By Art Gering

Different Sectors, Different Priorities

Not all property sectors are created equal when it comes to energy matters. REITs show great diversity in their priorities and practices regarding energy efficiency, across and even within specific property sectors, according to the Institute for Market Transformation, an organization that promotes energy efficiency and environmental protection in the U.S.

The differences in energy issues across the property sectors notwithstanding, the curious investor may encounter difficulty digging up data on a REIT's energy expenses. These costs are aggregated in the property operating expenses line of an income statement with other expense items. Also, some REITs are reluctant to share comprehensive information on energy costs in either financial statements or their discussion of operating results because reporting requirements do not obligate them to provide such specific disclosures. Still, it's important to the REIT investor to understand how office, lodging, multifamily, retail and industrial firms treat energy management and cost reduction differently because of how energy costs affect the bottom line.

Office

According to the Building Owners and Managers Association's (BOMA) "2003 Experience Exchange Report," utility costs of $1.94 per square foot for downtown office properties represented 28 percent of property operating costs in 2002, the last year for which numbers are available. Costs for suburban properties came in at $1.77 per square foot, or 30.4 percent of operating expenses.

The real estate adage, "location, location, location," also applies when examining energy costs. Office assets in downtown markets such as New York City, Boston, San Francisco and Washington, D.C. run up electricity costs greater than $2.00 per square foot, BOMA reports. By comparison, electricity in downtown Atlanta is a relative bargain at $1.31 per square foot (see table above).

In office markets where tenants sign gross leases (sometimes known as a full-service lease), the owner assumes responsibility for utility costs. These expenses are passed through to tenants in the form of an escalation payment, an amount calculated as the difference between the current year's operating costs and an operating cost figure established in the first, or base, year of a lease. In some markets, office leases are written triple-net, meaning the tenant pays all operating costs for the property. Triple-net leases are common in suburban markets and in some downtowns, such as Washington, D.C., according to David Houck, a senior vice president in the Washington, D.C. office of the Staubach Co., a Dallas-based real estate services company.

Paying at the Office Average electricity costs per s.f. for office space in selected markets
Downtown Locations		Suburban Locations
New York	$2.61	Minneapolis	$0.87
San Francisco	2.28	Chicago	1.00
Boston	2.01	Denver	1.22
Washington, D.C.	2.01	Houston	1.34
Houston	1.84	Atlanta	1.38
Los Angeles	1.79	San Antonio	1.40
Portland, OR	1.31	Indianapolis	1.41
Atlanta	1.31	Dallas	1.50
Pittsburgh	1.20	Sacramento, CA	1.54
Chicago	1.17	Portland, OR	1.56
Source: "2003 BOMA Experience Exchange Report," a survey conducted by the Building Owners and Managers Association.

Under a gross lease, an owner operating an inefficient building with rising energy costs has the escalation mechanism to recover the amount of an increase, suggests Dove Goldman, director of Integra Realty Resources. However, it's unlikely office tenants would allow owners to continually pass through rising energy costs, he adds. Properties develop reputations, explains Edmund Cronin Jr., the chief executive officer of Washington Real Estate Investment Trust(NYSE: WRE).

"Any type of building that does not have double-paned windows, for instance, is going to have a much higher utility expense," Cronin says. "Sooner or later, tenants are going to find out they are paying more for utilities than they should be."

Intent to keep tenants happy and retain them beyond the current lease term, office REITs have the strongest cost-reduction motivation to pursue energy efficiency, the Institute for Market Transformation contends. Office REITs also display the greatest level of activity among all REITs in this area, according to the organization.

"Ideally, we like to find ways to make our buildings operate more efficiently," Reckson's Senior Vice President and Managing Director Todd Rechler says. "That makes our properties more competitive in the market and also keeps the tenants happier within our assets."

"We have great motivation to reduce energy costs," Equity Office's Senior Vice President of Engineering and Energy Operations Frank Frankini says. "When we do, it increases our net operating income and reduces expenses for our customers."

The commitment of office REITs to energy efficiency is evident by the number of such firms enrolled in the Energy Star program. Of the 24 REITs enrolled as Energy Star partners, 20 are in the office sector, according to the agency's Web site.

Lodging

In the lodging sector, where occupancy rates typically run well below those for office properties, the effect of volatile energy costs hits property owners particularly hard. Whether a hotel is half empty or completely booked, costs are being incurred to light common areas, run elevators and operate food and beverage services, among others.

Utility costs account for 4.4 percent of annual total property revenue for all hotels, according to the Hospitality Research Group of PKF Consulting. Differences exist between property subtypes, ranging from 3.3 percent of total revenue for resort assets to 4.8 percent for limited- service and extended-stay properties. Geographic factors also play a part, as it costs more to cool a hotel in Phoenix or heat one in Boston than in other locales.

"Our utility costs are running from about the high 4 percent range to 5 percent of total revenue," relates FelCor's Senior Vice President of Asset Management Jack Eslick. Total revenues for the firm were $921 million through the end of September.

Both natural gas and electricity costs increased during 2003 and Eslick expects the final tally of utility expenses to be up between 8 percent and 9 percent for the year. Natural gas is used in food and beverage services, hotel laundry and to heat some hotels, he says.

Because energy comprises such a significant expense for FelCor, the firm is testing energy saving technologies, such as a sensing device in guest rooms that moderates heating and cooling depending upon whether the room is occupied.

"We've been watching the devices for about a year and a half and we're going to pursue it a bit more in 2004," Eslick says. The REIT is also testing a water recycling system in an Atlanta property and has been upgrading lighting across its portfolio.

"Like any expense item, some owners will concentrate on energy more than others," Eslick says. "In the past three or four years, however, energy has become a line item that is not taken for granted and something to focus on."

Multifamily

Multifamily REIT investors have many factors to consider when investigating a company's energy consumption and expenses. The property can either be master metered, where the owner pays for energy, or it can be individually metered, where tenants assume responsibility. Market location is also important and there is a difference in utility costs between garden-style assets and buildings with elevators.

For example, mean annual utility costs in New York City, a predominantly elevator market, run $1,838 per unit, according to the Urban Land Institute. In San Diego, which has mostly garden-style properties, the cost is $713 per unit (see table above).

"Typically in a high rise, your common area utilities are going to run double what garden-style properties do because you have interior halls that have to be lit 24/7," explains Randall Ell, executive vice president of property operations for Summit Properties Inc. (NYSE: SMT) and the president of Summit Management Co.

Largest U.S. Apartment Markets Ranked by Mean Utility Expenses Per Unit
Market	Mean Utilities Per Unit
New York City	$1,838
Boston	1,152
Philadelphia	1,055
Nassau-Suffolk Counties, N.Y.	873
Chicago	871
Washington, D.C. MSA	842
Detroit	784
Minneapolis-St. Paul	753
San Diego	713
Los Angeles-Long Beach	642
Source: "Dollars & Cents of Multifamily Housing," a survey by the Urban Land Institute.

In its "2003 Survey of Income and Expenses in Rental Apartment Communities,"the National Apartment Association reports that utilities run $317 per unit per year, or 9.6 percent of total operating expenses, for all individually metered market-rent properties. Master- metered complexes incurred average costs of $893 per unit per year, or 20.5 percent of total operating expenses.

Summit has a number of individually metered properties in its Southeast markets. Here, the REIT pays common area utilities-items such as breezeway, interior corridor and parking lot lighting. In total, these expenses run approximately $110 per unit annually. Summit owns approximately 14,700 units, according to the company's Web site.

"We got real smart on energy conservation a long time ago, even when the residents were paying for it," Ell says. One of the energy efficiency measures undertaken was the replacement of incandescent common area lighting with longer life fluorescent bulbs.

Summit also has a property in Atlanta that uses natural gas. Natural gas prices doubled during 2003, Ell says.

"It really hurt us, especially when you charge residents a flat rate for utilities. If you don't expect utilities to go up, then you don't get a chance to pass the increase along to the residents," he adds. "A lot of property owners in the Northeast experience the same thing."

Home Properties owns more than 41,000 units, many located in the Northeast. The company pays heating costs for approximately 70 percent of its units, relates Senior Vice President and CFO David P. Gardner.

In the 2002 to 2003 heating season—encompassing the fourth quarter 2002 and first quarter 2003—Home Properties' same store gas costs were $11.3 million, up 6.8 percent from the year earlier, due primarily to a harsh winter.

"In 2002, gas costs represented just under 9.9 percent of same store property operating expenses," Gardner says. "During the heating season gas costs are approximately 14 percent of property operating expenses."

To save money, Home Properties has a schedule of window and door replacement in its properties. In 2002, the REIT installed 10,000 new windows. "This is significant, considering the average age of our apartments is 33 years and when we purchase older properties, which is part of our repositioning strategy, they often have original windows," Gardner says.

Retail

Utility costs at retail properties also show great variation. According to New York City-based International Council of Shopping Centers, utilities at enclosed malls run $2.06 per square foot, compared to $16.37 per square foot of total operating expenses. Open-air centers, by comparison, run cheaply at $0.25 per square foot and $4.10 total.

"Whatever we can do to reduce the cost to the tenants and ourselves helps because a certain amount of the costs are borne by us," says John Hoeller, senior vice president of property management at Glimcher Realty Trust (NYSE: GRT). "We've retrofitted mechanical units with variable speed motors, we've co-oped with utility companies to provide emergency power and found opportunities to reduce spikes in our energy usage.

"We're constantly looking at energy," he stresses. "I have a national director of operations and probably 60 percent of his job is to investigate ways to save energy."

Industrial Warehouse

Warehouse and industrial properties are typically leased triple-net, meaning the tenant assumes utility costs. For an industrial REIT, energy costs are not as relevant as they are in other property sectors. Energy costs run "around 40 cents to 50 cents a square foot on an annual basis," says Kevin Crowley, vice president of the Society of Office and Industrial Realtors. "That's assuming the product doesn't have to be maintained at a certain temperature (such as a cold storage facility)."

"As a proportion of our non-reimbursable expenses, energy accounts for less than 1 percent of total property operating costs," reports a spokesperson for AMB Property Corporation (NYSE: AMB). While the REIT acknowledges its concern for minimizing tenants' occupancy costs and building customer goodwill, energy efficiency is "not as large a priority for us as other property types because of how leases are structured."

From a competitive standpoint, AMB acknowledges the value of energy efficiency initiatives and says the inclusion of such programs makes the most sense during the development or retrofit phase.

All commercial property owners pay for power on vacant units. But today, with occupancies near cyclical lows, the hit on industrial owners is not that great because the temperature assets are lower than those maintained in other properties, explains David P. Draft, executive vice president of operations for First Industrial Realty Trust Inc. (NYSE: FR).

"The impact is miniscule on a relative basis for a portfolio of more than 61 million square feet," he says. "Less than $150,000 annually with a 2 percent variance in occupancy."

Energy issues seem to capture the public's attention only in times of crisis, such as the Arab oil embargo of the 1970s or the California deregulation imbroglio a few years back. The REIT investor, however, should pay attention to these issues all the time because energy consumption, costs and efficiency practices can influence the bottom line and affect property values.