Programs/Energy/Office/Pages/default.aspx Idaho Governor s Office of Energy Resources - gov/financialassistance/index.htm

9 programs and may be able to tailor an estimate of incentives, which can then be entered into Spark s sensitivity analysis for comparison. Revenue Increases Initial market response to NEEA s demonstration project efforts confirms that there is potential for a rent increase based upon building modernization, particularly for those projects with measures that clearly improve tenant conditions. Modernized lighting, improved thermal comfort, enhanced controls, and improved air quality have proven to add to tenant perception of quality. Added to this, reduced operating expenses enhance the value proposition. Each of the completed demonstration properties have experienced a shift in market recognition reflecting the enhancements and resulting in rents commensurate with higher quality. In addition, tenants who are looking specifically for demonstrated high levels of green performance in leased space, may be willing to pay a premium for space that can demonstrate improved environmental qualities and reduced utility expense. One of the key inputs asked of the User is tenant roll-over by year, over the 10-year analysis period. Spark s built in assumption is that once the renewal project is completed and new leases are signed, they will reflect the updated and newly modernized space and superior operating performance of the building. Spark s initial scenario processing enters a default value of $1.00/s.f./year in increased rental revenue the first time space rolls. Spark applies this rate on an incremental basis as space turns. The User has the opportunity, on the Analysis page, using a slide bar, to evaluate the impact of varying rent differentials between $0.00 and $5.00/s.f./year on the investment returns. This gives the User the ability to do a sensitivity analysis of best case, worst case and the most likely impact on rent, as well as incorporate changes in lease structures that allow the owner to recapture a greater amount of the energy savings. All things being equal, happy, comfortable tenants are more likely to stay in their space at lease renewal. Avoided costs associated with tenant turnover can be significant lost revenue from vacant space, marketing and re-leasing costs associated with tenant improvements and lease commissions. These avoided costs are not currently built into the Spark tool, however, they can be estimated and NPV of the savings incorporated into the investment analysis as an individual line item. Expense Reductions Spark technical analysis and the resulting scenarios will estimate energy use savings as a consequence of the improvements. The cost savings calculated by Spark is directly incorporated into the investment analysis. The tool allows the User to test the sensitivity of energy expense savings through the use of a slide bar either up or down by 20%. Based on the results from the demonstration projects, savings on operations and maintenance have averaged about $0.05/s.f./year. The Spark User is able to adjust this numb, within the range of $ $1.00/ sf-yr, using an O&M Savings slide bar. Key Assumptions Default Assumptions: Capitalization Rate: Location Specific Discount Rate: 0.5% above the CAP rate. Operations & Maintenance Savings $0.05/s.f. Reversionary Capitalization Rate: 0.5% above Cap rate Static Assumptions: Time Horizon: 10 years CPI: 3% Energy Cost Escalation 4% These sensitivity analysis capabilities allow a Spark user to explore how the interaction among factors effects the estimated value of a project, including what combination of measures and metrics are necessary to generate a positive value, and what combinations will result in less stellar performance. The results of the sensitivity analyses are captured in Spark s reports.

10 REPORTING Spark provides a summary of valuation calculations, measures, and metrics on the Business Case Key Indicators page of its Report, where the reader will find the following information for the scenario that is being reported. l The project internal rate of return (IRR) and net present value (NPV) are presented at the top of the page for a quick indication of scenario investment potential. l Estimates of the total project cost and the aggregate incentives assumed for the scenario are provided, along with the net project costs after incentives have been applied. l Projected changes to annual net operating income, assuming stabilized vacancy, are indicated for years one and ten, indicating the impact upon income, derived from energy savings, O&M expense reduction, and the annual rent differential. l The bottom of the Business Case calculation page lists the key assumptions used for the scenario s discounted cash flow. Time horizon used for project analysis (10 years) Discount rate Capitalization (CAP) rate used to calculate changes to the reversionary value at the end of the project time horizon, resulting from the building renewal project [double check this definition as the reversionary CAP rate, or ] CPI assumption used for general inflation, and the annual rate used for energy price escalation Spark provides this information so that the report creator or any member of their team can quickly understand key elements used for its discounted cash flow model. l A breakdown of the key value components are graphically shown to indicate how much value is derived energy and O&M savings, how much from modernizing and repositioning the asset and the resultant rent differential and overall asset appreciation.