Funding Your Building Renewal
Building renewal is a concept that may be unfamiliar to some of your sources of funding. It can be challenging to tailor a building retrofit proposal to each financial source and assemble enough capital to make the project feasible. The goal for building renewal financing is the same as any real estate financing: to reduce the average weighted cost of debt capital and still meet investment objectives, which will enhance the return on equity.
Here are a few things to consider as you move into the financing stage.
Your ability to articulate a compelling financial case, challenge preconceptions, remove doubts, and convince investors of your building renewal project’s viability is your best tool to secure capital. As with any real estate transaction, much of the project will rely on funding needed to purchase, improve, and operate the commercial property investment, often referred to as your “capital stack.” The capital stack refers to the layers of funding sources that go into building renewal, which should include planned future capital improvements such as end-of-life system replacements or upgrades. Though derived from commercial investment terminology, this view of resources could be applied to owner-occupied buildings.
Investing in strategies that help future-proof the building and make it better over time provide the best financial returns—and may create avenues for increasing occupancy rates and/or rent. Linking your building renewal to a solid real estate strategy helps support a broader rationale for requesting funds. Any transaction should be viewed as an opportunity to secure capital for your project. Positioning your building renewal as a real estate investment helps increase the available funding sources, including more traditional options such as:
- Equity: Ownership of assets that may have debts or other liabilities attached.
- Grants, subsidies, and incentives: Grants are typically provided for specific purposes and do not have to be paid back. Subsidies refer to direct contributions, tax breaks, and other financial assistance to offset a firm’s operating costs over a specific period. Incentives are often represented as tax credits or rebates that promise cash back or a percentage in return for a desired action.
- On-balance sheet financing: An accounting practice that records and considers assets or liabilities on the balance sheet, which can affect the financial position of a company.
- Off-balance sheet financing: An accounting practice that allows companies to keep certain assets and liabilities off their balance sheets, which helps keep their debt-to-equity ratio low to help secure lower rates.
Funding sources aimed at improving energy efficiency, supporting building-sector decarbonization, or defraying the cost of building performance standard compliance are becoming increasingly available to commercial building owners. Additionally, providers such as energy service companies (ESCOs) offer the opportunity for efficiency improvements without significant capital outlay.
The process that allows a person or organization to take on financial risk is called underwriting. Most real estate transactions fall go through the underwriting process, in which many large loans are secured against the equity of the building, its ownership, and/or a larger portfolio of investments; smaller loans are more likely to be against an individual’s credit rating or business assets and liabilities. Sustainability and energy efficiency projects stimulate the development of numerous approaches to financing with different underwriting methodologies.
Energy service contracts, performance contracts, Property Assessed Clean Energy loans—commonly referred to as PACE or C-PACE, specifically for commercial properties—and utility incentives are underwritten primarily on the expected energy savings of the project. The additional cashflow freed up by energy efficiency improvements can act as added security for financing the retrofit. Factors such as the ability to pay property taxes and utility bills become more important than traditional real estate asset considerations.
You may need to close funding gaps through tools that are underwritten primarily on energy savings. The challenge will be assembling all the different resources in a sensible way: some underwritten to the asset or owner, some to the energy savings. Diagnosing the underwriting context of each financial tool—property versus energy—will allow you to better understand the mindset and expectations of those making decisions on whether to invest in the project.
Every transaction has risks, and different capital sources emphasize multiple sources of risk. Capital providers with credit enhancement may not be as worried about downside risk, but it could be a concern to the source of the enhancement. Debt investors worry about downside risk that could threaten cashflow continuity, whereas equity investors are much more willing to take risks if there is compelling support for potential rewards, such as value enhancement and profits. In many ways, risk is a more powerful factor in financial decisions than rewards.
It is essential to understand, acknowledge, and address directly with your funders all foreseen risks, including regulatory ones. The path to securing financing often boils down to diagnosing the risks felt by a particular funding source, then presenting how the building renewal strategy aligns with those issues, along with a documented contingency plan.Defining Risk*
- Credit Enhancement: A strategy used to improve the credit-risk profile of a business to get better terms for repaying debt.
- Downside Risk: An estimation of a security's potential loss in value if market conditions precipitate a decline in the security's price.
Selection of the best capital source is based on more than interest rates or equity returns. It is critical to get information on all the attributes of capital—terms, timing, transaction costs, and complexity—that may impact the control you have over the project. The least expensive capital is not always best if covenants, restrictions, remedies, transaction costs, and timing are not workable or competitive.
Successfully renewing your building requires an integrated, sequenced, and cohesive approach. When different financial resources are in play, the integrated nature of the project can rapidly deteriorate. To mitigate this, maximize the financial resources that give you the most control, and if necessary, move to more speculative resources to close any remaining funding gaps. The more you lose control over how the money is spent, the greater the risk of losing the integration and sequencing strategies necessary for a successful building renewal.
After understanding the underwriting process, potential risks, and terms associated with the project, you can begin to articulate a financial case. For greatest success, your strategy should put you in the best financial position when approaching each potential funding source. Ideally, aim to build your capital stack in a way that provides you with as much control as possible, while aligning the project’s financing with the goals of the renovation and the overall investment strategy. Due to ongoing changes to tax and legal considerations, and the complexity of combining financial sources, always consult your legal and accounting teams.
- DSIRE: Database of State Incentives for Renewables & Efficiency is the most comprehensive source of incentives and policies that support renewables and energy efficiency in the United States.
- Better Buildings from U.S. Department of Energy offers resources and insights for financing energy-efficiency projects in commercial buildings.