John F Kennedy once said, “The Chinese use two brush strokes to write the word ‘crisis’. One brush stroke stands for danger: the other for opportunity. In a crisis, be aware of the danger – but recognise the opportunity”. This could not be more relevant today.
With the fastest interest rate rises in history causing global economic turbulence, combined with a volatile clean energy transition, this confluence of megatrends poses risks for commercial property owners and tenants alike. As we transition to a greener future, commercial building owners must prioritise environmental improvements to maintain property values, meet investor and tenant expectations, and navigate tighter capital availability in existing debt covenants.
How can property owners mitigate these risks through alternative forms of finance, and why is collaborating with tenants crucial for grasping the opportunity?
Building owners who engage with tenants to fund energy-efficient upgrades through EUAs can benefit financially as well as reputationally. These improvements may increase the property’s value, resulting in improved debt covenants and Net Operating Incomes (NOI).
An Illustrative Example
Consider a property valued at $25 million with an existing Debt Ratio of 40% and debt facilities priced at 5.71% with an assumed capitalisation rate of 4.5%.
The building owner takes out a EUA loan of $1.5 million to fund a 1MW solar array.
The tenants of the property will repay the loan through additional repayments totalling $162,000 while, on the other side of the ledger the tenants will receive $225,000 saving on their utility bills.
Current interest rate rises are putting more pressure on commercial debt covenants, and property owners need to find innovative ways to improve NOI.
Building owners can potentially improve their Interest Coverage Ratio (ICR) and maintain their Loan Value Ratio (LVR) by using EUAs to generate additional income from their tenants.
Illustrative Example
In the scenario described above, the building owner’s ICR will increase from 1.97x to 2.03x, while the Debt Service Coverage Ratio (DSCR) will remain constant. The building owners will benefit from the additional income received from their tenants as a result of the recovery of the charges declared under a EUA, while the finance costs are excluded from NOI. As such the property value can increase by more than $3.6 million.
Simultaneously, the LVR will be maintained at 40% due to the increase in property value caused by an increase in NOI.
The Landlords’ existing debt facilities are not utilised in this scenario and remain available for other purposes. This is achieved without the need to renegotiate existing leases and is possible within a short timeframe. In addition, tenants become ‘stickier’ and are more profitable while risks to the tenants and the landlord are reduced.
EUAs can help tenants reduce energy costs, resulting in less exposure to rising energy prices and immediate positive cashflow benefits.
Tenants are bearing the brunt of a volatile energy transition, with market energy price increases of 200% or more. Tenants must simply address these costs, with the cheapest form of energy now available through EUAs, delivering Levelised Costs of Energy (LCOE) ranging from $0.067 to $0.085 per kilowatt hour.
This can be accomplished through EUAs without affecting a tenant’s balance sheet (the tenant pays an additional council rate and does not own the system).
Illustrative Example
Continuing with the previous example, the financed project saves $225,000 on utility bills, while the tenant pays $162,000 in repayments. As a result, cash flow is improved, exposure to rising energy prices is reduced, and environmental credentials are enhanced.
Collaboration is critical in achieving sustainability goals through EUAs. By working together, building owners and tenants can achieve significant financial, reputational, and environmental benefits.
The alternative is to refrain from participating, risking asset depreciation and incurring higher input costs and lower profitability. Because traditional methods of financing sustainability projects harm owners’ debt covenants, separate and complex lease amendments, variations, or separate agreements are required, resulting in the loss of an opportunity in most cases.
The convergence of a volatile energy transition and banking and liquidity crises create an environment where collaboration is essential. Building owners can improve their financial position through increased property values and improved debt covenants. Meanwhile, tenants can enjoy reduced energy costs, leading to improved cash flow and increased profitability.
Collaboration on environmental initiatives delivers benefits to tenants and landlords alike, each meeting supply chain and investor requirements. The added benefit is that such collaboration delivers wider societal benefits and accelerates the clean energy transition.
EUAs can be a valuable tool for commercial building owners and tenants to achieve financial benefits and sustainability goals. As JFK famously observed, crises present a choice between danger and opportunity, and the current economic turbulence and environmental transition present such a choice.
By taking advantage of the opportunity to collaborate on energy-saving projects through EUAs, building owners and tenants can mitigate risks, improve their financial positions, and contribute to a more sustainable future. It’s time to act and embrace EUAs to turn danger into opportunity.
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