Energy And Real Estate Are Colliding

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by: Elias Hinckley

Summary

A wave of technology and innovation is fundamentally changing the way that building owners and other real estate investors are thinking about the role of electricity in real estate investments.

New energy companies are emerging. The current environment, with persistently low interest rates, has made the use of money extraordinarily inexpensive, and investors have been willing to enter parts of these new energy markets at a scale and pace that has surprised many as they search for new sources of yield.

The need for investment to support the energy transition that has just begun is immense - this transition will require the largest deployment of capital in human history, so there is plenty of room for new participants, especially investors that are filling in underserved portions of the market.

A wave of technology and innovation is fundamentally changing the way that building owners and other real estate investors are thinking about the role of electricity in real estate investments.

Since the very earliest days of electricity generation the world's electric systems have been based on a model centered on large generating stations, with complex transmission and distribution systems to transport and deliver electricity to users. Now we are in the early stages of a fundamental shift, driven by trillions of dollars of investment, from the traditional centralized energy model to a system that is significantly distributed. This investment will manifest in several distinct forms, including onsite power generation like solar or combined heat and power systems, enhanced energy efficiency and energy management tools, on-site electricity storage, as well as systems built around supporting electrification of vehicles.

In the old model electricity came in from the wires and was a cost over which a building owner had either no control (in settings like self-used and gross leased property, where electricity might be paid by a building owner and recovered through higher rents) or no real interest (as with net leases, where a tenant is responsible for energy costs). As that old energy model is being replaced, the increasingly distributed energy system is creating tremendous opportunities for real estate investors to profit from this multi-trillion-dollar energy market transformation.

Who will own these assets is far from settled in this changing market.

Traditional energy companies are only just beginning to embrace the economic potential of this shift - and will continue to struggle to adapt, for a few reasons. Utilities are subject to regulatory limits on owning generation or energy management tools inside a building and beyond the meter where the sale of electricity occurs. Traditional energy companies have also not been quick to embrace a market that represents demand destruction for their core product and does not build off of core skills within these companies. Finally, the culture of the traditional power business is one built on glacial-like response to change, in which advancements (if they occur) take decades to unfold, making it very difficult to react to what is now a technology driven market, producing new technologies and new ideas around process on a time scale measured in months.

New energy companies are emerging. The current environment, with persistently low interest rates, has made the use of money extraordinarily inexpensive, and investors have been willing to enter parts of these new energy markets at a scale and pace that has surprised many as they search for new sources of yield. The result has been several early success stories among these new energy companies. Residential rooftop solar has been the most notable early success. Deals are easily replicated with take-it-or-leave-it approaches to documents. Credit risk is pooled based on FICO scores just like mortgages and the result is a market that can not only attract capital, but one where investments have successfully driven public stock offerings or have been re-sold into the secondary, market further reducing the cost of money supporting these projects.

One area where these new energy-focused investors have struggled to find success so far is in the market for energy projects associated with commercial and industrial buildings. Finding consistently credit worthy owners and tenants, along with the complexity and expense of the transactions, have presented the biggest challenges. There are layers of decision makers within the process, with owners, tenants and management companies rarely aligned on the energy value proposition, and navigating these relationship from the outside can be very difficult. There have been some limited success stories working with very large companies (where multiple sites can be managed under a single transaction process and credit ratings make evaluating credit risk easy), but across much of the commercial real estate market we have seen limited activity, despite the potential for very significant investment returns.

New groups of investors have begun exploring this untapped part of the market. Some real estate investors have recognized that these new energy investments are remarkably similar to the underlying real estate investments that they serve. There are certain identifiable operational risks, but once these are controlled, the payment risk is a combination of occupancy and tenant credit risk - exactly what a building owner already models to determine the value of the underlying real estate investment. The energy investment can actually enhance the value of the underlying real estate by reducing occupant operating costs, augmenting cash flows, and improving a tenant's ability to pay for property use.

These investments require a better understanding of the relationship between building use and energy than has been necessary for most real estate investors to date. Otherwise, the most significant difference is that these energy investments can generate substantially higher rates of return than the underlying real estate investment. For a real estate investor who has already evaluated a property, layering on an energy investment to increase returns has obvious appeal. An investor that is already comfortable making the real estate investment understands the loss, default, and occupancy risks of a property, so adding a further layer of additional investment is a relatively easy decision.

The emergence of this new type of real estate-energy investor has broader significance. The need for investment to support the energy transition that has just begun is immense - this transition will require the largest deployment of capital in human history, so there is plenty of room for new participants, especially investors that are filling in underserved portions of the market. By applying a more sophisticated understanding of real estate-related risk and process to the distributed energy market, these new investors will rapidly and dramatically expand the available capital for distributed energy investments. With this expansion expect a new class of energy companies and investors to become a vital part of our energy mix.

This article was originally published at The Energy Collective on June 9, 2015.

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