Green office construction: a discounted after-tax cash flow analysis

Abstract

Purpose– The purpose of this paper is to address the apparent slow acceptance on the part of developers located in the USA to seek green certifications. If green-certified construction costs more than non-green construction, then is there a financial reason for not seeking a green rating. Do green buildings perform better than non-green buildings financially? The paper develops and presents a discounted present value model for doing a cost-benefit analysis for building green. This model enables an investor to determine the feasibility of constructing a new green-certified building instead of a conventional non-green building. Non-green buildings are not certified by a rating agency such as Leadership in Energy and Environmental Design (LEED), Energy Star or Building Research Establishment Environmental Assessment Method (BREEAM). Real estate permits are granted by local municipalities in the USA. This means that local government mandates requiring green construction that significantly adds to the initial cost of a project could have the unintended result of encouraging new non-green construction just outside their municipal boundaries.Design/methodology/approach– The paper collects publically available research data for office buildings located in the USA, and inputs this information into an income statement. It tests the hypothesis: is green-certified construction a financially feasible choice for an investor? An incremental approach using a 15-year holding period is presented. This time period takes into account equipment wear and tear. Heating/cooling systems and other green-technologically based operating systems have a limited life and do not last for 30 or 40 years. They are likely to need replacement after 15 years have lapsed.Findings– The negative net present value (NPV) results and high payback periods indicate that increased rents for green construction, a tax credit for the present value loss and/or property-tax reduction covering the shortfall is needed as an incentive to commercially build green. The implication of a negative NPV is that green office buildings will be built by government agencies where green is mandated, corporations that want a green image and benefit from this image, where local ordinances mandate green construction features and where local and federal tax incentives are available increasing a construction project's feasibility.Research limitations/implications– The limitation of any cost-benefit study is that analytical models and/or data used to forecast energy and water consumption savings in green-certified buildings compared to conventional buildings can be inaccurate. Forecasting models can understate or overstate the actual savings realized from green construction especially in the long-term given the difficulty of predicting equipment wear and tear, net rents and energy costs. The modeled percentage cost associated with green new construction features could remain constant or grow through time. Tables I and II results assume energy and water expenses remain a constant percentage over the 15-year period. The agency costs associated with obtaining a LEED or BREEAM certification was not calculated as an upfront cost. Certification by LEED or BREEAM increases the upfront cost associated with building a green building.Practical implications– The length of the payback period estimates coupled with negative NPV for green certified compared to non-green construction suggests that developers do not have an incentive to build green. Higher WACC rates would result in green-certified projects being less feasible to build.Social implications– The LEED certification point system may need to be reviewed. Points are assigned for features that improve occupant satisfaction, but may have little impact on reducing energy usage.Originality/value– A model is presented for determining whether green-certified construction is financially feasible. The model enables the investor to determine the size of a tax incentive that is needed to enable new green construction to be economically feasible to build. The higher the negative NPV the larger the income or property tax incentive or other financial incentives needed. Prior research studies compared green and non-green buildings, but did not compare the energy savings generated to the additional construction and upfront costs incurred using a discount rate. They assumed the energy savings justified the additional initial cost associated with building a new green certified.