Innovative Funding for Energy Retrofits Tackling the Financial Barriers of Energy Efficiency in Commercial Real Estate

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www.TranscendEquity.com

Introduction to Transcend Equity &

Managed Energy Services Agreement (MESA)

As part of any commitment to sustainability, The Real Estate Market is exploring a wide variety of strategies for making its assets more energy efficient. The ideal approach should:

✓ Build asset value not through speculative increases in rent or decreases in occupancy but through measurable savings in operating or capital expenditure;

✓ avoid creating any obstacle to asset disposition;

✓ remain consistent with the near- and long-term business strategy for the asset.

In the course of evaluating various approaches, Transcend’s MESA approach is one that may have broad application to any commercial portfolio. Other approaches are likely to emerge that are suitable for different assets and asset classes, but the Managed Energy Services Agreement should be evaluated for its suitability for commercial buildings.

The Managed Energy Services Agreement (MESA) is a balance-sheet

neutral method of accomplishing major capital improvements in a real

estate asset with private funds.

✴ A property agrees to pay its historical energy usage for a period of 5 – 10 years with adjustments for changes in weather, occupancy and type of tenant user.

✴ Transcend Equity (creator of MESA) assumes responsibility for payment of the actual energy bills for the asset and invests capital in a deep retrofit of the asset’s energy systems.

In this way major system upgrades can be made, leading to easier management, better tenant comfort and satisfaction, typically without requiring any expenditure of capital from ownership. Meanwhile, the building becomes “green” – MESA usually leads to ENERGYSTAR rated buildings and accomplishes the most difficult, energy-related components of LEED for Existing Buildings.

J. Stephen Gossett President

Steve Gossett Jr. Vice President

Robert Myers - Director of Project Development

Over 85 Years of Management Experience

in Energy Services

MESA is an ideal funding strategy for buildings with the following Characteristics:

Total Energy Expenditure for

electricity and all fuels

Exceeds $2.50 per square foot, leaving aside sub-metered tenant electric use.

Total Energy Usage for all fuels

Exceeds 75 kBTU per square foot. Requires conversion of all fuels to BTUs.

Rent Roll Does not reflect a turnover of more than 40% of the square footage in any single year within the next six years. (Total turnover of 40% during a six year period is fine, just not 40% in a single year.)

Major energy systems for cooling and heating

Are centralized with expenses allocated pro rata rather than floor-by-floor and sub- or direct metered to tenants.

Leases on a square footage basis

Are mostly full service gross or modified gross with a base year. Triple net leased buildings with good credit tenants are also good.

Why wouldn’t the owner make these investments if they generate returns to MESA’s investors?Because  in  most  assets,  the  savings  calculated  by  an  engineer  is  not  the  same  as  the  recovery  to  the  asset  owner.    Our  ability  to  recover  capital  is  usually  restricted.    But  MESA  is  an  auditable  GAAP-­‐valid  opera>ng  expense,  meaning  it  does  not  face  the  same  capital  recovery  problem.    

To  simplify  the  math,  the  table  below  gives  a  typical  set  of  improvements  for  a  1  M  square  foot  building  with  the  cost  and  savings  in  rounded  numbers.

IMPROVEMENT SAVINGS COSTBldg  Control  System   $270,000   $1,000,000  

Ligh>ng   $190,000   $450,000  

Variable  Frequency  Drives   $90,000   $550,000  

High  Efficiency  Chiller   $450,000   $3,000,000  

$1,000,000   $5,000,000  

Simple  Payback      5  years

The lease roll shows steady turnover and varying, but typical, terms for capital recovery.

TENANTS   SQUARE  FEET LEASE  TYPE LEASE  END  DATE CAPITAL  EXPENDITURE  SHARING

A   200,000   Modified  Gross   1/1/2013   Useful  Life  

B   200,000   Modified  Gross   1/1/2015   None  

C   200,000   Modified  Gross   1/1/2017   Useful  Life  

D   200,000   Modified  Gross   1/1/2019   None  

E   200,000   Modified  Gross   1/1/2021   Useful  Life  

Q&

A:

Where capital expenditure is allowed, the lease requires amortization to tenants according to the useful life of the systems being installed. The allocable capital expenditure looks like this:

IMPROVEMENT   SAVINGS   COST   USEFUL  LIFE   ALLOCABLE  RECOVERY  (AT  7%)  

Bldg  Control  System   $270,000   $1,000,000   10   $142,378  LighKng   $190,000   $450,000   7    $83,499  Variable  Freq.  Drives   $90,000   $550,000   12    $69,246  High  Efficiency  Chiller   $450,000   $3,000,000   25    $257,432  

$1,000,000   $5,000,000    $552,554  

Applying the recoveries to the leases and the turnover schedule, the payback is still 9 years. Pro rata savings flow to the asset owner at lease turnover (as the base year falls) but other recoveries (if allowed) are restricted to the pro rata share of useful life amortization, $110,511.

Tenant   1   2   3   4   5   6   7   8   9   10  

A   $110,511   $110,511    

$110,511    

$225,102    

$231,855    

$238,810    

$245,975    

$253,354    

$260,955    $268,783  

B      -­‐       -­‐        -­‐        -­‐        -­‐      

 $238,810  

 $245,975  

 $253,354  

 $260,955    $268,783  

C    

$110,511    $110,511  $110,511  $110,511    $110,511  

 $110,511  

 $110,511  

 $253,354  $260,955    $268,783  

D      -­‐       -­‐        -­‐        -­‐        -­‐        -­‐        -­‐        -­‐        -­‐        $268,783  

E    

$110,511    $110,511    

$110,511    

$110,511    

$110,511    

$110,511    

$110,511    

$110,511    

$110,511    $110,511  

 Total    

$331,532    $331,532    

$331,532    

$446,123    

$452,876    

$698,643    

$712,971    

$870,573    

$893,375    $  

1,185,644  

 Recovery   7% 13% 20% 29% 38% 52% 66% 84% 101% 125%

An investment recovery of 9 years would be difficult to justify for Commercial Real Estate. Since MESA is an operating expense, though, it recoups the initial outlay much faster. Using this structure, we can avoid capital expenditure on the asset, pay operating costs no higher than they were before, and let someone else spend capital to retrofit the building and make it green.

Q&

A:

Adjusted  Simple  Payback  is  9  years

What about triple net leased buildings?

In a triple net-leased property, the asset owner typically cannot share any capital costs with tenants. And tenants are the sole beneficiaries of retrofit savings since they pay all operating costs. Even under very generous assumptions about the owner’s ability to recover savings at turnover via higher rent by marketing a lower cost of occupancy, the owner would recover the capital invested in the same project described above in 11 years. MESA is even more ideal for such a property. Transcend Equity would assume responsibility for engaging tenants and developing the project in collaboration with them and ownership.

In a triple net-leased building, however, the MESA developer assumes the risk of tenant ability to pay its utility expenses. Buildings with tenants that have not proven steady payers of rent or other operating expenses are not good candidates.

What about buildings with all full service gross leases (i.e. where the landlord pays all operating costs)?

MESA may be a good choice even in a building where the owner recoups all savings by virtue of leases with all-in rents (typically called full-service gross) that place all operating and capital cost responsibility on the owner. Why?

• Under MESA, Transcend assumes all performance risk. In the project above, the $1 M in savings is a projection that assumes effective development, implementation and operation. The returns associated with the project drop dollar for dollar if those savings are not achieved. A complex retrofit or a difficult operating environment may make MESA preferable in order to shift risk away from asset ownership.

• Securing commitments of capital may not be easy, particularly in joint ventures. An asset manager must originate a project and feel secure enough in its feasibility and the validity of savings projections to pursue the necessary capital. In a joint venture, this may mean convincing a partner to share the cost. All too often as projects become complicated, it is easiest to adopt the default position – to simply drop the project. Meanwhile, every year that passes represents a year of savings that could be used to accomplish the retrofit. Since MESA requires no expenditure of additional capital and uses the developer for origination and development, execution is easier.

When would it make sense to use our own capital?

There are, of course, other options for retrofitting a property including spending our own capital. We expect other investment structures like MESA to emerge in future years as well. Expenditure of our capital may be most appropriate when:

• The local rental market is strong and an asset is approaching a major lease roll;• Leases are full service gross (no base year) and the retrofit savings are relatively certain;• A building is relatively efficient and a retrofit consists primarily of lighting or other items

with short useful lives and predictable savings that are high relative to cost.

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4099 McEwen, Suite 420 Dallas, TX 75244 972-386-5335www.TranscendED.cominfo@transcendED.com

Managed Energy Services Agreement - Tackling the Financial Barriers in Commercial Real Estate