Why Capital Improvements Could Be Free

Why Capital Improvements Could Be Free

Q&A with Stephen Gossett Jr., co-founder and vice president, Transcend Equity Development Corp.

In 1997, Stephen Gossett Jr. predicted that commercial real estate would become a huge emerging market for retrofitting office buildings that are not energy efficient. As it turned out, Gossett was prescient given rising energy costs and forthcoming federal regulation that is anticipated to impact commercial real estate in the next few years.

At the time, Gossett was employed by CSI Energy Solutions, an energy services company that primarily targets public sector buildings. There he began to develop the template for his future company, Dallas-based Transcend Equity Development Corp., which was launched in 2002 as an incubator company. To prove the business model, the firm began with a couple of low-risk projects — 2 million sq. ft. of buildings under long-term lease to Bank of America and another 2 million sq. ft. of office buildings owned by publicly traded office real estate investment trust (REIT) Corporate Office Properties Trust. Transcend is now targeting the larger office market, including office REITs.

Transcend finances energy-related capital improvements such as HVAC systems for building owners at no cost. The firm then pays the utility bills directly over the life of the contract — typically eight years — and reaps the rewards of the utility savings. On average, the company spends $3 million in improvements per building.

To date, Transcend has retrofitted 30 buildings in the Northeast and has six more under contract slated to begin early this year. NREI spoke to the vice president about his company and its plans for growth.

NREI: What makes Transcend Equity’s business model successful?

Gossett: The primary problem with the whole energy-efficiency industry in working with commercial real estate is the landlord-tenant standoff. The big issue is that the landlords are responsible for the capital side of the building, and the tenants are responsible for the either some of or all of the operating expenses. Our program was designed to bridge this landlord/tenant gap, and is very unique in that regard.

The second big issue involves the mortgage lender/landlord relationship. In most cases, once a mortgage is in place the property lender cannot allow an equipment lender to subsequently finance the replacement of the original equipment in a building. Despite the fact that replacing this old equipment will improve the value of the property, financing this replacement is quite often considered an event of default under the mortgage. So, unless an equipment lender is willing to finance equipment without any form of lien, the landlord's only remaining option is to use his own capital to replace equipment. Now, through MESA we are able to replace a great deal of equipment in our clients' buildings without using the landlord's capital and at the same time steer clear of the mortgage restrictions.

NREI: Can you give us an example of a project and how you worked with the client?

Gossett: Elm Place in Dallas is an office building that was built in about 1918 and was rehabbed over the years. The mechanical systems in the building were ancient, and we were able to come into the building and invest about $5 to $6 per sq. ft. to replace air handling units, chillers and boilers, and cooling towers. We were able to fund the project through energy savings. We reduced the energy use of that building by nearly 40%.

The owner didn’t pay one dollar for doing this work. The owner was spending about $2 per sq. ft. on energy costs, and [the owner] signed a contract with us to pay us $2 per sq. ft. for eight years. We assumed responsibility for buying the electricity and natural gas for that building for eight years. Our investment basically reduced our cost of providing natural gas and electricity to the building. It allowed us to generate a return on our $1 million investment in the building.

NREI: What was the rate of return?

Gossett: The rate of return for the landlord is infinite because the landlord has received improvements and some financial benefit from the project in fixing their building, and didn’t have to pay for it. As for our rate of return, we typically build deals on an unlevered return basis of about 12% to 14%. We have to have a little healthier return requirement because of the risk-return requirement.

NREI: Can you give us another example?

Gossett: We’ve retrofitted 24 properties with Corporate Office Properties Trust in Columbia, Md. The average energy reduction in those 24 buildings is about 25% annually. We’ve invested around $15 million in capital improvements in Corporate Office Properties’ buildings. Again, for those 24 buildings we took on the responsibility of buying electricity and natural gas. We recover all of our money invested in that particular portfolio through that procurement method, whereby we’re reducing energy consumption.

NREI: How does Transcend Equity fund the energy retrofits?

Gossett: We go to a couple of different places to get money. We go to your more conventional, middle-market lending groups. Our deals are digestible by a lender who understands real estate. That’s one way, but obviously the market has changed a lot.

Another place we’re going to get money is the emerging green finance community, which is funding a lot of alternative energies like wind and solar. Companies like Wells Fargo and Bank of America have emerging green desks that want to invest in this stuff, and we’re starting to have conversations with companies like that to do deals.

We’re also talking to hedge funds because there are a lot of them trying to enter social responsibility investing (SRI). They want to have an SRI component to their portfolio. The SRIs are one of the fastest growing asset classes in the investment world.

NREI: When does the building owner own the improvements?

Gossett: In most cases, our clients own the improvements immediately. Generally, our transactions are not secured against the equipment we install because it would run afoul of the lender on the property.

NREI: If a building owner chooses to sell his property before the contract is up, what happens?

Gossett: Agreements can be assigned to the buyer or terminated by the seller by paying a termination payment. The assignment scenario plays out like any other contract assignment during a sale. Under a termination scenario, the seller pays a termination fee based on the remaining term of the deal and the actual energy savings performance on the project.

NREI: What are your growth projections for Transcend Equity in 2009?

Gossett: We expect substantial growth in 2009. We're under contract for six more buildings with projects that will likely occur in the beginning of 2009. We are also in discussions with enough potential clients to double the size of our project portfolio in 2009.

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