Payback is dead, long live payback

“We only implement retrofits that are low-hanging fruit.”

“Show me the projects with 5-year simple payback or less.”

“My leadership is going to need to see higher utility bill savings than that.”

Anyone who has spent time in retrofit consulting or decarbonizing real estate has heard these phrases over and over again. It makes sense: business owners should be concerned with the return on investment.

The problem is not the focus on ROI — it’s how narrow the field of that focus has become. Considering only the utility costs (in today’s dollars) to justify a retrofit can undermine long-term business goals, especially as the impact of carbon on asset value emerges in importance as a risk investors care about. Rather, ROI needs to account for value creation and value protection, not just simple payback.

Focusing solely on short-term costs, and ignoring the longer-term impact of carbon, introduces several fallacies to decarbonization efforts:

• Future property markets will not value carbon performance beyond Net Operating Income
• Occupiers will not value carbon performance when making leasing decisions 
• Incentive programs will always exist to bring payback within acceptable ranges

At best, this type of thinking limits our ability to take advantage of retrofits with significant co-benefits. At worst, it’s creating an incentive for sustainability professionals to fudge the numbers to make the business cases. This never works. Either the construction costs balloon beyond the budgets, or savings results disappoint, exacerbating an already widening trust gap between the ESG and broader business community. 

Leaders in the decarbonization space are doing things differently — they’re already building strong business cases for decarbonization, which focus on creating and protecting asset value, and thereby creating a competitive advantage in a low-carbon economy. Those investing in decarbonization planning now are poised to reap the benefits from this economic transition towards low-carbon buildings. Those who don’t risk getting left behind.

In a recent webinar, our CEO, Christopher, was joined by Mauricio Serna of Starwood Capital Group and Jill Brosig of Harrison Street to explore how to build a successful business case for decarbonization, the paradox of the simple payback model, and how to win capital to drive zero-carbon efforts.

(Missed the webinar? Listen to it here.)

Meet the experts

Harrison Street invests in alternative real estate assets, with around $56 billion in assets currently under management. They set an internal goal of reducing carbon emissions across its portfolio by 70% in 2025—as of 2023, it had reduced it by 35% and is on track to meet its targets.

Starwood Capital Group is a global private real estate investment firm with around $110 billion assets under management. It is committed to reducing its portfolio’s carbon emissions by embracing renewable energy. To date, it has deployed about 30 megawatts of renewable energy generation equipment across some of its assets in the United States.

Moving away from the simple payback model

Historically, real estate owners have embraced the simple payback model because it’s, well, simple — an energy efficiency assessment would reveal opportunities to decarbonize, and stakeholders would make decisions based on the length of time a project would take. LED light bulbs with a three-year payback? Sure. A larger heat pump project with a 15-year payback? If an owner plans to sell an asset in five years, there’s little incentive to invest in that. 

“They weren't thinking about the value that was actually created. They were just doing these small projects,” Jill said. “And I think a lot of opportunity has been missed.” 

Larger-scale retrofits and decarbonization fuel more meaningful change around climate and financial resilience. The simple payback model can undermine a conversation about long-term value creation; other amenities, like a gym, have a recognized, enduring value for tenants and aren’t considered in terms of payback. 

“We don't think that way. So why should we be thinking that way for ESG activities?” Jill asks.

That’s not to say that the lower-hanging fruit should be ignored. 

According to Mauricio, tackling the smaller changes first to score quicker wins can help drive behavioral change and momentum within an organization. With decarbonization in real estate still being relatively new, this can have a lasting impact — it demonstrates that decarbonization is both achievable and can move the needle.

“It is a much more strategic decision going after the lower hanging fruit initially to get quicker wins as you're setting up your ESG or sustainability strategy within an organization,” Mauricio said. “Going after the early wins allows you to get much more buy-in so that the function of ESG becomes an integrative function across every single team.”

Re-thinking ROI in terms of value creation

Value creation and value protection (risk mitigation) are missing from the simple payback model, but they’re increasingly important for how owners and investors think about real estate. By projecting out the future costs of carbon through fines, deferred retrofit costs, and the resultant ‘brown discounts’ during transactions, savvy investors are starting to see meaningful risk on the horizon and using it to justify expenditures today (when it’s relatively inexpensive). 

“We're focusing on the value creation. We don't talk about carbon emissions upfront. We talk about the value generated as a result of the electrification or energy efficiency initiatives that we implement,” Mauricio said. “At the time of underwriting, we quantify the value generated and look back and make sure that we track it and correct it so that our internal models are calibrated and it helps us as an investor be more informed — and, quite honestly, play a little bit more offense in the next stage of capital deployment instead of playing defense.”

There’s also a growing awareness of carbon on the occupier side. JLL recently reported a surging demand for low-carbon office space, anticipating that 70% of those needs will be unmet by 2030.

While still early in implementation, the arrival of CRREM in North America will only popularize the concept of stranded assets, or those that will not meet market expectations with respect to energy and carbon, leaving them exposed to brown discounts. According to JLL, GRESB found the average stranding year for GRESB-submitted buildings (about 150,000 assets) is 2024. CRREM’s draft curves for the US and Canada still have much to be worked out, but it is clear that real estate leaders who proactively address stranding risk will be much better positioned to both attract and retain institutional capital.

We obviously can’t abandon this building stock, and it is a signal of an industry in distress. Science-based targets now exist across most aspects of our global supply chains, and real estate is an inextricable part of this ecosystem. As alternative assets emerge to service this demand, there will be clear winners and losers, and it’s exciting to see stakes being placed in the ground. 

“We are getting to that point where you can actually implement a lot of initiatives that either reduce operating costs at the property, enhance the value of that property, increase the resilience, and protect or mitigate the risk either from physical extreme weather events or from financial penalties being imposed,” Mauricio said. 

“ESG truly is value creation,” Jill said, who has witnessed this through Harrison Street’s ESG initiatives.

Decarbonization’s changing narrative is backed by numbers: according to McKinsey, failure to decarbonize could jeopardize companies' profits by 2030 by an average of 20%. JLL also found an average green premium of 7.1% across eight major cities in North America. 

At Audette, we aim to model a pragmatic yet forward-facing view of the carbon economy surrounding real estate. The business intelligence we generate arms sustainability leaders with all of the necessary capital projects to achieve their ambitious goals while making their businesses more resilient and successful. 

Winning buy-in from stakeholders 

To truly take root, decarbonization shouldn't be treated any differently than any other investment. In this emerging space, be sure to welcome even the most skeptical stakeholders into the conversation.

“Make sure you understand what's important to your key stakeholders, and then, you as the expert, make sure you meld that appropriately,” Jill said. “Listen and then make sure you're educating where it makes sense.”

For today’s decarbonization leaders, part of this education is in re-thinking the business case to include creating and protecting future value in a new low-carbon economy. 

Payback is dead… Long live payback.

__ 

What efforts are you making to get to zero? For monthly insights into decarbonizing real estate and what decarbonization market trends mean for you, subscribe to Christopher’s newsletter, Zero. Sign up here.