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U.S. Economic Downturn: A Boom or Bust for Sustainable Development?

The question may be not if Corporate America can afford to go green, but rather if it can afford not to go green.

Oct/Nov 08
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Commercial buildings in the United States are estimated by the U.S. Green Building Council to account for 71 percent of all electric usage and nearly 50 percent of all energy usage. Further, they contribute 39 percent of greenhouse gas, compared to only 32 percent for transportation and 25 percent for industry. U.S. office buildings alone are responsible for more carbon dioxide emissions than those in any other country in the world, except for China. Thus, improving the environmental performance of a property may not be a choice for building owners in the future.

As a result, the government's role in this issue is being gradually stepped up. The Energy Independence and Security Act of 2007 requires federal buildings to have more specific and ambitious green building requirements, including a goal of zero net energy buildings by 2030. The beneficial impact of this legislation is mitigated when you factor in that government buildings require congressional approval and funding in future budget cycles, thereby creating lag times in embracing new technologies. That being said, there is still an opportunity for the private sector to provide green leases to government to fill the gap.

Is This Downturn Different?

There are many indicators that this downturn, while significant, has the potential to be materially different than the last two. Torto Wheaton Research (TWR) data through the first part of 2008 provides a great perspective.

First, according to TWR, the overall state of the office market has not substantially deteriorated. The market is far from overbuilt (this is the key difference between the 1990 and 2001 recessions), and job losses which drove the severe fallout in the office market in those downturns were far more significant than we are experiencing today. Second, even in the current downturn, rent growth has continued, albeit not at the historic pace of 2006-2007. Key to this is that overbuilding does not appear to be a major exposure in this cycle. The pipeline shut down quickly, and, in the midst of the commercial mortgage-backed securities debacle, it's hard to say that markets have financial discipline.

Clearly the difficulty in financing new projects as a result of the mortgage meltdown will further moderate supply, which is anticipated to catch up with demand by 2010. Although rent growth slowed in the first half of 2008 and concessions are back, this has not yet resulted in rent declines. While 2009 looks challenging, with greater vacancies and real rent declines expected of between 0.5 and 1 percent, these are much lower than the 7 percent decline at the bottom of the last real estate cycle in 2003.

Another key insight is the nature of rent and inflation. In past cycles, rent growth raced ahead of inflation, thereby creating a more severe correction. Since 2003, rent growth has occurred hand in hand with inflation, and in adjusted terms, rents remain below their previous peak; thus no major correction is required.

Out With the Old

The most significant driver for keeping sustainability at the forefront is the long-term impact of our current energy crisis. Bubble or no bubble, resource scarcity is driving cost. Energy and water will cost more, and costs will rise at an accelerating rate. High-performance buildings will redefine the market.

The very nature of the constrained amount of new office development in this last cycle underscores one critical data point: the U.S. office inventory is aging, with most major markets defined by Class A buildings that are 10 to 20 years old. The U.S. office inventory has nearly doubled in 20 years from 1.27 billion square feet in 1988 to 2.1 billion square feet in 2008; 92 percent of that inventory is more than five years old, and 78 percent is more than 10 years old.

Most developers are calculating that modern, high-performance office buildings can use 30 to 50 percent less energy than last-generation buildings, and consume as much as two million gallons less of potable water per year, while boosting the health and productivity of tenants by 5 to 10 percent. The energy crisis is making payback analysis more rudimentary, where the investment in performance is no longer optional, but mandatory.

It is expected that new office deliveries will redefine the Class A market in the coming cycle, and the entire product previously considered Class A - that cannot be materially retrofitted to higher performance standards - will be relegated to a lower status. As metrics from Corporate America become more available on productivity and health improvements, tenants will embrace the moderate rent increases needed to enjoy these benefits. Demand is forecasted to return in 2010 and 2011; while we know it takes two years to deliver new product, the question is, when will market fundamentals provide debt vehicles that allow the pipeline to fill again to meet this demand?

Sustainability should benefit from this downturn, driven by the energy crisis, buttressed by corporate responsibility, and anchored by future regulation. Yes, the wheels could still fall off the sustainability bus, but at least it will likely be electric-powered.

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