We’ve all seen it – retail sites and commercial buildings that proudly display LEED certifications or other clean energy and efficiency achievements. What is easy to miss is how many commercial real estate (CRE) sites do not make property-related ESG claims.
The uncomfortable industry secret is that the majority of properties are ripe for energy efficiency upgrades, can decrease their energy consumption, and can procure the electricity they do consume from renewable energy sources, but they don’t - because of contracting hurdles and credit and financing barriers.
Burdensome financing requirements have inhibited green investments across the CRE sector. Creative structuring and innovative financial and insurance products can help alleviate investment barriers.
The problem with ESG implementation, interest alignment, and credit in CRE
Property owners, building managers, and tenants have more incentives to implement energy efficiency and clean energy procurement strategies than ever before. Property owners, LPs, and REIT investors are demanding ESG action – they want goals to be developed, solutions to be found and implemented, and metrics that demonstrate impact. The same applies to many building managers and tenants.
Regulatory requirements are further driving the demand for CRE ESG solutions. New standards are being placed on buildings and corporations – both structures and occupants need to be more efficient and reduce consumption and climate impact. The US Securities and Exchange Commission (SEC) is slated to require companies to disclose climate change risks. In California, all new builds are required to meet certain energy efficiency (EE) standards. And the list goes on.
Unfortunately, landlords and tenants often have differing incentives, which causes difficulties in building-by-building implementation. Consider the hospitality industry – often the property owner is not the site property manager, nor the hotel operator. A hotel chain that is working to achieve ESG goals can run into implementation barriers if they go to implement energy efficiency retrofits or on-site solar installation. They need property owner agreement and alignment, and the property owner will also want to share the benefit of any impact claims or financial rewards.
Structural challenges further compound the issue. Commercial and industrial (C&I) properties are typically held in bankruptcy remote LLCs, or subsidiaries that do not carry parent guarantees. This structure is non-problematic for real estate financing purposes, but creates a blocker for non-recourse project finance.
It is a perfect storm of demand and misalignment, ripe for a solution that brings together all stakeholders, and aligns interests across landlords, tenants, investors, project developers, and financiers.
We view coordination and standardization as the key to expanding the C&I ESG market.
The challenge of heterogeneity in C&I energy transactions
The residential market benefits from a level of homogeneity that enables contracts of adhesion or a price-taker environment. Unlike the residential market, the C&I market has more variability and is rife with price-setters and negotiators.
Standardization has been a problem with C&I energy transactions due to the inherent heterogeneity of properties, owners, tenants, locations, energy markets, and desired terms. Though a standard Solar Energy Industries Association (SEIA) form exists, contracts in the C&I sector have historically been negotiated on a project-specific basis.
Business owners are accustomed to negotiating individual contracts, whether it be employment, capex, or opex agreements. Although these negotiations can be critical for property owners and offtakers, contract negotiations can present a blocker for project developers. Developers, financiers, and customers each have their own preferences, challenging alignment across stakeholders.
C&I efficiency or clean energy deals are typically not large enough to warrant the cost and effort associated with individual contract negotiations. Site-specific contracts are simply not efficient.
Structures and why they matter
The non-recourse nature of project finance presents a structural challenge. Bankruptcy remote LLC structures work well for secured lending, like mortgage lending, because they allow for properties to be taken over cleanly in bankruptcy. Unlike secured lending, project finance for energy projects is non-recourse.
Property owners or real estate investment trusts (REITs) are not often willing to front and offer their credit (rating) and/or may be unable to provide more significant upfront cash, making it challenging for them to overcome this hurdle.
We’ve collaborated with project developers and financiers to overcome this hurdle. We underwrite the credit worthiness of LLCs and tenants and take a comprehensive view of the project and site attributes. Further, we recommend programmatic structuring, which affords contracting efficiencies and enables multi-site development.
How standardization can enable C&I energy transactions
Bulk structuring, or programmatic structuring as we call it, lends efficiency and facilitates economies of scale. Programmatic structuring refers to multistakeholder structuring events that apply to multiple sites.
Consider a real estate investment trust (REIT) that wants to deploy efficiency solutions and enable clean energy procurement across their property holdings. Asset manager(s), developer(s), and financier(s) are brought into a single negotiation event. They align on a contract that has applicability to multiple sites at once. This means one set of lawyers, negotiating one or two contract sets for all buildings. Property owners can work with tenants, help them understand the ESG and cost benefits, demonstrate landlord alignment, and encourage tenant involvement and agreement.
This coordinated process allows for solutions to be implemented across hundreds of buildings at once under a single program with standardized contracts, and value propositions. This process facilitates replicability, helps developers overcome high customer acquisition (CAC) costs, and minimizes the costs of contracting associated with individual site-by-site contracts.
At Energetic Insurance, we unlock economies of scale by working alongside building or property owners with a vested interest in helping their tenants and themselves achieve ESG goals, and with developers and financiers eager to support project development.
We enable all stakeholders to overcome the ubiquitous CRE structural and credit barriers.
When it comes to energy project development, there is no aim to take over buildings or properties in the case of default. Rather, the security interest lies in the solar assets, wind assets, or energy equipment. In other words, financiers lending into equipment deals are not entitled to take over properties. Requirements pertain to the equipment and its maintenance throughout an event of default. As such, we underwrite projects through a different kind of valuation – rather than focusing on underlying property value, we assess the probability that someone will remain in and use the building. This is an entirely different approach that a mortgage lender assessment of an LLC.
We see credit risk through a different lens; we look past the problematic structures and quantify the real probability, frequency, and expected severity of losses on an actual properties. We underwrite the credit worthiness of the LLC and tenants. We take a comprehensive view of the properties, ownership, and occupancy. We understand that as long as tenants occupy the building they will pay for electricity, especially if the clean energy offered is cheaper than fossil fuel-derived alternatives.
Have questions on how Energetic Insurance can help you implement a programmatic partnership to deploy energy efficiency and/or renewables across commercial real estate sites? Contact us here.
This article does not constitute and is not intended by Energetic Insurance to constitute financial advice or a solicitation for any insurance business.