One of the most common questions I get asked by real estate investors is how do you actually measure the value of going green? Energy-efficiency is nice in theory but if you can’t get an increase in your property’s value then why spend the money? In addition, most appraisers have little clue how to measure the value of energy-efficiency upgrades. There aren’t any national standards to go follow and very little data to reference.

Luckily for all of us there are a few formulas, originally presented by Energy Star that you can use to compute the value of energy-efficient upgrades. In this post we’ll take a look at a few of the formulas and I’ll present a checklist for you to use to make the case to boost your properties value with an appraiser, buyer, investor, whoever.

**How to Estimate Rehab Costs!**

Estimating rehab costs accurately can make or break your real estate business, and it takes years of experience for even the best rehabbers to master the art. However, you can expose yourself to less risk and get more accurate with your projections by learning how the pros think when estimating construction costs.

## Green Formulas:

*For purposes of example let’s assume the following:
The cost to make 123 Happy Street [Trivia question: What movie?] a high-performance green home = $5,000
Annual savings in energy costs = $1,200
Capitalization rate = 7%
*

**1. Return on Investment (ROI):**

The return is the annual savings in energy costs.

The investment is the cost of the project.

In our example, the equation would be:

$1,200 / $5,000 = .24 = 24% = ROI

**2. Estimated Asset Value Increase:**

ESTIMATED increase in asset value can be computed as follows:

Annual savings in energy costs / Capitalization rate

In our example, the equation would be:

$1,200 / .07 = $17,143 = Estimated increase in asset value

Currently this is the best formula to use with an appraiser. Most appraisers I’ve worked with use this formula to quantify the value of the energy efficiency measures my clients have made. It has definitely helped me (and I would recommend) walking your appraiser through the formula to make sure they understand it.

**3. Payback is calculated by:**

The payback period is the amount of time it takes to recover the amount invested and is computed as follows:

Project cost / Annual savings in energy cost

In our example, the equation would be: $5000 / $1,200 = 4 years, 2 months = Payback period

If the answer included decimals, you would have to convert the decimals (which are on a base of 10) to months (which are on a base of 12). For our example, the equation becomes:

$5000 / $1,200 = 4.166. This would be 4 years and 1.6/10 of a year. Then .166 x 12 months = 1.992, which is approx. 2 months. Therefore, the payback period is 4 years, 2 months. Not bad for a guy who got a C in Algebra in 9th grade.

Once you have these formulas down it’s time to make the case with the appraiser as to the increased value you’ve created. Unlike the old days, appraisers are now largely assigned by the buyers bank. Since you probably won’t know the appraiser it’s critical that you give them ALL of the info below:

- Energy Audit report (if completed).
- List of all energy-efficient measures completed (wall insulation added, HVAC system optimized, etc.).
- List of energy-efficient materials/equipment installed (low-flow shower-heads, CFL lighting, weatherstripping, etc.).
- Projected annual utility expense savings based on historical data (homes past 12 months utility bills or comparable home utility bills).
- Projected asset value increase amount according to the formula above.

In my experience, appraisers are very open to giving you an increased value on your property as long as you give them the information listed above. They know that ‘green’ adds value, they just don’t know how much. Potential investors and buyers also tend to believe ‘green’ adds value but like appraisers, they just don’t know how to quantify it. By using these formulas and checklist you should be in a better position to talk about the value of your property.

INTERESTING GREEN FACT:

LED lights save energy not only because they use 90% less than regular light-bulbs but because they run cooler. Incandescent lights run hotter and make your AC work harder to cool the room they’re in. LED run cool so your AC doesn’t need to work as hard.

## 11 Comments

Jim, very useful post. I was not aware that this is the formula most knowledgeable appraisers use in determining the ‘green’ (no pun intended). It’d definitely be a good practice to walk/talk with appraisers to make sure they have a better understanding of how to compute that accurately.

Hi Alex,

Thanks for the comment. Most appraisers don’t know how to quantify ‘green’ so walking with them is definitely a good idea. it’s good to use these formulas with potential buyers as well.

Thanks..Jim

.-= Jim Simcoe´s last blog ..Conscious Capitalism speech =-.

Jim – I’ve debated this at length with appraiser members of the ICAAF and elsewhere. I don’t believe you haven’t factored in the initial cash flow in your cash flow. The return of $1,200/year on a $5,000 investment is 24% annually, but to calculate NPV the initial capital outlay of $5,expense (cash flow period “0”) must be included. Think a series of cash flows inputted into a HP12c. The 1st cash flow is Each successive cash flow is Now, those cash flows won’t continue in perpetuity. PV cells lose efficacy over their life span; maintenance, cleaning, upkeep expenses should be considered as well. Will a subsequent buyer pay a premium for the house with 10 year-old PV cells versus brand new? Likely not.

For example, assume 10 annual cash flows at $1,200 per period with a $5,000 initial capital outlaw, 2% “safe rate” (alternative investment rate of return), minimal reversion due to life expectancy: NPV = $5,779. Assuming 20 annual cash flows: NPV = $14,621.

The 2nd sentence should read “I don’t believe you’ve factored in the initial cash flow of in the overall series of cash flows. (thank you)

Thanks for comments Charles. As a general rule I almost never recommend PV on residential investments as rarely pencil out. happy to discuss more with you offline, email me if you want as I am not sure I understand your logic in the 1st comment. Thanks..

.-= Jim Simcoe´s last blog ..Conscious Capitalism speech =-.

Jim – thanks. Somehow my post got butchered up a bit. Will proof things before posting next time

Basically, take 10 years of cash flows at $1,200 per year. Cash flow “zero” (before the 1st payment of $1,200) is

So, your cash flow schedule would appear as follows:

CF0 =

CF1 = $1,200

CF2 = $1,200

.

.

.

CF10 = $1,200

Reversion = 0 (for this argument)

Assuming 0% interest (discount rate), the NPV of the series of cash flows is $7,000. NPV at 2% = $5,779. NPV at 4% = $4,733.

I think the ideal way to go about this would be to estimate the life expectancy of the PV cells and use that number as the total number of cash flows. It’s safe to assume the reversion (instrinsic value) at the end of their physical life woud likely be close to zero. So a 20-year life expectancy would give you one cash flow of and 19 cash flows at $1,200. Choose a reasonable rate and you can calculate the NPV of the investment.

Jim-in approach#2 you introduce a cap rate. Where did that come from? The cap rate is only fair if it has been derived from analysis of recent sales of green properties, similar in type, location, etc. And this is where the problem lies for appraisers. You can’t just borrow a cap rate used somewhere else in the universe of real estate and assume it makes sense. As one appraiser put it, “Applying a discount [cap] rate, any discount [cap] rate, without supporting its applicability to the situation is misleading. You might as well throw darts at a rate chart or use a magic 8 ball to select the rate, cause it would have the same amount of credibility”.

Tim,

Cap rates are commonly used based on similar rental properties in the same area. You do not have to compare green properties to green properties to calculate a cap rate for a green property. The green benefit is an additional add-on in value. You compare the green rental property as a rental property to a comparable rental property. That is the commonly accepted way to generate cap rates for green properties.

They aren’t created by shaking a magic 8 ball. The magic 8 ball is used to calculate college hoop brackets…

Jim, a cap rate from an income property is driven by a varied market, including owner occupants, investors and novice investors. Their motivations and perspectives on income can be completely unrelated to how savings influence buyers who typically have a whole set of other concerns and preferences which could easily change the importance of the savings.

Commonly accepted method by whom? I’ve worked in real estate for 18 years and I can tell you that the two sets of buyers can be different animals. I would not say that borrowing a cap rate from rental properties is ridiculous. It may be the best place to get a cap rate. What I am saying is that it is unreliable. So unreliable that it’s more of a guess than a calculation of estimated contributory value.

If you are using a cap rate from a multi-family property and applying it to a green multi-family property, then it makes more sense. But not if you are going to try use it on single-family dwellings.

However, the cap rate is problematic in other ways. We’re talking about savings from a depreciating component, not income. There is a difference. Will that energy efficient item that saves $1,200/year still bring $17,143 in value when it needs to replaced in a two years? Have you factored in maintenance? Will someone pay $17,143 more for a home when they could buy another home without this item and install it for $5,000?

In appraisal, the best way to really determine the contribution to value from such items is to compare the sales of similar homes with and without such items. In this comparison, you account for the other differnces between the properties and the net difference is the contributory value of that item. This is called paired sales analysis. And even this can be viewed as guess that is within the framework of supporting data since it is predicated on applying ESTIMATED adjustments to the sales to account for their differences other than green items.

There are lies, damned lies and then there are statistics. By default, you and sellers of energy effiicient items have a conflict of interest. What better way to entice potential customers than to quantify their profit? But, if anyone is playing with cap rates from dissimilar properties they may be selling a bill of goods or, need to take some appraisal courses.

You really can’t “compute” or “measure” the contribution to overall value to real estate of such energy effiicient items. You can only estimate. This is what I would tell clients to be fair, if I were in your shoes.

Thanks for your comments, Tim. Based on my experience of working with appraisers, investors, lenders throughout the US and Energy Star directly over the past several years, I stand behind my post and my comments.

I do understand your points, I just don’t agree with them based on my experience. I’m not sure how many green projects you’ve worked on but I’m assuming none [correct me of I’m wrong]. If/when you do work on one you may see what I’m talking about. Then again, you may not.

Either way, I appreciate your comments and discussion. If you have more questions or would like to talk, feel free to call me directly. Outside of that, I’ll consider this thread closed for now. Thx..jim

1st paragraph edit “…how savings influence SINGLE-FAMILY buyers…+