The Brilliant Economics of Green Buildings

Say what you will about the benefits of clean energy or the costs of pollution, the jury has returned an unambiguous verdict on the greening of the commercial real-estate market.  The niche has become mainstream. Anyone who says green buildings, which are certified by third-party verifiers as demonstrating superior environmental performance and resource efficiency, are “boutique” has not been paying attention.

The commercial buildings sector boasts the most explosive growth in green building. In 2010, a third of all new commercial construction was green, amounting to a $54 billion market for commercial green buildings. By 2015, green buildings in the commercial sector are expected to triple, accounting for $120 billion to $145 billion in new construction and $14 billion to $18 billion in major retrofit and renovation projects.

But not all commercial buildings are the same. For all practical purposes, there are three classes of commercial buildings – Class A, Class B and Class C. These classifications are commonly used as a proxy for a building’s ability to attract high-value tenants.

While there is no standard definition for what qualifies as Class A, Class B and Class C commercial buildings, the Building Owners and Managers Association suggests considering the following criteria when classifying commercial buildings:

Class A: Most prestigious buildings competing for premier office users with rents above average for the area. Buildings have high quality standard finishes, state of the art systems, exceptional accessibility and a definite market presence.

Class B: Buildings competing for a wide range of users with rents in the average range for the area. Building finishes are fair to good for the area. Building finishes are fair to good for the area and systems are adequate, but the building does not compete with Class A at the same price.

Class C: Buildings competing for tenants requiring functional space at rents below the average for the area.

In other words, Class A buildings are the most desirable and Class C buildings are the least desirable from the typical tenant’s perspective. Greater desirability means more money. It turns out Class A is where the green paradigm has achieved the deepest penetration.

“Green building is fundamentally altering real estate market dynamics – the nature of the product demanded by tenants, constructed by developers, required by governments and favored by capital providers,” according to RREEF Research. “The upshot will be a redefinition of what constitutes Class A properties and even institutional-quality real estate.”

The predicted “upshot” is rapidly becoming a reality in Manhattan‘s commercial real-estate markets, which is dominated by Class A properties. In Manhattan, Class A office buildings account for 61% of the total market. Class B buildings make up 26% of the market and Class C accounts for the remaining 13%, according to Cushman & Wakefield.

While stricter government regulation may ultimately make green buildings the de-facto standard for new and renovated buildings in the future, tenant demand is the primary reason why green buildings are becoming mainstream in today’s Class A commercial real-estate market.

“At Hines, we specialize in Class A space, and we’ve reached the point where clients don’t think it’s Class A unless it’s green,” said Jerry Lea, the Executive Vice President of the real-estate investment and management firm.

Many tenants are willing to pay a premium for space in green buildings because of the lower operating costs, higher worker productivity and reputational benefits associated with the superior environmental performance of green buildings.

If the past presages the future, today’s green buildings market is chump change compared to the opportunity likely to come down the pike over the next decade. To put the scale in perspective, in 1995, the total floorspace of U.S. commercial buildings – 58.8 billion square feet of floorspace – exceeded the total area of the State of Delaware and amounted to more than 200 square feet for every U.S. resident.

Talk about a sea of green.