When it comes to high-performance building mitigating investment risk, most real estate finance investors and mortgage companies don’t get it. In fact, many lenders tend to discount (undervalue) green-high-performance projects and consider them risky investments. Antiquated lending and appraisal guideline policies along with market preconceptions continue to plague the green real estate market and have not evolved for decades; regardless of building industry and technological advancement. We are still experiencing an old paradigm of lending guidelines that simply don’t match or support 21st Century building performance innovation.
Older, outdated, inefficient buildings and homes continue to pose a real economic risk for mortgage industry investors. Loan portfolios today are bundled or tranched according to their risk, which impacts the interest rate and loan guidelines, including down payment requirements. The borrower’s credit score, down payment, and the loan product all play a role in pricing and risk assessment. Collateral is a big part of the risk analysis, but it is often overlooked as posing a threat due to deferred maintenance or obsolescence. Life cycles for older properties with high deferred maintenance improvement costs can be upside down, translating to properties that won’t exceed a 30 – 15 year loan cycle and will require capital to offset and pay for the costs of improvements.
Outdated properties should be considered more risky than newly constructed, energy efficient or net- zero homes (generate as much or more energy they are using) that will require less maintenance and dramatically reduce their costs to operate, thereby reducing the risk. Older homes represent depreciative assets, whereas, newly constructed properties meeting or exceeding 2015 IECC (International Energy Conservation Code) requirements, represents an appreciative asset.
The Uniform Appraisal Disclosure (UAD) implemented by Fannie Mae in 2011, includes a new technology data platform that reviews appraisal adjustments, market analysis, and essentially analyzes risk. The UAD regulatory requirements also included new line items for appraisers to be able to make adjustments and appropriately rate homes and comparable properties. UAD guidelines now include a line item for property condition ratings, C-1 –C-6; with C1 rating being excellent condition and C6 rating being the worst condition. UAD requirements expose the property value to potential devaluation adjustments or discounts and can require home owners to upgrade deferred maintenance repairs to be completed prior to closing. The Condition rating adjustments have come to be known as a “brown discounts” for properties that clearly demonstrate obsolescence or deferred maintenance risk that may require additional capital outlay for improvements.
Many neighborhoods in America are old post-war era homes requiring major revitalization. Fannie Mae and FHA requires properties with a Condition rating of C5 – C6 to be repaired and brought up to code, prior to funding. According to national real estate market data, over half of the U.S. home inventory is well over 50 years old and may represent Condition ratings of C4. Real estate properties below a C4 condition rating are now at the threshold of either requiring major upgrades or, in many cases, will need to be torn down due to excessive obsolescence and necessary improvement costs. These properties also denote land values that exceed the building value by over 70 percent. In these cases it is more financially viable to tear down the building, rather than attempting to renovate the property. Also properties with high land-to-property value ratios could be non-fundable in the secondary markets, Fannie Mae guidelines typically dictate a land ratio to not exceed 40 percent of the home’s value.
The Appraisal Foundation (appraisal industry’s governing body appointed by Congress) published a guidance white paper including information on brown discounts. The Appraisal Foundation’s 2013 1st Exposure Draft Report Valuation of Green Buildings: Background and Core Competency, and definition of a brown discount noted in their research: Potential for obsolescence, also known as the brown discount, for existing buildings that don’t “green up”: Just as green buildings that outperform the market may show a value premium, brown buildings that underperform relative to their market may show a discount.
The Brown Discount vs. Green Premium chart reflects the trend that will escalate in future years as more dated homes decline in value. Investors will be facing brown discount challenges due to deferred maintenance in order to retain their portfolio risk balances; and property owners will be forced to upgrade their properties for purchases and refinances to shore up their home value to avoid reductions with potential sales and rental prices. As mass production and demand for green premium homes are built and absorbed in the market, the spread of risk will escalate. This trend will also impact lenders and could cause potential mortgage write downs for brown discounted loan portfolios, making them less marketable and desirable due to additional collateral risk.
The UAD guidelines and Appraisal Foundation (TAF) guidance continues to provide appraisers with critical tools to make proper comparisons and adjustments to appraisal valuations. Appraisers are now being armed with sound guidance from TAF for a “green premium” value to be added to adjustments for homes that are better quality, more durable and energy efficient. Still, many appraisers that are not competent in interpreting or adopting green premium guideline adjustments.
The Energy –Efficient (EE) line item adjustment, also included in the UAD guidelines, is fast becoming an industry standard. The energy efficient adjustment (E-1-6 Rating) can also be used in valuations in addition to the Condition rating adjustments. The energy efficient line item adjustment allows for potential increases in value to be utilized for energy efficient and high-performance homes reduction in energy costs or operating expenses. However, the energy efficient appraisal line item potential valuation adjustment continues to be ignored by underwriters and appraisers when comparing high-performance or green homes to conventional homes. A home that saves an average of $2000-$5000 (50%-100%) in annual energy costs, should be worth more. This is now quantifiable with new building science technology performance measures that has proven high-performance homes to be more marketable or desirable than a home that is less efficient due to the HERS Index and Audit third-party certifications.
Green Energy Money, Inc., (GEM) developed an Energy Efficient (E-Rating conforms to C-Rating) rating methodology that includes over 39 points of certified data for appraisers to properly quantify value. GEM also offers a nationally accredited Green Appraisal valuation continuing education course for appraisers.
The GEM Green Appraisal Course teaches and demonstrates how quantified energy performance data supports energy efficient (E-Rating) value adjustments using the HERS Index and audit report provided by third-party building science energy raters. The HERS Audit includes home energy performance data for appraisers to support high-performance building upgrades in their valuations. The HERS Index also provides a miles per gallon (MPG) and calculates energy savings associated with a high-performance home or building.
In addition, the HERS Index was matched with an E-Rating that allows appraisers to make additional adjustments on the Energy Efficient line, verified by HERS software calculations of yearly energy savings. Over $30m in loans were appraised and funded using this system in GEM’s Beta Program. The E-Rating, coupled with the HERS Index and performance modeling has proven to adhere to appraisal and lending guidelines and can provide the right data for appraisers to make verifiable, quantified, green premium adjustments.
A green premium adjustment using quantified home performance data (delete) HERS data, provides recognition and certification that demonstrates a more durable, better quality, efficient building that costs less to operate (loan payments are offset with lower energy or operating costs) and allows for a present-value formula calculation or discount rate over a 20 year life cycle of annual energy savings.
It is important to note that the costs associated with high-performance building upgrades cannot be factored, but the costs to operate can be quantified and used to make adjustments in value. This is a critical factor for appraisers who need data in order to support value adjustments and can now use HERS Analysis data to calculate a present-value formula, which in turn can impact higher “green” value premiums in appraisals.
If you want to review the history of appraisal and the mortgage industry legislation and regulations and how they continue to impact financial markets and our economy, this white paper, Regulatory Issues Facing the Real Estate Appraisal Profession, is a good resource and interesting read.