Friday, January 20, 2012

Challenges Associated With Incorporating Future Energy Savings into Traditional Loan Underwriting

Direct borrowing of capital from private lenders is an option for funding energy efficiency investments. While banks generally agree that more energy efficient buildings are ultimately a good investment, it is crucial that banks develop the ability to fully recognize the benefits in their loan underwriting process. To accomplish this, however, banks need to develop a much stronger energy efficiency performance database and then build scalable financing models. Unfortunately today, rarely is future energy savings considered in loan underwriting.

Traditionally, banks have rated the borrower’s ability to repay the loan (the borrower’s “creditworthiness”) at the highest end of the spectrum in the loan decision-making process. Moreover, for most commercial businesses, operational savings associated with energy retrofit projects are often too small a percentage of total expenses to impact in any significant way the borrower’s ability to pay down debt. Factors such as location that affect occupancy rates and rents are much easier for banks to analyze.

The existing mortgage on commercial properties can also present a challenge to borrowing for energy efficiency improvements in that loan covenants may restrict the addition of further debt. At a minimum, there typically are strict rules about incurring debt, particularly for commercial mortgages that have been securitized.

Another challenge that banks face is associated with understanding how a building’s energy performance can impact its value. The fact is that to-date there is insufficient data on how building valuation is impacted by energy efficiency improvements. Appraisers are not focused on a property’s energy efficiency and therefore it is not reflected in their valuation. This void creates uncertainty and adds to the potential risk associated with energy efficiency investment.

Interestingly, lenders have had a difficult time getting their hands around energy savings because energy savings cannot be measured directly. Energy savings must be based upon what is not going to happen in the future, rather than what will happen. Moreover, cash flow from future energy savings is not a familiar form of revenue or collateral to back traditional lending. There also is a general lack of confidence in energy savings projections because of the embedded bias to present projects as compelling investment opportunities.

Notwithstanding, banks are beginning to recognize that energy efficiency loans can help preserve the value of a building by avoiding obsolescence. In fact, the obsolescence issue, directly related to the value of the collateral, may even be a more important consideration today than operational savings.

Fortunately, today standardized measurement and performance protocols have emerged and are now being deployed with success to identify energy savings at a high degree of confidence. By building these protocols into the loan documentation and underwriting process, banks will eventually become more comfortable with the way energy savings and risks are quantified. Moreover, the advent of “energy savings” insurance and loan guarantees by the government will further reduce the risk and uncertainty. In the final analysis, this should enable energy efficiency financing to become a mainstream financial asset class with a high degree of standardization, predictability and scale. It should also go a long way toward moving the commercial real estate industry toward large scale adoption of energy efficiency investment.

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