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

The greening of America has achieved significant momentum, with virtually all industry media now espousing the benefits of sustainability to tenants and building owners alike. For the first time, both political parties are addressing energy policy as a key issue. In past elections, this has been strictly a "hands off" topic, with no individual addressing the real costs and impacts of meaningful change, or willing to bear the short-term negative impacts on the national economy.

California has once again grabbed the horns of change led by a governor committed to implementing meaningful but costly policies; now other states are following its lead. But how will the current economic downturn affect the momentum already achieved? In the face of job losses and increasing vacancies, will Corporate America pay to go green? Without compelling justification, will institutional investors continue to pay a premium for sustainable development?

A Popular, But Still Fragile Movement
Sustainable development isn't a new trend, but it has truly attained broad acceptance at the peak of this economic cycle, as developers and investors look to create their own competitive advantage among Corporate America with new product that justifies higher rents to cover the cost of inflation our industry has absorbed over the last decade. The residential boom not only caused significant escalation in land values, but also - combined with worldwide development activity - drove commodity prices to a point where new office development simply didn't underwrite in most markets. As the residential boom cooled, so did price escalations. A period of relative normalcy during 2006-2007 allowed commercial development to boom again, and then the bottom fell out.

The housing and subprime meltdowns have pushed buyers of existing product out of the market with no debt products that make underwriting sense available. New development has slowed as job losses and recession fears have put the capital markets on hold until a clear bottom to this cycle can be called. In the face of increasing vacancy and falling rents, the cost inflation is back again, driven by world demand for energy and energy supply uncertainty. Dramatic construction cost increases have returned and are expected to continue in labor, copper, fuel, petroleum-derived components, and concrete for the foreseeable future.

The United States is caught in the throws of our second great energy crisis, the first occurring from 1974 to 1982. The origins of the current crisis can be traced to 2003, as the power shifted to the OPEC providers. Now, in 2008, it's hard to see a clear end in sight. Whether this is our new reality or merely a speculatively fed bubble poised to burst is yet to be determined.

Tenant Decision-Making in a Changed Environment
Many of the benefits of green and high-performance buildings accrue to the tenants, not the owners and investors, unless they are evident in higher rents - and that has been the show-stopper. Lower employee absenteeism and turnover, fewer headaches, and higher productivity are a few justifications for corporations to pay higher rental rates. The challenge is that only a small number of high-performance buildings have been in place long enough for the data to be compelling to many corporate decision-makers. In a time of cost reductions and layoffs, lower rents become attractive; however, data supporting the benefits of sustainable development are finally becoming less anecdotal and more empirical. Recently published data underscores that green does pay off in the form of higher occupancy rates, rental rates, and sales price per square foot.

Perhaps most importantly, developers are beginning to master the maze of LEED® certification and the premiums associated with it. Early issues related to cost premiums were primarily due to a lack of planning and education, but slowly more developers and investors are embracing sustainable development and have learned that cost premiums of going green can be dramatically reduced by initiating an integrated design approach from the outset and leveraging knowledge across a large platform. A key consideration for tenants is to realize that because a building is LEED-certified does not mean that it will bring all of these benefits to its employees. Tenants will have to become equally sophisticated in understanding what their leasing alternatives in the new generation of buildings really mean.

Green Goes Mainstream
Numerous Fortune 500 companies have led a market transformation focusing on corporate responsibility and the health benefits to their employees, including Bank of America and Best Buy. Food distributor Sysco and Shell Oil are both developing corporate campuses outside of the City of Houston to drive down energy costs and attract employees. Sysco is also taking measures to cut down the power usage at its warehouses. The Houston Chronicle quoted Shell's director of real estate as saying, "In the future, you won't find Shell in a non-green building."

Similarly, software giant Adobe's headquarters facility, which spans three office towers and one million square feet in San Jose, has initiated more than 70 separate energy and conservation projects to improve the site's environmental sustainability. The effort has reduced indoor water use by 22 percent, landscaping water use by 76 percent, electricity by 35 percent, and natural gas by 41 percent.

When building their flagship store in the Pacific Northwest several years ago, outdoor retailer REI used recycled products and salvaged wood wherever possible, including 76 percent of its previous site's building materials. In addition, the facility was designed so that water from the roof is used to charge the waterfall that runs through the natural landscaping surrounding the outside of the store, masking the sounds of the nearby highway. The company is now piloting its first sustainable concept store in Boulder, Col., using all three solar strategies available for architectural design: passive solar, solar thermal, and solar electric, which is resulting in 20 percent less energy usage.

Landlords and architects are following suit. "As landlords have continued to institute a wide range of environmentally sustainable practices throughout their properties, an increasing number of tenants in the market have made `green' leases a priority when searching for office space," said Sally Wilson, Global Director of Environmental Strategy at CB Richard Ellis. "Be it replacing existing infrastructure with more energy-efficient appliances, establishing clear guidelines and receptacles for recycling, or something as easy as turning lights and computer monitors off at the end of the day, many landlords are working hard to provide environmentally friendly working conditions for existing and potential tenants."

"Energy-saving techniques including natural lighting and ventilation dramatically increase the building's performance and reduce consumption well beyond code requirements," said Bert Gregory, president and CEO of Seattle-based Mithun architectural firm. "It also creates a much more delightful place to work, filled with daylight and fresh air. Buildings that use less energy have better air quality and are driving demand in cities like Seattle, Portland, and San Francisco. As long-term costs savings from green building become apparent, the marketplace will get the message: You can be green and profit, too."

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.