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On the Cost of Building "Green"

Dr. Chegut and Dr. Kok have led frequent  NAREIM discussions.   This executive summary of a recent report that explores the true price of innovation is a must read for any investor in the built environment.
Dr. Andrea Chegut Research Scientist Director of The Real Estate Innovation Lab Massachusetts Institute of Technology - Center for Real Estate
Prof. Dr. Piet Eichholtz Professor of Real Estate Finance and Economics Co-Founder GRESB Maastricht University - Department of Finance
Dr. Nils Kok Associate Professor of Real Estate Finance and Economics Co-Founder GRESB Maastricht University - Department of Finance
  ‚ÄúGreen‚Äù construction is gaining in popular market awareness, with 13% of the United States commercial office stock now certified by LEED and/or ENERGY STAR. It has become common knowledge that buildings can play a key role in the reduction of energy consumption and carbon emissions. Yet new construction and building refurbishments are still mostly conventional: in the United States just 38 percent of current construction is earmarked as ‚Äúgreen,‚Äù while some 12 percent of total construction employment was in green construction in 2011.[1] Given the fact that much of the research on green-certified buildings documents positive income and value premiums, averaging 16 percent for transaction prices and 7 percent for rents, the lack of broader uptake of green construction is a bit of a puzzle. The marginal income should be sufficient to tantalize even the most cynical real estate developers ‚Äì why would anybody leave a $100 bill on the sidewalk? This raises questions about the barriers that prevent more widespread adoption of green building design and construction practices. For example, conventional wisdom has it that the value premiums are just not high enough to recoup the additional costs associated with green construction, especially when it involves the refurbishment of existing buildings. This is an important issue, but the costs of building green have hardly been investigated, making a simple cost-benefit analysis for green construction hard to obtain. This lack of information may be one of the reasons why developers do not yet construct sustainable green buildings in larger quantities. A recent MIT working paper by Andrea Chegut, Piet Eichholtz and Nils Kok entitled ‚ÄúThe Price of Innovation: An Analysis of the Marginal Cost of Green Buildings,‚Äù aims to fill this gap. It compares 200 BREEAM-labeled commercial construction projects in the United Kingdom to 300 conventionally constructed projects over the 2003 to 2014 period (BREEAM is the equivalent to LEED). The paper employs detailed data regarding different construction cost components and construction contracts, and controls properly for location, building characteristics, property type, building ownership, and construction materials. Surprisingly, the paper finds that the average additional cost of green-labeled construction projects is zero ‚Äì on average across the study period as evidenced by the traditional and green construction cost indices estimated by the authors. In other words, green construction is not more expensive than conventional construction. This holds for new construction and the refurbishment of existing buildings alike. These key results go straight against conventional wisdom. But they make it even more of a puzzle why green construction is still not the market standard: a positive value premium at no extra cost should provide a very strong incentive for all developers to build green. The authors investigate this further, and document that one aspect of construction is substantially more expensive for green buildings: their design. Design fees for green buildings are on average over 65 percent higher than the costs of conventional building design. For the buildings with the highest sustainability scores, this difference increases to about 180 percent. While these differences are impressive, design fees represent just 3 percent of total construction costs on average ‚Äì as evidenced by construction stage and the average construction costs for green and non-green construction. This small magnitude of cost difference seems unlikely to be the key to solving the low-diffusion paradox. However, it is crucial to realize that design fees are largely paid before construction has started, and even before a developer has any certainty whether the project can be developed at all. A substantial part of a project‚Äôs design fees have to be paid to prepare the initial plan that is needed to get planning permission from the municipality. And almost all of the remainder of the fees will be paid before construction even starts, so in a phase when market take-up (in the form of tenants and/or buyers) is still uncertain. So in essence, design fees are investments with a very high risk, since these fees are paid during a phase when developers still face fundamental uncertainty regarding the success of their project. Moreover, given the phases of the project in which design fees are paid, they will be paid mostly from the developer‚Äôs own equity.[2] At these stages, external financing can be difficult to obtain. Even if a developer knows that green buildings command a sales premium in the marketplace, uncertainty preceding the construction phase and lack of funding may prevent the developer from spending the additional fees needed for green building design. The study also finds that green construction projects take longer to complete ‚Äì on average 30 percent longer as compared to conventional buildings ‚Äì and that the exact contract length is less predictable than in conventional construction. This creates an additional disincentive to build green. The construction project‚Äôs length determines how long a developer has capital locked up in a project, so a longer contract period creates an opportunity cost, preventing the capital from being employed in the next profitable project. At the same time, the added uncertainty regarding the contract period creates more risk regarding this opportunity cost. It seems there are three major impediments to building green, even though the overall costs of green construction do not exceed those of conventional construction. These impediments are design fees, contract length, and uncertainty concerning contract length. These three results may provide insight into barriers to the adoption of otherwise economically rational ‚Äì and potentially profitable ‚Äì sustainable construction practices. The design fees can be regarded as the premium that a developer has to pay for the option to develop a building. The fact that the results show design fees that are almost double for the most advanced green buildings reduces the likelihood that developers engage in the option to develop such projects. Moreover, the longer project length and higher variation in development duration for more efficient green buildings increase the uncertainty of total project costs, and may impact the developer‚Äôs expected return on equity. In addition, lack of solid information on the total cost of construction and development may lead the developer to believe that the cost of ‚Äúgoing green‚Äù is much higher than it actually is. These findings are important for developers who are trying to increase sustainability development practices, institutional investors seeking green buildings in the market place and policymakers who aim to diffuse green buildings. Interestingly, the paper also documents that the added design costs for sustainable building projects seem to be coming down: in the later years of the sample period, design fees of sustainable buildings were on par with those of conventional buildings, possibly reflecting the fact that the property development industry has been gaining experience in this area, albeit slowly. This bodes well for the future diffusion of sustainable construction. It is increasingly common knowledge that energy efficiency plays an important role in the reduction of the carbon externality from buildings. Green building innovation typically does not occur during the stabilized asset management phase, but during (re)development. Change for the building sector in abating carbon emissions and energy consumption is most effective at the time of property design and construction ‚Äì developers, investors and policy makers should take notice. Link to full MIT working paper: [1] McGraw-Hill Construction (2013) [2] Geltner et al., 2013
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