With a third large interest rate hike last week, an increasingly tough financial environment is starting to crush property owners’ willingness to spend on environmental compliance and green improvements.
“A lot of people are value-engineering their projects, figuring out how you can get costs down, because these costs are on the rise — and unfortunately, sometimes ESG components of projects are on the chopping block,” Rafi Goberstein, CEO of the PACE Loan Group, said at Bisnow’s National Finance Summit last week.
Goberstein told the story of a developer who had planned to install solar panels atop a 400-unit multifamily building in Minnesota, but had to scrap the plans as costs escalated.
“As we go through the process of getting the bids … the costs came too high and [the panels] got scratched this summer,” he said. “Which is really, really a bummer to see that happen.”
Since the onset of the pandemic, project costs have increased as supply chain hurdles, materials shortages and inflation put project feasibility under pressure. Those dynamics have been a headache for CRE investors, developers and owners alike, but have been disastrous for smaller investors and landlords.
Now, with rising interest rates and the industry bracing for a recession, some are placing their environmental commitments on the chopping block. YuhTyng Patka, a partner at Duval & Stachenfeld who represents borrowers and lenders on PACE financing, told Bisnow that one borrower she represents in New York City is seeking around $15M from the program, which is designed to fund sustainability upgrades.
“As interest rates have started increasing, my client is starting to rethink their strategy,” she said. “It’s not because they’re not interested in the energy-efficient space. It’s more the economic drivers, the rising interest rates … It doesn’t make business sense for them to continue proceeding with what they had originally planned.”
Building energy-efficiency company Ecosave has worked with building owners in Australia, Europe and multiple states within the U.S., and even in more climate-conscious countries, sustainability upgrades are usually “all about finance,” Ecosave founder and Chairman Marcelo Rouco said.
Rouco recalled a recent meeting with a French company that has 200 manufacturing plants in the U.S. and is trying to meet its environmental target of reaching carbon neutrality by 2050. The first question asked, he remembers, is what the company is willing to pay to meet that goal.
He said the company responded that improvements needed to pay for themselves within three years.
“So even in the countries that are supposed to be more advanced, it still boils down to the money,” Rouco said at the summit.
That attitude isn’t uncommon, Nuveen Green Capital CEO and co-founder Jessica Bailey said. Many CRE companies have started making bigger, bolder environmental commitments over the last 18 months, she said, but few are talking about how to progress toward those goals.
“Very few are starting to operationalize and put the blueprint in place towards that 2040 future in which my building portfolio is net zero,” Bailey said. “It’s not enough just to put out the statement. You’ve got to do the work, you’ve got to go through and do the audits, and look at the roofs, and figure out where solar fits, and all of the things that are quite difficult.”
Planning for the building upgrades necessary to meet ambitious environmental goals is a time- and capital-intensive process for owners, operators and investors. For many, additional financing is necessary in order to pay for building upgrades that go beyond switching out older lightbulbs for LED options: switching out older heating and cooling systems for heat pumps, or adding solar panels, takes months and can cost tens of thousands of dollars.
After three swift federal interest rate hikes this summer, coming in at 75 basis points apiece, some property owners are wondering if they can still afford to make the upgrades they had hoped to.
“As banks start to reprice the cost of debt, and as insurers start to reprice insurance given climate risks, those things are going to impact just fundamental drivers of the NOI of a real estate asset,” McKinsey & Co. partner Brodie Boland told Bisnow in an interview.
Boland, whose work involves talking to real estate investors, operators, services firms and proptech firms about how to reach their climate goals, says most CRE players view getting ahead of climate risks as a necessary investment. And while many companies have rapidly accelerated their decarbonization plans over the past three years, what happened to those commitments during the pandemic is indicative of how a recession may impact CRE’s environmental commitments.
“If you’re an owner of office real estate or retail real estate, and you’re struggling through the pandemic, you’re really looking critically at every element of your [profit and loss statement] and trying to figure out what is necessary,” he said. “I think for some, that did reduce the importance of some of the quote-unquote ‘optional’ elements of ESG.”
Advancing energy goals is broadly seen as an investment worth making to not only fight climate change, but to combat rising energy costs, supply chain hurdles and the effects of Russia’s invasion of Ukraine, Savills North America Director of ESG Consultancy Hyon Rah said. Additionally, regulations like the Securities and Exchange Commission’s proposed ESG reporting rules and local measures like New York City’s Local Law 97 and Boston’s BERDO are spurring building owners into action, she said.
“I am seeing a lot more activity and requests for things like installing solar panels, assessing the portfolios to see what is feasible to actually install as much as possible,” Rah said. “Cities like Boston, New York, D.C., have really stringent requirements for building performance that you cannot just dodge. It’s the law and you’re going to face fines if you don’t meet certain requirements.”
But smaller building owners, without as much capital to deploy, are already struggling. Those difficulties will likely only increase as borrowing gets more expensive.
Lincoln Eccles is one such property owner. Prior to the pandemic, he had been seeking a way to put solar panels on the roof of his 14-unit rent-stabilized property in Brooklyn — but once the pandemic hit, those plans were no longer feasible, he said. Then, a few weeks before the end of the heating season in spring 2021, his building’s oil boiler broke.
Eccles set about trying to find a replacement, either for the oil boiler or for a steam equivalent. During the spring and the summer, he called suppliers as far west as Chicago — but amid the supply chain crisis, he was unable to find a replacement before the winter set in, he said.
He wound up paying for space heaters for his tenants for last winter, and is now wrapping up a heat pump installation with energy-efficiency company BlocPower. But Eccles said only some tenants paid rent or received emergency financial assistance during the pandemic, so he wasn’t able to pay his property taxes on time — let alone repair his building easily.
“It’s just been touch-and-go for a while,” he said. “I’m balancing around close to half a million dollars in debt.”
Still, experts are hopeful that the Inflation Reduction Act, featuring 30% tax credits for installing green energy measures into buildings and setting aside billions of dollars for green retrofits and building weatherization, will help struggling CRE players push past the current economic hurdles.
The overall push toward ESG is unlikely to be reversed by an economic downturn, but owners who spend beyond their means installing long-term upgrades could face short-term financial pain.
“In another recession, I think it’s going to be not an overall decelerant on climate-related activity, I think it’s going to be a separator,” McKinsey’s Boland said. “Those who have figured out how to do this in a value-creating way, and those who haven’t.”