By Art Gering
As REITs take steps to mitigate rising energy costs and improve efficiency, will investors see
a spark in their returns?
Many REITs from different property sectors entered 2003 with modest expectations for top-line growth, their optimism tempered by shaky property market fundamentals and weak prospects for rent increases. Under these circumstances, cost cutting—including the steps REITs have taken over the years to manage or reduce energy costs at their properties—became vital to protecting their bottom lines and driving shareholder value.
For REIT managements, energy is a constant concern and often a significant component of property operating expenses. Managements generally agree on the importance of managing energy costs and implementing cost-justified energy efficiency measures in their property portfolios.
Any reduction in property expenses through energy efficiency improvements raises a REIT's net operating income (NOI) and enhances a property's value.
"If you're able to drive a 30 percent or 35 percent decrease in energy costs, that's going to boil right down to the NOI of the building," says Scott Lyle, president of Next Edge, an energy management consultancy established as a taxable REIT subsidiary of Arden Realty Inc. (NYSE: ARI).
An improved bottom line will typically boost the value of any type of property. A question to consider is whether a higher asset value supports a lower cap rate than comparable properties, a factor that may be relevant when attempting to estimate the value of a property portfolio.
"You might find a spread in the cap rates (between an energy efficient building and one that is not energy efficient)," says Dove Goldman, a director with appraisal firm Integra Realty Resources. "The risk of a deteriorating asset is mitigated because the building is more efficient."
Arguably, an energy efficient and low-cost building helps attract and retain tenants. For example, Arden Realty has a roster of smaller office tenants that take 5,000-square foot to 6,000-square foot spaces. "Occupancy costs are very important to those tenants, probably more so than for a larger tenant," says Rick Davis, Arden's senior vice president and chief financial officer. "If we can reduce occupancy costs, it helps our retention efforts and shows tenants they'll pay less to occupy our buildings."
Impact of Deregulation
Additionally, deregulated energy markets have provided investors an opportunity to assess a REIT management's ability to navigate through a new market structure. An untold number of REITs are purchasing electricity in the deregulated markets where they have properties.
Some 24 states and the District of Columbia have set about deregulating electricity, according to the Energy Information Administration of the U.S. Department of Energy. California's deregulation problems are well publicized and "market restructuring," as the electric industry calls deregulation, has produced mixed results for REITs that buy electricity in other markets where it has been implemented.
In New Jersey, energy prices rose 20 percent between September 2003 and December 2003, says Barbara Yamarick, senior vice president of tenant services and administration for Brandywine Realty Trust (NYSE: BDN). But Brandywine found a low-cost source of power and took only a 12 percent hit. When power was deregulated in Pennsylvania five years ago, the REIT realized it had to look for potential savings. The firm hired energy consultancy EPEX Inc. to help in its effort.
"There are times you realize what you don't know," Yamarick says. "A lot of real estate companies here were paralyzed and didn't make any choices. They lost the chance for some terrific savings."
Equity Office Properties (NYSE: EOP) has been purchasing power in deregulated markets such as California, Illinois, New York, Pennsylvania, Texas, Massachusetts and Washington, D.C. since 1995. Annual savings have ranged from $16 million to $28 million, reports Frank Frankini, the firm's senior vice president of engineering and energy operations.
Reckson Associates Realty Corp. (NYSE: RA) has been buying deregulated power in New Jersey and New York, but
the firm has yet to capture any savings for its efforts. Todd Rechler, senior vice president and managing director of the REIT's New Jersey division, says energy costs have risen because of deregulation. "It will be a while before you see enough generation capacity to stabilize the market and bring prices down," Rechler says.
FelCor Lodging Trust Incorporated (NYSE: FCH) has approximately 25 percent of its 161 properties in deregulated energy markets, according to the company's senior vice president of asset management, Jack Eslick. And, multifamily trust Home Properties (NYSE: HME) has a hedging program to mitigate the volatility of natural gas prices. Executive Vice President and Chief Financial Officer David P. Gardner reports that at the end of the third quarter, the company had fixed contracts for the current heating season for 99 percent of its natural gas exposure, at a cost approximately 15 percent below current prices.
Effect on Stock Performance
A recent report by financial research firm Innovest Strategic Value Advisors suggests that a REIT's energy efficiency practices enhance stock performance. The firm investigated the involvement of 36 REITs in the U.S. Environmental Protection Agency's Energy Star program. Energy Star evaluates a property's energy performance to help building owners achieve energy efficiency. Buildings are graded on energy performance and a score of 75 or higher earns an Energy Star label, meaning the property is in the top quartile of all similar properties nationwide. A labeled building signifies the property is energy efficient and has lower operating costs than its peers, Frankini says.
Innovest divided the trusts into three groups of 12: those active in the Energy Star program; REITs that are less active in the program; and non-partners, i.e., REITs that are not involved. The active partners include Equity Office, Arden and Trizec Properties Inc. (NYSE: TRZ).
Active and less-active partners were distinguished by whether the company had a relatively high or low number of buildings that received an Energy Star label. From June 2000 to June 2002, stock prices of active members increased 33.1 percent, the less-active ones increased 26.5 percent and non-partners returned 20.4 percent.
Marc Brammer, an Innovest senior analyst, concedes that factors besides a firm's focus on energy management also contribute to stock price performance. However, he stresses that effective energy management is one of the most demanding challenges management must deal with.
"There are high levels of technical, regulatory and market
uncertainty as well as many stakeholders and complex issues to address," he argues. Firms that are willing to get their arms around a complex issue such as energy management, he says, are probably able to deal with a range of "knotty issues."
"A company that understands energy efficiency and is able to implement it really well is probably doing a good job handling other challenging issues of their operation," Brammer says.
Art Gering is a regular contributor to Portfolio based in New York City.
High Energy