7-Dec-20
By inefficient design I mean a building that is not designed as efficiently as it could or should be, and which then forces the contractor to build it and the facilities manager to operate it at subpar efficiency.
The primary reason for the real estate industry’s illogical acceptance of inefficient buildings (which goes against tenants’ best interests, as well as the investors’ and societies’ long-term benefit) is the process of how projects get developed and executed.
This process – designing the project, building it, operating it, financing it, and then selling it on – involves players who almost always have conflicting self-interests and misaligned incentives. And globally, this ultimately results in buildings that consume ~40% of global energy and generate ~33% of greenhouse gas emissions.
Ignoring for the time being all the pollution, political intrigue and wars that the search for fossil fuels has generated over the past decades, imagine for a moment the true economic costs for all the fossil fuels that had to be discovered, extracted, transported, refined and then burnt in a power station so that 25-30% of the energy value of that fuel can heat and cool inefficiently designed buildings. According to WoodMackenzie, the Oil & Gas industry is estimated to have spent $740bn in capital expenditure in 2020 (down 22% from 2015). This is just for exploration and production. Add to that refining and transport, and then add to that power generation and transmission/distribution. Now we're in the trillions of dollars.
That’s inefficiency personified.
Consider that China and India have to add 2,000 GW (gigawatts) of power generation capacity each over the coming 30-40 years. This is the amount currently generated in Europe and the US - and that has to be added to each of India and China. Its impact on global pollution will be staggering. And a gigawatt of fossil fuel power costs approx. $1bn, so 2,000 GW will cost $2 trillion And that's just the CapEx. OpEx is on top of that. Contemplate for a moment that pretty much half of that power generated is solely for HVAC.
It is also important to note the for each kWh (kilo-watt hour) of energy we consume unnecessarily, we need to produce 3 kWh worth of energy (so saving 1 kWh can in reality save 3kWh of energy at the source).
In the current real estate business model, profits are privatized (i.e. the financial returns are retained by the investor), while pollution and its impacts are socialized (i.e. society pays the price). In other words, ultimately we all are paying for it.
If pollution’s costs were truly reflected in a building’s financial model, buildings will - overnight - become the paragons of efficiency.
It all starts with the investor/developer in an extremely competitive market with high land values, where often the only differentiators are location and price. To maintain a respectable return in an environment of high land acquisition costs, construction costs come under pressure. So in most cases, the financial models drive them to search for the lowest construction cost, which they believe ensures the highest gross profit margin per m2 of space. The focus on cutting capital costs (CapEx) has decoupled the project’s true life-cycle cost from the decision-making process. Consequently, operations and maintenance costs (OpEx) have been relegated to an unwelcome distraction. Over the years, short term financial return targets (that also influence the remuneration of real estate professionals) have made CapEx develop an outsize influence on the financial model, creating an unrelenting march towards lower and lower CapEx. While OpEx is significantly discounted in Net Present Value terms in the financial model, and so becomes more and more inconsequential.
So, from a short-term perspective, ignoring OpEx may seem like a rational choice - as many developer/investors are neither exposed to the ongoing OpEx (which includes energy consumption for heating and cooling, as well as related facilities maintenance costs - but their tenants are), nor will they own the project for too long (their exit strategy may dictate disposing of the asset, monetizing their investment and using the proceeds to develop more projects).
This creates no immediate incentive to reign in future OpEx (i.e. by spending a bit more upfront on higher quality design, products and construction). OpEx does not come out of their pockets, but CapEx does. OpEx does not influence their compensation, but CapEx does.
And even for the developers who seek to retain the asset (e.g. a government building a school or hospital), the project procurement process has one focus: the lowest possible construction cost (CapEx), as the CapEx funding allocated for the project is totally separate from the funding for facilities management (OpEx). Therefore, there is no incentive to make a wise CapEx decision that benefits a lower OpEx. OpEx “is not in my budget” is a common but perversely faulty response when a project owner – or their consultant - is asked about the importance of OpEx in their decision-making process.
If we think about things rationally, the main task of the developer should be to ensure a successful long-term project (i.e. where both CapEx and OpEx) are optimized.
Because looking at the total life-cycle costs, CapEx comprises only 20-25% of the project cost, and OpEx 75-80%. This 4-1 ratio should force the developer to adopt measures that helps save money from the “4” even if the “1” costs a bit more.
To take an example, if we spend ~10% more on CapEx but can save ~20% on OpEx over let’s say a 30-year project lifetime, the total lifecycle cost goes down ~15% - from 5 (1+4) to 4.3 (1.1 + 3.2). This is significant, as that 15% lifetime savings comes close to covering the 20% that CapEx costs in the first place.
Developers are part of the problem, but they're not the only ones. Bankers / lenders, architects / engineers, contractors / government regulations, as well as end-users are also part of the mix...