The Economics of Green Building
An Investment Perspective on Energy Efficiency
and Sustainability in Real Estate
According to a paper by Dr. Nils Kok and Dr. Piet Eichholtz of Maastricht University and Dr. John M. Quigley of the University of California, Berkeley, there is strong evidence to support the notion that green building is financially as well as environmentally responsible. Kok presented their recent paper, "The Economics of Green Building," at the Strengthening the Green Foundation conference, hosted by the Atlanta Fed and Tulane University in March 2011.
Their research examines the environmental and financial performance of a large sample of existing U.S. commercial properties, documenting that:
- Revenue generated by "green" buildings has remained competitive in an otherwise depressed market.
- More efficient buildings bring substantial premiums in rent and asset values.
- Specific techniques intended to provide environmental benefits directly translate into economic benefits (for example, a one-dollar saving in energy costs is associated with an increase in rents of about 95 cents)
Momentum is building for building green
The word "sustainability" is being used more and more to describe methods of production, qualities of consumption, and attributes of capital investment. Use of the related term "green building" almost tripled between 2005 and 2009 in the popular press in the United States. In addition, the number of participants at the major international conference devoted to green building (Greenbuild) tripled during the past three years. These increases reflect popular concern with environmental preservation but also reflect possible changes in tastes among consumers and investors.
Building green can make a big environmental impact
Because the built environment and sustainability are closely intertwined, popular attention to green building has greatly increased over the past decade. The rise in the consideration of green building reflects the potential importance of real estate in matters of environmental conservation.
Buildings and their associated construction activities account for almost a third of world greenhouse gas emissions. The construction and operation of buildings account for about 40 percent of worldwide consumption of raw materials and energy (Royal Institute of Chartered Surveyors (RICS) 2005).
In the United States alone, buildings use 75 percent of total annual electricity consumption. Influential analyses of climate mitigation policies have pointed out that the built environment offers a great potential for greenhouse gas abatement (McKinsey 2007, IPCC 2007, Stern 2008). Small increases in the sustainability of buildings, or more specifically in the energy efficiency of their operation, can have large effects on their current use of energy and on their life-cycle energy consumption.
Projected trends in urban growth in developed countries (Kahn 2009) and in the urbanization of developing economies (Glaeser and Kahn 2010) suggest that the importance of energy efficiency in building will increase further in the coming decades.
Building green helps the bottom line
The cost of energy directly affects occupants and investors as well. Energy cost represents about 30 percent of operating expenses in the typical office building in the United States. This cost is the single largest and most manageable expense in the provision of office space. Rising energy costs will only increase the salience of this issue for the private profitability of investment in real capital.
Measuring the impact
Given the potential of building more efficiently to reduce the source pollutants that cause climate change, we use a variety of techniques to determine empirically the economic impacts of green buildings. The methods employed yielded encouraging results.
- Technique: Analyzed a panel of office buildings certified by independent rating agencies (U.S. Green Building Council's LEED rating and EPA's Energy Star).
Finding: Large recent increases in the supply of green buildings and the unprecedented volatility in property markets have not significantly affected the relative returns to green buildings. The economic premium to green building has decreased slightly, but rents and occupancy rates are still higher than those of comparable properties.
- Technique: Analyzed a large cross section of office buildings.
Finding: Economic premiums in rent and asset values of buildings designated as "green" are substantial. For instance, the selling prices of green buildings relative to comparable buildings nearby are more than 13 percent higher.
- Technique: Compared the economic premiums for green buildings to their underlying sustainability.
Finding: The attributes rated for both thermal efficiency and sustainability both contribute to premiums in rents and asset values. LEED registration is associated with an increase in effective rents (i.e., rent times the occupancy rate) of 7.9 percent. A LEED-certified building with an above-average score of 60 (out of a standardized 100 points) can garner rent more than a fifth higher than that of a conventional building. Even a LEED-certified building with a modest score of 40 (the minimum score for certification) can yield rent 2.1 percent higher than that of an identical building that is not certified.
The results for the sample of Energy-Star labeled buildings are surprising: a one-dollar saving in energy cost is associated with a 3.5 percent higher rent and a 4.9 percent premium in market valuation. The increase in rent corresponds to an average of 95 cents per square foot and an average increase in transaction price of 13 dollars per square foot—a capitalization rate of about 8 percent.
This strongly suggests that both tenants and property investors evaluate energy efficiency quite precisely when considering investments in real capital. Finally, the findings also suggest that—within the population of buildings rated by one system—buildings certified by the other system are more valuable. The LEED and Energy Star certification programs measure somewhat different aspects of sustainability, and both command higher returns in the marketplace.
This research has certain limitations, including:
- uncertainty in predicting post-occupancy behavior
- the availability of data
- the relatively early stage of the diffusion of green building practices in the marketplace.
A detailed set of control variables and weights in the analysis mitigates these issues but does not completely resolve unobservable differences between the samples of rated and unrated buildings.
Ideally, the analysis would include:
- A longer time series with repeat observations of buildings that were certified during the sample period.
- Information on the thermal efficiency or sustainability of the noncertified control buildings. Such information would distinguish more precisely between the economic returns to green labels and the actual valuation of energy efficiency and sustainability.
- Systematic and credible evidence on the incremental construction costs of new green buildings or the costs of retrofitting existing buildings. More complete evidence would allow for a more complete estimation of total returns to energy-efficient and green-construction practices.
Implications for investors and developers of commercial office buildings
Green building now accounts for a considerable fraction of the market for office space, and in some U.S. metropolitan areas, certified office space extends to more than a quarter of all commercial space. Measured attributes of sustainability and energy efficiency are incorporated in property rents and asset prices, a situation that seems to persist through periods of volatility in the property market.
These developments will affect the existing stock of noncertified office buildings. The findings already suggest that property investors attribute a lower-risk premium for more energy-efficient and sustainable commercial space. Rated buildings provide a hedge against higher energy prices, and against the shifting preferences of both tenants and investors about environmental issues. Increasing market awareness of climate change and rising energy costs can only increase the salience of this issue for the private profitability of investment in real capital.
Implications for environmental policies
These findings also have implications for current considerations of energy conservation policies and of measures to reduce global warming and climate change. It appears that modest programs by government and nonprofit organizations to provide information to participants in the property market (i.e., "nudges") have a large payoff.
Additionally, buildings certified by independent entities as more energy efficient or sustainable command economic premiums in the marketplace. Energy savings in more efficient buildings are capitalized into asset values that are not affected by the recent volatility in the U.S. property market. These results suggest that more aggressive policies—in the United States and elsewhere—of certifying, rating, and publicizing buildings along these dimensions (including, perhaps, those buildings that score low on measures of energy efficiency) can have a large payoff in affecting energy use, and maybe the course of global warming.
By Nils Kok, PhD, visiting scholar, UC Berkeley (firstname.lastname@example.org, www.nilskok.com)
This article is a summary of the complete paper presented at the Strengthening the Green Foundation: Research and Policy Directions for Development and Finance conference in March 2011. You can read the full paper online.
Enkvist, Per-Anders, Thomas Naucler, and Jerker Rosander. 2007. A cost curve for greenhouse gas reduction. The McKinsey Quarterley 1: 35–45.
Glaeser, Edward L. and Matthew E. Kahn. 2010. The greenness of cities: Carbon dioxide emissions and urban development. Journal of Urban Economics, 67(3): 404–18.
International Panel on Climate Change. 2007. Climate Change 2007: The Physical Science Basis. Cambridge, UK: Cambridge University Press.
Kahn, Matthew E. 2009. Urban growth and climate change. Annual Review of Resource Economics 1:333–49.
Royal Institute of Chartered Surveyors (RICS). 2005. "Green Value." London: RICS, 2005.
Stern, Nicholas. 2008. The economics of climate change. American Economic Review: Papers and Proceedings 98(2):1–37.