The total cost of ownership and sustainable investments in Real Estate

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The total cost of ownership and sustainable investments in Real Estate

Abstract

Current literature has shown cost and benefits of sustainable buildings and sale price premiums of sustainable certified buildings. This is the first study that explains the composition of the extra value of sustainable buildings compared with non-sustainable buildings. Using the total cost of ownership approach (TCO) with real cost figures an attempt is made to identify the critical factors underlying the sale price premium. Using a financial model it is investigated which sustainable investments decrease the TCO and which variables have an impact on the sustainable investments. The exit value, the energy use and other operating costs determine the extra value of a sustainable building. The variables that have an impact on the TCO are the electricity price, the WACC and the inflation rate. All sustainable investments can be implemented at an electricity price of 20 euro cent, which is the average price paid for electricity, except the TL-lighting and the solar panels 42k.

Keywords: financial model, total cost of ownership, sustainability, real estate JEL-code: Q56

Author: Albert Koekkoek Student number: 1400541 E-mail: akoekkoek@gmail.com Date: 26-08-2010

University of Groningen

Faculty of Economics and Business MSc Business Administration (Finance)

Supervisor TNT Real Estate B.V. Drs. C. Plugge

Supervisors University of Groningen: 1e Dr. W. Westerman, 2e Prof. Dr. L.J.R. Scholtens

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Preface

This thesis has been written for TNT Real Estate B.V. which is part of the TNT N.V. and the faculty of Economics and Business of the University of Groningen. I hereby would like to thank drs. C. Plugge for his continuous support and feedback during the internship. I also would like to thank Dr. Westerman for his valuable feedback and flexibility during the period.

In addition, I would like to thank the rest of the TNT Real Estate department for their useful tips and advice.

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1 Introduction

1.1 Introduction and motivation for research

In August 2008 energy prices were at record levels with the oil price reaching $135 per barrel¹. Although the markets recently experienced a decline in energy prices as a result of the economic crisis, the long-term energy demand is still expected to growth (EIA Outlook 2009).

Given the current carbon intensity of energy usage, strong growth in energy demand would imply that the level man made CO2-emmissions is also expected to grow fast. In turn, the atmospheric temperature as well as sea water levels, which can have an enormous impact on the future environment such as flooding highly tensed population regions. Decreasing CO2- emissions could reduce this impact (Warrick and Farmer, 1989).

TNT N.V. is a logistic company on the global market and as part of the new strategy the company is trying to become the first logistic company that has a neutral carbon dioxide footprint.² Of all current CO2-emissions of TNT, TNT’s real estate is responsible for 20% of the CO2-emissions due to heating and lighting the buildings.³ Globally, 30-40% of CO2 emissions originate from real estate, making it a large contributor to the overall level CO2- emissions (UNEP, 2007). Substantial savings (given high energy prices) can be made if less energy is used by heating and lighting the buildings. In order to achieve the reduction in energy use the buildings have to be adapted by investing in sustainable technology. Among other authors, Miller, Spivey, and Florance (2008) have indicated that investing in more energy efficient buildings is generally profitable. The total cost of ownership (TCO), which refers to the cost of building the structure, should not increase when investing in sustainable technologies. The competition in the postal market is fierce, so increasing costs would deteriorate the competitive position in the market. This consideration has to be made by the people that manages the buildings. The real estate department of TNT manages all buildings and maintenance of all structures owned by TNT N.V. Given TNT’s carbon strategy, it will have to decide how to meet the ambitious goals by constructing a sustainable building. At the same time, it also has to keep in mind that the costs should not increase when trying to reduce CO2-emissions.

Certificates are a measurement tool to see how sustainable a building is and how much CO2- emissions are saved compared to traditional buildings (Reed et al, 2009). LEED, GreenStar and BREEAM are certificates which have been used for several years now and are becoming widely accepted in the real estate sector. A certified building will likely have a higher market value due to the guarantee of lower energy costs. Sustainable office buildings generally have a higher rent and sale price premium compared to traditional less sustainable buildings (The CoStar-group, 2008; Miller, Spivey, and Florance, 2008; Wiley, Benefield, and Johnson, 2008; Eichholtz, Kok, and Quigley, 2009; Fuerst and McAllister, 2009). However, the composition of the rent and sale price premiums is not clear. The value of the sustainable investments could verify the rent and sale price premium. This would indicate that the exit value of sustainable buildings is higher than traditional buildings which would justify the extra costs that are needed to implement the sustainable technologies. The amount of extra costs depends on the amount of sustainability that is implemented. Sustainable buildings do not necessarily have to be more expensive. Kats (2003) shows that costs only increase with very small percentages depending on the level of LEED-certification that is reached. The

1 Bloomberg.com

2 Implying that the company as a whole abates the same amount of CO2 as it produces, and therefore has net zero CO2-emissions.

3 Source: TNT’s presentation Veenendaal 2008

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benefits of the sustainable investments are the following: Fuerst and McAllister (2008) mention lower holdings costs and a lower risk premium, while they also found better occupancy rates for sustainable buildings compared to traditional buildings in a later research (Fuerst and McAllister, 2009). Lower energy costs are cited by Turner and Frankel (2008) as well as Miller and Poque (2009). In the Netherlands sustainability subsidies can be applied for certain sustainability investments (AgentschapNL, 2010). All costs and benefits have to be valued to improve the understanding of the composition of the increase in exit value.

Therefore, several valuation methods to measure the market value of traditional buildings will as well as sustainable investments will be discussed.

Then, an exploratory case study is performed to show the valuation of sustainable investments and the calculation and composition of the total cost of ownership of constructing a building with sustainable investments. Using the TCO, the valuation methods for real estate (Ten Have, 2002 and 2003) and valuation methods for sustainable real estate (Ellison, Sayce and Smith, 2007), the total investment sum of sustainable investments is calculated. An explanation on which technologies are profitable is provided. The exit value, energy savings, and the dependence of market variables like the energy price or the inflation rate on the calculation is discussed in more detail. The results can be used to determine the investments to implement in a new sustainable building without increasing the total cost of ownership.

1.2 Practical and academic relevance

There are sufficient articles, as can be read in the literature section, that show the evidence for cost premiums and rent and retail price premiums for sustainable certified buildings in the US.

Hypothetical cost studies that show the extra value of a sustainable buildings compared with a non sustainable building, as the one in McAllister (2009) and Robinson (2005), have been made, but there is still a lack of literature with real costs figures. With the real costs, which are used in this study, the real extra value of sustainable investments can be calculated. This study uses a refined approach, the TCO approach, to estimate the value of a sustainable building compared to a traditional building. In addition, not just the surplus in value of a sustainable building is shown via a different approach, the composition of this surplus is evaluated as well. The profitability of each investments and the impact of market variables on these investments is shown. For the real estate sector, it does not only provide another example that sustainable buildings are economically better than traditional buildings, but this study also illustrates which sustainable investments under which circumstances should be implemented. For science, this example cross-checks the results of sustainable studies already made by a calculation from the TCO perspective with real cost figures. It is the first study that shows a more in depth view of the value of sustainable investments for real estate.

1.3 Literature review/background information

Relevant literature can be divided into three parts. The first paragraph discusses sustainability in real estate and the costs and benefits it has for the owner and user of the building. The second paragraph includes the description of sustainability certificates for real estate and their value for buildings. Finally, the third paragraph consist of the valuation methods for real estate and the valuation methods specifically for sustainable investments.

First, the elements of sustainable investments in real estate are categorized into 5 general aspects: sustainable sites, water efficiency, energy and atmosphere, materials and resources, and indoor environmental quality. These are further divided into 9 categories: management, energy, transport, health and well being, water, materials, land use and ecology, pollution, and sustainable sites (BRE, 2008). Sustainability certificates are aimed on the same goals as well.

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Davis Landon (2008) shows the costs and benefit analysis of the elements of sustainability in real estate and the increase in costs and benefits of ‘Green Star’-ratings⁴. It shows the extra costs for each level of Green Star certification for buildings and the reduction in CO2 emissions that comes with the certification’s level. Kats (2003) and GSA (2004) show the cost premium to achieve different LEED certifications. Even more, Davis Landon (2007) shows the cost premiums of Green Star buildings. Moreover, there are also costs which cannot easily be measured but that possibly have an effect, the indirect costs. Jones Lang Lasalle (2008) shows possible extra insurance costs. Grootes (2009), SenterNovem (2009), and Jones Lang Lasalle (2010) mention the unwillingness to pay for sustainability. Then again, the benefits of sustainable buildings are mentioned by Kats (2003), Turner and Frankel (2008), Miller and Poque (2009), and Fuerst and McAllister (2009). These include lower energy costs because of lower energy use, higher occupancy rates results in lower occupation risk for the owner and thus a lower required rate of return than he normally has. Besides indirect costs there are also indirect benefits. McAllister (2009) mentions improved productivity and less absenteeism of employees. In addition, a sustainable building complies with future government regulations with respect to CO2 emissions. Lastly, sustainability subsidies can be obtained which reduce the investment sum (AgentschapNL, 2010).

Second, sustainability certification is used as a measurement tool to calculate the sustainability of a building. Reed et al. (2009), BRE (2008), and Sayce and Sundberg (2009) all mention certificates which are used to measure the sustainability of a building. The higher the building scores on the level of certification, the more sustainable the building is. A certification increases the awareness of environmental issues, gives appraisers a method and framework to use for sustainability, and it gives management more focus on building maintenance and performance. Certification is therefore used often as a tool to investigate if sustainability adds value and with what amount. The studies of SenterNovem (2008) and Dutch Green Building Council (2008) have compared the possible sustainability certificates for the Dutch real estate market. Possible sustainable investments that can lead to certain certificates are summed by AgentschapNL (2010). The value of having a certification can in theory be calculated by adding up the investments one has to make to get the certification minus the costs savings the technology returns plus the exit value of the investment. The value of a certification can also be calculated by observing market prices and rent prices of buildings with and without certificate. These sale price and rent effects of the level of sustainable certification of commercial buildings have been investigated by the CoStar group (2008), Fuerst and McAllister (2008), Miller, Spivey, and Florance (2008), Wiley, Benefield, and Johsnon (2008), Eichholtz, Kok, and Quigley (2009), and Fuerst and McAllister (2009).

They all used the CoStar database⁵ to obtain the results. The CoStar database consists of all LEED-certified and Energy Star-certified buildings in the United States. Although, the approaches as well as the results differ among the authors, all studies show positive premiums. Jackson (2009) estimates internal rates of return above 100% based on the results of these studies.

Third, before setting to a valuation, the definition of value is needed to be able to compare values across studies and valuations. The definition used in this paper is the sustainable development definition of the Brudtland Report (1987) which is also used by Myers, Reed,

4 Green Star is a certification for sustainability of real estate in Australia. (www.gbca.org.au/green-star)

5 COstar is a company which provides commercial real estate research and information services for property investors and sales professionals. It has a database of independently researched information available including commercial real estate for sale, property for lease, verified comparable sales transactions, and tenant

information. (costar.com)

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and Robinson (2007). This definition centres around meeting the needs of the present without sacrificing the abilities of the future. Then as Pomykacz (2009) argues, the goal of the valuation approach has to be chosen to get the proper value. The composition of the valuation depends on the subject and the target of the valuation. When the target has been chosen the costs and benefits of the real estate item can be investigated. Then, to set the valuation of sustainable investments into perspective, as much as eleven general methods for valuing real estate can be distinguished (Pagourtzi, Hatzichristos, and French, 2003). The most used approaches are the comparable approach, the income approach, and the residual approach. A widely used method which is part of the income approach is the discounted cash flow (DCF) method. It is used to calculate the value of future cash flows back to the present. Valuing real estate can be difficult because the property has its own characteristics, and if so, the hedonic regression method is used (Janssen et al, 2001) It is demonstrated for rents on office buildings by Dunse and Jones (1998). Obtaining the value of the sustainability investments is the next difficult step. The valuation is hard to achieve because the extra value of the sustainable investments is still uncertain. The source of the premiums is difficult to asses (McAllister, 2009). Investments in energy saving technologies have been discounted with high discount rates (Anderson and Newell, 2004). Yet, a proper assessment reduces risks which could reduce lending and insurance costs (Lützkendorf and Lorenz, 2007). Bowman and Wills (2008), Pits and Jackson (2008), and RICS (2009) prefer the discounted cash flow method for valuing sustainable buildings because different values in rental and growth rates can explicitly be shown in the valuation. However, Guidry (2004) mentions the cost, sales and income capitalization approach for valuing a sustainable building. Davis Langdon (2007) argues that one should not use the traditional design and add the sustainable investments because it does not value the design trade offs which are made when designing the building as a whole.

Robinson (2005) and McAllister (2009) show a hypothetical calculation of a standard and a sustainable building. Ellison and Sayce (2006) and Ellison, Sayce, and Smith (2007) present a model with some case studies to show the difference between the value of a standard and a sustainable building. The inflation rate, the discount rate and exit yield are among the variables in the model. These models show the total value including uncertain cash inflows of rents.

1.4 Problem statement

The problem statement consists of the main research question and sub-questions which extend the subject. The main research question is as follows:

What does the current literature show about sustainability for real estate, the substance of the total cost of ownership of a sustainable building, and what does practice show?

The sub-questions are formulated as follows:

1. What does the current literature say about having and granting a certification for sustainability in real estate?

The literature on sustainability for real estate has recently gained more attention. Certificates have a signalling function for the level of sustainability of a building. Most of the literature is based on the certificates of LEED and GreenStar. Most of the buildings with those certificates are located in the United States and Australia. The certificates focus on elements of sustainability. The requirements for the certificates are aimed on those elements and can be fulfilled by investing in sustainable technologies. Certified buildings have both extra costs and extra benefits. Having a certificate should indicate that the building has lower energy costs than a comparable non-certified building. This should result in a higher sales price premium

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but since certificates are mutually different, there is uncertainty if the sale price premium results can be compared among each other.

2. What are the costs and benefits of implementing sustainable investments in real estate and how can they be structured in the total cost of ownership calculation in the financial model?

It will be investigated which investment has a positive impact on the TCO. Better occupancy rates, higher exit values, lower energy costs, and sustainability subsidies can have a positive effect on the TCO. Extra insurance costs, and the unwillingness to pay can have a negative effect on the TCO. Benefits from the sustainable investments are energy savings and the collection of subsidies for sustainable investments. In addition, risk premiums are reduced because of less uncertainty for investors and more sustainability has a positive effect on the image of the company. By using one of the various valuation methods for real estate, the value of the building under consideration is calculated. Depending on the target of the real estate in question, a valuation technique is chosen to value it. If the building can be reused for other purposes, then the current building has to be valued, or if it can be demolished, the possibility of a future new building has to be valued. The possible investments that have a positive effect on the exit value are considered. Finally, a valuation method is chosen and the valuation for the complete total cost of ownership is made using the financial model.

3. Which variables have an impact on the cost and benefits and what is the impact on the sustainable investments of TNT specifically?

Market variables like the electricity price can have an impact on the TCO. It depends on the sustainable investment if the impact is small or large. Scenarios that provide other values for market variables like the inflation rate can be executed to show their impact on the TCO and can show which types of costs and benefits are affected, such as the exit value and the energy savings for example.

1.5 Research strategy

The research strategy consists of conceptual models and the methodology that is used to find the answers to the research questions. The first conceptual model shows the relations among the subjects discussed in this thesis. The second conceptual model shows the structure of the financial model that is used to calculate the TCO of a standard and a sustainable building.

Then, the methodology provides the used research technique, an explanation of the working of the financial model and the time frame in which this study is performed. Finally, a data description shows the source of the data used.

1.5.1 Conceptual model and financial model

In Exhibit 1.1, a conceptual model is drawn which shows the setup of the research. On the one side, sustainability for real estate is the starting point. The cost and benefits of sustainability in real estate is discussed to see the possible impact of sustainability on real estate. Then, sustainability certificates can be used as a signalling function that the building is sustainable.

The availability of different certificates and the requirements to achieve them is treated as well as the cost and benefits of the certificates. These certificates can be obtained by investing into sustainable investments. The investments increase the investment sum but decrease the operational costs during the period of use of the building. The cash in and out flows due to the investments are valued by the total cost of ownership approach. This approach shows the total cost of owning an object during the use of the object. Building data is then put into the

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calculation as building blocks for the standard building and the sustainable investments. Data for the building variables for the standard building and the sustainable investments such as the variables that make up the investment sum needed to build it and the operating cash flows.

Market variables that have an impact on the calculation such as the inflation rate and the electricity price. On the other side, the valuation methods are explained after which a method is chosen to be used into the total cost of ownership calculation. The methods for valuing real estate is discussed after which the valuation methods of sustainable investments follows. The discounted cash flow method is used to calculate the TCO value in present monetary terms.

The TCO values for the standard building and the sustainable building can then be compared to decide if the building should be build sustainable.

Exhibit 1.1: Conceptual model of the setup of the research.

In Exhibit 1.2, the setup is drawn of the financial model. The financial model provides the total cost of ownership of a standard building and a building with sustainable investments implemented. The values for the building inputs are chosen for each specific building separately. Then the market variables are chosen. They depend on the characteristics of the firm such as the electricity price it pays and the actual required rate of return. Various sustainable investments can be selected, which results in the difference between the standard and the sustainable building. The input data of the standard building is set as well as the input data of the sustainable investments. The building variables, the input of the standard building, and the sustainable investments are put into the DCF to obtain the net present value. The output is the total cost of ownership of the standard building and the sustainable building. If the TCO of the sustainable building is lower than the TCO of the standard building the sustainable investments should be implemented.

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Exhibit 1.2: Conceptual framework of the financial model

1.5.2 Methodology

The research will be executed by performing a single case, exploratory case study. Current literature is combined with internal information from TNT and their subcontractors. The literature forms a framework and gives an overview of the important issues that play a role in finding the answer to the research question. Academic literature like journals and academic books are used to acquire the necessary information. The topics of the literature reviewed will be about sustainability in general and specifically on real estate. In this way the advantages and disadvantages of sustainability are mentioned to give the current status of sustainability.

Then the cost and benefits of sustainability is shown which shows, based on qualitative arguments, whether sustainability should be taken into account or not. Besides that, the willingness to pay for sustainable buildings will be investigated. The sustainability certificates are explored to see how these can be used as a measurement tool for sustainability. If a sustainability certification shows the amount of sustainability, having the certification should simply signal all the benefits that comes with that certification. Then, the criteria for the sustainability certifications, which are the elements that can be calculated and valued for each sustainable investment, will be explained. The criteria are divided into components which can be saved upon when implementing a sustainable investment. Knowing these elements gives the constructor the information which sustainable investment to chose in order to achieve certain sustainability levels. Further more, literature is used to determine which certificate is used in the case study. Additional literature will draw the methods for current valuation for real estate and valuations of sustainable investments. The valuation method that will be chosen depends on the target of the real estate in question. If the building can be used for redevelopment then the capitalization method will be used to calculate the market value of the building based on rent income flows. The discounted cash flow method will be used to calculate the net present value to obtain the value of the sustainable investments.

Next, on an interview basis, the methodology will be discussed with the transaction managers of TNT Real estate to investigate which techniques are used the most in practice. The concept of the total cost of ownership is discussed and whether it will decrease or increase when a building is built more sustainable than traditionally. In order to investigate whether the total cost of ownership stays unaltered a model will be built to estimate the costs and which future market variables have an effect on those costs. After that, the building data is gathered by

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interviewing subcontractors of TNT and the people working at the real estate department.

Among the subcontractors a construction company, a specialized lighting company and a government agency have been interviewed to specify the structure of the model. The

categories and the cash flow variables that determine the operating costs and investment sum for the standard building as well as the sustainable investments have been specified with their cooperation. The starting point is a standard building after which each sustainable investment can be added which increases the total investment sum and the sustainability of the building.

The model itself is an Excel-generated calculation structure, which has several sheets to calculate the TCO of a sustainable building and a traditional building. Appendix 2 shows, with several screenshots, an overview of the financial model. To get the final TCO values one starts with sheet 2 (Screenshot 2) where the building variables and the market variables have to be specified. The sustainable investments alternatives can than be selected to show the impact on the TCO. The TCO values, the sensitivity analysis, and the conclusion if the building should be built sustainable can also be seen on this sheet. Sheet 3 (Screenshot 3) shows a more in depth view of the cash flows during the period of use of the building. All input data combined with the building and market variables result in cash flows which are stated here. The cash flows are calculated back to the present via the discounted cash flow method to obtain the total cost of ownership per variable. The input of the standard building is shown in sheet 4 (Screenshot 4) where the costs of a standard building per square metre is shown. The data here is combined with the building variables and further calculated in sheet 3 to calculate the present value of the building. Sheet 5, 6, 7 and 8 (Screenshot 5, Screenshot 6, Screenshot 7 and Screenshot 8, respectively) show the costs and benefits of each investment.

Combined with the specified building and market variables the total cash in and out flows are further calculated in sheet 3. The final sheet, sheet 9 (Screenshot 9), shows the explanation of the variables of the model. The model is easy to navigate as single investments can be easily in- or excluded in the calculation and the final TCO value of the standard building as well as the sustainable building is calculated immediately. The model is kept simple and extendable.

More investments can be added and all variables that have an impact on the calculation can be changed. Replicating the model is easy because only a few inputs and variables are hard coded. Given some values for the market variables and building variables the TCO is eventually calculated. Two examples are made to find out which variables have the highest impact. A way to measure the impact of input values on the key outputs can be observed using a sensitivity and scenario analysis. Therefore, the variables that have the highest impact will be checked using a sensitivity analysis and a scenario analysis.

An overview is given in Exhibit 1.3 with which research methods the research questions will be answered.

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Exhibit 1.3: An overview how the research questions will be answered.

Research question Research method

1. Sustainability and sustainability certification

Literature

2. Cost and benefits of sustainability and structure of the financial model

Literature and interviews

3. Impact of variables on sustainable investments

Financial model in combination with a sensitivity analysis and scenario analysis

Then, to give insight in the time schedule in which this study has been written, Exhibit 1.4 states an indication of the time frame used.

Exhibit 1.4 The time frame of the thesis process

March 1st – March 31 Setup of research proposal

April 1st – April 30 Setup of research question, research design and introduction May 1st – May 18 Completion of the introductory chapter

May 19 – June 10 Collection of relevant literature and taking interviews June 11 – July 1st Collecting the data and building the financial model July 2nd – July 12 Write out results and preliminary conclusions July 13 – July 26 Finalize the first version

July 27 – August 23 Last adaptations before final concept August 24 – August 31 Finalize the final version

1.5.3 Data

The largest part of the data comes from the TNT Real Estate department, the other part comes from Datastream⁶. The values of the variables for a standard building are the building variables and the market variables. The building variables depend on the building and have to be specified beforehand. The amount of ground needed, the size of the building, the size of the roof of the building, and the time period that the building will be used. The market variables are partly specified by TNT and partly by using data from Datastream. The WACC, the VAT percentage, the inflation rate for buildings and for electricity, and the electricity price are specified by TNT. The cost of building a standard building as well as the costs of building the sustainable investments comes from TNT. These are cost for designing and constructing the building, costs for maintenance and costs for insurance. The values for the variables of the sustainable investments such as installation costs, depreciation schedule come from TNT as well.

6 Datastream is a large financial statistics database (www.datastream.com)

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1.6 Structure of the thesis

This thesis is divided in four chapters. The first chapter has introduced the topic with the motivation of the research, the academic and practical relevance, a basic current literature review, the problem statement, research strategy and data description. The second chapter provides current literature about the sustainability of real estate, the costs and benefits of sustainability, the availability of sustainability certificates and the valuation methods of real estate in general and of sustainability investments for real estate. The third chapter is used to extend a exploratory case study and the final chapter contains the conclusions and recommendations.

2 Literature review

This chapter gives an overview of the current literature on topics which are all related to sustainable investments in real estate. The first section starts with sustainability in real estate, the costs and benefits of sustainability, and the willingness to pay. The second section contains the introduction to sustainability certificates and the costs and benefits of having such a certificate. The third and last section consists of the valuation approaches used for real estate in general and for sustainable investments for real estate specifically. The chapter ends with a concluding paragraph.

2.1 Sustainability of real estate 2.1.4 Introduction sustainability

As mentioned in the introduction, sustainability has only recently received more attention.

Journalists speak of the rise of the third industrial revolution (de Volkskrant, 25 March 2010).

In the past it has been more a matter for people who thought that the environment suffered too much in the gain for economic profits and welfare. Nowadays, the discussion has focussed itself on cost reductions and a CO2 emissions. Since the green house effect due to extra CO2 emissions cannot be proven yet with hard evidence, the cost reduction factor should have more weight into the sustainability reasoning. In this section, first the definition of sustainability and more precise for real estate will be explained. Next, the costs, the benefits of sustainability and the willingness to pay for it will be discussed.

2.1.5 Definition of sustainability in real estate

In this paper, the definition of sustainable development of the Brudtland Report (1987) is used, which is also adopted by Myers, Reed, and Robinson (2007). It is stated as follows:

“sustainable development is the development that meets the needs of the present without compromising the ability of future generations to meet their own needs” (p. 126). Adams (2006) divides sustainable development in three general pillars: economic, social and environmental. Later, this became known as the triple P’s: profit, people and planet (Elkington, 1994). Profit aims on the economic effects on goods and services, people aims at the effects on the people inside and outside the firm, and planet aims at the effects on the environment. These three subjects have to be in line with each other otherwise they will negatively affect each other. When the main definition of sustainable development is adapted to real estate the following can be interpreted: a building is sustainable when the building can be used now and in the future without a change in quality of the building and its environment.

2.1.6 Costs of sustainability

The costs of sustainability can be divided into direct and indirect costs. The direct costs of sustainability are the costs for implementing the investments in the building that have to be

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made to get the sustainability elements. When the elements are combined, a certificate can be achieved when the building is checked for sustainable elements by a certifier. The set of investments needed for a specific level of certification can be seen as the final price of a certificate. Kats (2003) shows that of a sample of 33 buildings the costs of a LEED- certification increase with the level of sustainability. The higher the sustainability level of the certificate the higher the cost premium is. An additional LEED cost study has been published by GSA (2004), which also shows the cost effects of implementing a LEED certificate. The study divides the costs in construction costs and soft costs with building a new courthouse and renovating an office building. Construction costs are the costs of constructing the building and soft costs are design and document costs. The construction costs increase with the level of sustainability. One should bear in mind that the costs can vary by size. The buildings here are quite large with 27.000 and 24.000 square meters. Another study by Davis Langdon (2007) shows that the increase in costs only starts from a four star⁷ Green Star rated building. Until a four star level, no extra costs have to be made. However, from the four star level onwards the costs increase with the level of sustainability as well. Exhibit 2.1 shows the costs premiums of the studies.

Exhibit 2.1. The cost premiums of sustainable buildings

Mid level Second highest level Highest level

Kats (2003) 2.11% 1.81% 6.5%

GSA (2004) 1.4% 4.4% 8.1%

Davis Langdon (2007) 0% 5% 11%

Source: Kats (2003), GSA (2004), and Davis Langdon (2007)

2.1.7 Indirect costs

The indirect costs of sustainability are mainly focussed on confidence of the performance of sustainability investments. The building sector cannot easily get used to the idea of sustainability. No strict regulations for the environment have been made and as such there is no clear point of view where everybody can adapt its policy on. This results into uncertainty and unwillingness to act on the sustainability matter. Jones Lang Lasalle (2008) shows the possible extra costs of insurance of having a sustainable building. The uncertainty of recertification or reinstallation of the replacement of installations can increase the costs which are not covered by standard insurance contracts. Debris removal and additional unexpected costs because of the sustainability of a building will increase total costs. The insurance payments will increase if the costs of these items increases as well when they are covered in the insurance contract. As stated by Davis Langdon (2007) the cost of incorporating sustainable elements differs by building type, location, climate, site conditions, and familiarity with sustainable design. Most of the studies mentioned above have found cost premium on building schools or office buildings. However, the results of the cost studies discussed should therefore be interpreted with caution. Although most of the features of a sustainable building will be the same (with external building facilities like solar panels and windmills), the priority on certain operating costs can differ depending on the business that is done in the building.

Besides this, installing investments can temporarily lower business performance because business operations have to be interrupted.

7 The Green Star certification has its rating levels denoted in stars, the more stars, the more sustainable the building

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2.1.8 Benefits of sustainability

The benefits of sustainability can be seen as benefits that result from implementing the investments in the building that have to be made to get the sustainability elements. Again, the benefits can be divided into direct and indirect benefits. There are direct benefits for the owner of the building as well as for the tenant of the building. As McAllister (2009) mentions, the benefits for the tenants are reduced operating costs, improved productivity because of less absenteeism of employees, and marketing and image benefits. The owner of the building has reduced holding costs because of lower vacancy rates and higher tenant retention rates, reduced depreciation, and less regulatory risks. Kats (2003) indicates that the benefits are

“lower energy, waste disposal, and water costs, lower environmental and emissions costs, lower operations and maintenance costs, and savings from increased productivity and health”(p.5). He argues that a third of the total energy costs can be saved for LEED certified buildings. Turner and Frankel (2008) finds equivalent numbers for LEED certified buildings compared with non-LEED certified buildings. Miller and Poque (2009) show slightly lower energy savings but they only look at Green Star-certified buildings. They also mention that Green Star-certified buildings that have a separate energy meter instead of all included energy rent use even less energy. The results of the three studies are stated in Exhibit 2.2. Another important issue in the sustainability matter are subsidies. With a subsidy, the expenses decrease because the costs of the investments are partly compensated by the subsidy.

Subsidies can be granted for sustainable technologies. Mainly, there are three different sustainability subsidies in the Netherlands: the energy investment reduction subsidy, the stimulating sustainable energy production subsidy, and the energy research subsidy⁸. The amount of subsidy one can get depends on the size of the investment and the amount of sustainability (AgentschapNL, 2010)

Exhibit 2.2: Energy savings results of certified buildings. Three different studies show the results of different certified buildings.

Energy savings (on average per year)

Kats (2003) (LEED) 30%

Turner and Frankel (2008) (LEED) 30%

Miller and Poque (2009) (Green star) 21%

Source: Kats (2003), Turner and Frankel (2008), and Miller and Poque (2009)

2.1.9 Indirect benefits

The indirect benefits of sustainability are possible future positive effects on real estate or the firm participating the building. For example, having a sustainable building avoids possible future energy taxes and above all, if energy prices increase in the future, the cost advantage increases very steeply. Future emission trading or emission tax of some other kind of energy tax will be avoided by having a building that uses less energy. McKinsey (2009) shows the return that can be made in the future by implementing certain technologies. They show that LED-lighting and insulation is very profitable by reducing CO2 emissions. Jones Lang Lasalle (2010) shows that building occupiers want the government to implement extra restrictions for buildings such as obligatory sustainable certificates, taxes on non-sustainable buildings, and increasing subsidies for sustainable initiatives.

8 In Dutch these subsidies are phrased: Energie investeringsaftrek (EIA), Stimulering duurzame energieproductie (SDE) and Energie onderzoek subsidie (EOS) source: www.agentschapnl.nl

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2.1.10 The willingness to pay for sustainability for real estate

The willingness to pay is very important in the whole discussion about sustainability investments in real estate. The evidence can be as robust as it can be, practitioners have to be convinced in order for demand to meet supply. A survey of Jones Lang Lasalle (2010) shows that the willingness to pay has increased compared with former years. In Exhibit 6.1 and Exhibit 6.2 in the Appendix the results are shown for Dutch office occupiers. Energy costs were the two third of the questionees the most important factor for sustainability, with the second most important one being employee health and productivity. Almost three quarters of the occupiers are willing to pay a small premium (1% to 5%) on the rent price for sustainable buildings. Occupiers who are also owners of the building are less willing to pay for the same small rent premium. With respect to building costs for sustainable investments Exhibit 6.3 in the Appendix shows that a third of the respondents thinks that building sustainable costs more than a 10% premium on the traditional design while more than half of the respondents think that the premium is much smaller. Another study by Grootes (2009) shows that the respondents think that implementing sustainability is profitable when building a new building but less profitable when trying to make an existing building more sustainable. The largest limitation for implementing sustainability is the uncertainty of the profitability of sustainable investments. Almost two third says that the pay back period is important when deciding to implement sustainable investments. Besides, respondents say that they see too few alternatives to earn back the investments by raising rent for tenants. Sustainability certificates are not used often because most respondents do not know which certificates are available and what the benefits are. This includes builders, tenants, as well as investors. They also like to see just one certification instead of several certifications. All respondents expect that sustainable buildings are worth more than non sustainable buildings in the future. Besides this, a widely known phenomenon known as ‘the circle of blame’ in the sustainable real estate world shows the difficulties for cooperation between the stakeholders and delays the implementation of sustainability. In Exhibit 6.4 of the Appendix the framework is shown of the interaction between occupiers, constructors, developers, and investors for sustainable real estate. The occupiers of the building argue that they want sustainable buildings but there are none. Constructors of buildings argue that developers do not ask for sustainable buildings and thus these buildings are not built. Developers say they do not give orders for sustainable buildings because investors are not willing to pay for them. The investors complete the circle by arguing that they are willing to pay for the buildings but there are no occupiers who are willing to occupy sustainable buildings. SenterNovem (2009) as well as Myers et al (2007) show that the circle can easily be broken by extra information from external people (Myers et al, 2007) and framing the issues on a more positive matter (SenterNovem, 2009).

2.2 Sustainability certificates 2.2.1 Introduction

Sustainability certificates are certificates which show a level of sustainability of a building.

The higher the level of the certification, the higher the level of sustainability. First, the availability of sustainability certificates will be discussed. Thereafter, the required criteria for achieving the certificates are mentioned. Finally, the specific costs and benefits of achieving and having a sustainability certificate are illustrated.

2.2.2 Which certificates are available and what are the criteria?

Reed et al. (2009) show an overview of all sustainability certificates and Sayce and Sundberg (2009) orders the certificates by country and by comparability. They show a table with 11 certificates and 15 subjects to which the certificates are tested. Many certificates then can be

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put aside because they do not aim on complete building sustainability or do not have enough reputation and therefore are hard to compare among other certificates. The focus in this study lays on new building certification. The sustainable criteria for the certificate are divided into five general criteria: sustainable sites, water efficiency, energy and atmosphere, materials and resources, and indoor environmental quality. The energy and water criteria are aimed at reducing the use of it. Less use results in lower costs. The materials and resources criteria is meant to reduce the use of resources making the material and stimulate the use of sustainable building materials which contain less environmental damaging fundamentals. Health and environment is aimed at improving the environment for people that are using the building.

Creating a better work place could improve work efficiency. Since the following studies are all based on the certificates of LEED and Green Star a comparison is made to show if the results have other implications now other certificates are used. BRE (2008) divides the five criteria into management, energy, transport, health and well being, water, materials, land use and ecology, pollution, and sustainable sites to compare four certificates. The difficulty with comparing the certifications lays on the country standard of building where the certification is based on different climate zones and the inflexibility of the criteria of the certificate. BRE (2008) compares four sustainability certificates: BREEAM, LEED, Green Star, and CASBEE.

The main characteristics of the certificates are used to compare the certificates to see if results from articles based on certain certificates can be extended for other certificates. Due to the CoStar group database much is known for LEED and Green star certified buildings, but it is unsure how the results can be extended for BREEAM certified buildings. The LEED- certificate is based on building guidelines of the United States and cannot be adapted to national guidelines which makes the label harder to implement (SenterNovem, 2008). Some criteria which are important for the US could be not relevant for other countries. Certificate points for that criteria will not be achieved because the criteria are not relevant for that country. For example, the weighting of materials is almost twice as high in the LEED criteria as for BREEAM or GreenStar. An investment in materials will achieve double the points in a LEED certification as with the other two certificates. The weightings of the categories are shown in Exhibit 6.5 in the Appendix. In addition, Reed et al (2009) state: “In a hypothetical scenario, a six-star Green Star building (the highest Green Star rating possible) is less sustainable than a platinum LEED building (the highest LEED rating possible) and approximately equal to a ‘very good’ BREEAM-rated building” (p. 13) which is illustrated in Exhibit 6.5 in the Appendix. Thus, a certain level of LEED qualification is not the same standard for other certifications. This would indicate that the costs could be higher than first anticipated because the lower level of certificate is not good enough for the standard preferred. For example, the way energy efficiency is measured differs between LEED and BREEAM. LEED uses annual energy costs and BREEAM uses annual carbon dioxide emissions (Jones Lang Lasalle, 2008). CO2 emissions then first have to be transformed to annual costs to make it comparable to other certificates. Besides, the price of the CO2 emissions can vary which makes the costs harder to compare. According to BRE (2008) there are more differences between the certificates. LEED is not a life cycle analysis, BREEAM is.

The assessment process differs with each certificate which results in different costs for achieving a certificate. In addition, the costs vary by building size and level of certification thus there is no clear measure to calculate the total costs. Summarizing, the certificates can be compared but one has to keep in mind that the level of certification varies and the weightings for categories differ but the categories are comparable.

The Dutch Green Building Council (DGBC) is an affiliate of the USGBC. They have performed a search for the best certificate for the Netherlands (DGBC, 2008). BREEAM, LEED, GreenCalc+, and EcoQuantum are compared. BREEAM is advised to be the best

‘simple’ certificate and GreenCalc+ to be the best ‘difficult’ certificate. BREEAM is a well-

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know certificate which makes it accessible for a large part of the real estate world. The benchmark within the BREEAM-certificate may be adapted to current market conditions which makes the certificate future proof and comparable with BREEAM certificates achieved in other countries. The DGBC has therefore introduced BREEAM NL which is an adapted version of the BREEAM UK certificate. The certificate focuses on 9 categories: management, health and comfort, energy, transport, water, materials, disposals, land use and ecology, and pollution. Jones Lang Lasalle (2010) says that 85% of the respondents thinks that a certificate has a positive effect on the building. However, 44% does not know the specific content of the certificates. The best known certificates among the respondents is the BREEAM certificate (19%) and the Greencalc+ certificate (14%). This would indicate that based on familiarity the BREEAM NL certificate is the best alternative.

2.2.3 The costs and requirements of a sustainability certificate

Every building has to be certified by an assessor of the certification companies. For BREEAM, an assessor of BREEAM assesses the building and puts the data into the assessment tool of the green building council. Using the according weights of the criteria and checking the list of obligatory items a final score can be calculated. The points achieved for each criterion (management, water etc) of each investment is multiplied by the weights of the criteria. The final number then becomes a certificate which ranges from pass, good, very good, excellent, to outstanding, depending on the number. The higher the number, the more sustainable the building. The cost for the certificate itself for a BREEAM NL certificate can be grossly computed at the websites of the certificate companies. The website of BREEAM NL⁹ shows that one should take into account costs for the certificate and total certification costs which consist of costs for the assessor who has to check the building, costs for an internal expert who has to supply all required information to the assessor, and costs of possible investigation that is needed to supply evidence for the assessment. Exhibit 6.6 in the appendix shows the assessment fee and certification costs of the four certificates. The costs for both the assessment fee as well as the costs for certification differ among the certificates.

The points of the criteria of the certificate can be achieved by investing into sustainable investments. Some examples of investments for sustainability can be obtained from AgentschapNL (2010). These are solar panels¹⁰, hot and cold storage systems¹¹, rain water collection systems, wind mills and LED lighting to name a few. Each investment satisfies several conditions of the criteria of the certification. Depending on the investment, the points are achieved for meeting the different criteria.

2.2.4 Benefits of the sustainability certificates

The main function of the sustainability certificates for real estate is the signalling function. A potential buyer of a certified building knows the energy savings he will achieve compared to a building that has no certificate. Reed et al. (2009) mention that having sustainable certificates available increases the awareness of the sustainability of real estate in the world. A sustainability certification gives professionals a framework and checklist to work from.

Jackson (2009) mentions the relationship between risk and return for sustainability investments. There is uncertainty about the financial costs and benefits of sustainable design which results in uncertain rate of returns. Internal rates of return of LEED and Green Star

9 www.breeam.nl

10 Solar panels can be divided into thermal panels and voltaic panels. The former is used to generate hot water, the latter is used to generate electricity.

11 Hot and cold storage systems are used by pumping water or air through a hot-cold exchanger which warms up the cold fluid and cools down the hot fluids.

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projects are calculated based on the rent premiums and occupancy rates of articles in Exhibit 2.4. Cost premiums are drawn from the same articles and together Jackson (2009) estimates the average cost premium at 3%. With a Monte Carlo analysis the relationship between expected risk en return is calculated for the LEED and Energy star certificate. Average internal rates of return of 126% for LEED and 140% for Energy Star certification which means that investing in LEED and Energy Star certified buildings is a very profitable investment. The chance that an internal rate of return of lower than 30% is achieved is 3.4%

for LEED certification and 0.1% for Energy star certification. These high internal rate of returns indicate that the benefits of sustainable investments far exceed the costs of sustainable investments which are required to achieve a LEED and Energy star certification. The CoStar group (2008), Fuerst and McAllister (2008), Miller, Spivey, and Florance (2008), Wiley, Benefield, and Johsnon (2008), Eichholtz, Kok, and Quigley (2009), and Fuerst and McAllister (2009) all have done research for the relationship between rent premiums and sale price premiums of sustainability certificates by comparing prices of certified and non-certified buildings. In Exhibit 2.4 the results of the studies on sale price and rent premiums are shown.

All studies use a hedonic pricing model to get to the results. The hedonic pricing method builds on a framework for analysis for differentiated goods, thus properties with special characteristics like sustainable buildings. Their market prices are hard to observe. The hedonic pricing function shows the relation between the market price and the effect on the market price of the characteristics of the property in question (Janssen et al., 2001). A summary of the results of Exhibit 2.4 is shown in Exhibit 2.3 This indicates that the average rent and sale price premium is higher for LEED certified buildings than for Energy Star certified buildings.

Exhibit 2.3 The descriptive statistics of the results of the rent and sale price premiums of LEED and Energy Star certified buildings

Certificate Minimum Average Maximum

LEED rent premium Not significant 11% 36%

LEED sale price premium Not significant 23% 64%

Energy Star rent premium Not significant 5% 9%

Energy Star sale price premium 6% 13% 31%

Source: The CoStar group (2008), Fuerst and McAllister (2008), Miller, Spivey, and Florance (2008), Wiley, Benefield, and Johsnon (2008), Eichholtz, Kok, and Quigley (2009), and Fuerst and McAllister (2009)

A general remark can be made for the CoStar studies. The buildings taken are all office buildings. The cause of the different results among the studies could be the different time spans of transactions, the location, and age of the benchmark building taken from the CoStar data pool (Muldavin, 2008). If transactions are taken when the business cycle is positive a higher premium could be found because firms were less critical on the price they have to pay.

Besides, sale prices in general have increased steeply (Muldavin, 2008), which makes it even more important to compare transactions made in the same small time interval. The location of the benchmark of the non-certified building is relative important for the comparison. The location alone can have its own location premium because it is located in a well demanded area. This would drive up the sales price whether the building is sustainable or not.

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2.3 Valuation methods

2.3.1 Introduction to valuation

Valuing sustainable investments cannot be done via a straight forward valuation. First, the value of real estate will be explained after which the valuation methods for real estate follow.

Then, valuation models available in current literature is discussed to investigate how valuation methods are used in practise. The valuation of sustainable investments of real estate comes last.

2.3.2 The value of real estate

The practical value of real estate does not only lay in the real estate itself but also on the ground on which the building is built. All buildings underlay a specific destination plan which is determined by the government. Before construction a building, a permit has to be requested to build the building on that specific destination. The destination can then only be used for constructing a building that has fulfilled the requirements of the destination plan. Often, when a building is sold, the new owner has other plans with it than is described in the destination plan. The building has to be altered when someone buys the building. The building is then useless, has to be demolished and thus has no value. The value of the ground and the possibilities that a ground owner has with the ground has value.

2.3.3 Valuation methods for real estate

Pomykacz (2009) mentions that the goal of the valuation approach has to be chosen first to be able to choose the right valuation method. The value can be used for a sale report, accounting purposes, loan security, minimum price, insurance, taxation, or redevelopment. This means that different valuation methods have to be used to perform a proper valuation for each building. Ten Have (2002) mentions four main approaches: the comparative, costs, income, and law approach. The first approach is the comparative approach which bases its value on market comparables and not on fundamentals of buildings. However, every time the valuation has to be adapted somewhat to take the building specific characteristics into account. The comparable method is frequently used for valuation, however, it cannot be used when there is too few data to compare and the data should be accurate and complete. Within the comparative approach, the regression analysis is often used. Regression models can be divided into multi regression models and hedonic regression models. A multiple regression model delivers the effects of the included variables on the dependent variable. Increasing the value of such an included variable means an in- or decrease, depending on the sign of the coefficient, of the dependent variable. The data required depends on the variables which one thinks that has an effect on the value or price of a building. The second most used method is the residual approach which is part of the cost approach. The residual method, or development method which it is also called, is based upon the price of the land and the future sales price of a building on the land. Values of land are compared among comparable pieces of land to get the value for it, but the rest of the value has to be calculated more specifically. The residual value is the price of the building for which it can be sold when it is complete minus the cost to build it. The higher the residual value the higher the return is for selling the building.

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Exhibit 2.4: A comparison of literature which shows rental and sale price premiums of LEED and ES certified buildings in the United States based on market transactions. The name of the study, the data, the research approach taken, the results and the limitations are shown. With the word ‘LEED’ and ‘ES’ are meant the buildings which have a LEED certification and a Energy star certification. A rental premium is the difference between the rental price between a certified building and a non certified building. A sale price premium is the difference between the sale price of a certified building and a non certified building. Hedonic OLS regression is a specific way to estimate an ordinary least squares regression keeping the heterogeneity of the data in mind. The percentages shown are the amounts that the certified buildings are worth more than the uncertified buildings.

Study Data Approach taken Results

CoStar group (2008)

A sample of 973 LEED and 355 ES buildings.

Hedonic OLS regression for rental and sale price premiums. Controlling for age, size, location and number of stories

Rental premiums for LEED and ES are 36% and 9%.

Sale price premiums for LEED and ES are 64% and 27%, respectively.

Fuerst and McAllister (2008)

Rent prices of 990 ES and 210 LEED certified offices. Sale prices of 662 ES and 139 LEED certified offices between 1999–2009.

Hedonic OLS regressions for rental and sales prices.

Control sample is based on offices within same CoStar submarkets.

Rental premiums for both LEED and ES are 6%. Sale price premiums for LEED and ES are 35% and 31%, respectively.

Miller, Spivey and Florance (2008)

Filtered sample of 927 sale prices between 2003- 2007 of Class A buildings (larger than 200,000 sq ft, multitenanted, over five stories, built after 1970) to compare to 643 ES buildings.

Hedonic OLS regression for sale prices only. Controls for major markets but none for quality.

Rental premiums for LEED and ES are not statistically significant. Sale price premiums for LEED and ES are 11% and 6%, respectively.

Wiley, Benefield and Johnson (2008)

Rent prices of 30 LEED and 440 ES buildings and sale prices of 12 LEED and 70 ES buildings. All are class A office buildings only. 46 metropolitan markets (25 markets for sales).

Hedonic OLS and 2SLS regressions for rental and occupancy rates. Control sample seems to be other offices in same

metropolitan area. No controls for micro-location effects.

Rental premiums of 15%–

18% for LEED and 7–9%

for ES. Hedonic OLS model of sales prices in absolute form. Estimate sale price premiums of

$130 per square feet (psf) and $30 psf for LEED and ES, respectively.

Eichholtz, Kok and Quigley (2009)

Rent prices of 694 certified offices. Sale prices of 199 certified offices 2004–2007.

Hedonic OLS regressions for rental and sales prices.

Control sample is offices within 0.25 miles of a certified building.

No statistically significant results for rental premiums for LEED, but a 3.3% for ES. No statistically significant sale price premium for LEED but a 19% sale price premium for ES, respectively.

Fuerst and McAllister (2009)

Rent prices of a sample of 197 LEED and 834 ES buildings. For sale prices a sample of 127 LEED and 559 ES buildings.

Hedonic OLS regression for rental and sale price premiums.

Rental premiums for both LEED and ES is 4-4.5%

Sale price premiums for LEED and ES are 25% and 26%, respectively.

Source: The CoStar group (2008), Fuerst and McAllister (2008), Miller, Spivey, and Florance (2008), Wiley, Benefield, and Johsnon (2008), Eichholtz, Kok, and Quigley (2009), and Fuerst and McAllister (2009)

The building cost variables consists of demolition costs, ground preparations, standard building costs including permits and design costs, building interest rate and profit and risk

The total cost of ownership and sustainable investments in Real Estate

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