7.1 Introduction

Previous chapters discussed the social, environmental, and economic spheres of sustainable property management. This chapter takes a closer look at the economic sphere of sustainability. It introduces calculations to determine if a sustainable building initiative makes financial sense. There are multiple metrics within the accounting and finance function to account for sustainable initiatives. These include the calculation of net operating income (NOI), before-tax cash flow, cash-on-cash return, payback period, and cost-benefit analysis. Some impacts of sustainable building initiatives are difficult to monetize, such as the cost of carbon, an employee wellness initiative, or the enjoyment of building users from using power generated from renewable energy sources. However, sustainable property management initiatives will impact the economic condition at the property. As the overarching goal of a property manager is to increase property NOI, it is important to consider the associated economic impacts of sustainable initiatives at the property.

7.2 Statement of Cash Flow and Sustainable Property Management

It is crucial for the property manager to understand how to evaluate each line item of a cash flow statement. This financial literacy aids in understanding the financial impacts of various sustainable property management initiatives. The property cash flow statement is broken into “above the line” categories and “below the line” categories. “Above the line” categories refer to categories above the NOI line item and “below the line” refers to categories below the NOI line item. Figure 7.1 illustrates an example of a property statement of cash flows. The revenue category includes all line items down to effective gross income (EGI). The operating expenses (OPEX) category is below the revenue category, and the list below figure 7.1 illustrates common operating expense line items.

Common operating expense line items:

• Legal
• Maintenance and Repairs
• Management Fee
• Marketing
• Payroll
• Property Insurance
• Real Estate Taxes
• Supplies
• Telephone & Internet
• Services
  • Landscaping
  • Pest Control
  • Trash Removal
• Utilities
  • Electricity
  • Heating Fuel
  • Water & Sewer

As per figure 7.1, NOI is calculated by subtracting operating expenses (OPEX) from effective gross income (EGI). NOI is a significant calculation because it is a common measure the real estate industry uses to determine the financial health of a property. NOI is also important because it is a major element in the calculation of market value of an asset. Annual debt service (ADS), capital expenditures (CAPEX), and replacement reserves line items are typically accounted for below NOI. ADS is the total amount of principal and interest payments made over a twelve month period, CAPEX are expenses that are not regularly occurring operating expenses such as parking lot paving, and replacement reserves is like a savings account where funds are put annually to “save” for planned building component replacements as well as serve as an emergency fund. For example, the replacement reserves line item may be used to annually contribute funds for a planned roof replacement in five years. ADS, CAPEX, and replacement reserves are subtracted from NOI to arrive at before-tax cash flow (BTCF). (Note that before-tax cash flow refers to before income-tax considerations, not real estate taxes which are part of operating expenses.)

7.3 Cash-on-Cash Return Analysis

A helpful and easy calculation to quickly analyze a return of a sustainable building initiative is a cash-on-cash return. The cash-on-cash return calculates the rate of return on the cash invested in a property based on the annual cash income earned. The equation is as follows:

Cash-on-Cash Return = Annual Cash Income / Total Cash Invested

Let’s use an example to apply this equation.

The results of the cash-on-cash return can be used to compare the property owner’s required rate of return against the cash-on-cash return. The investor will move forward if the cash-on-cash return is greater to or equal to the required rate of return. For example, suppose the property owner’s required rate of return in the example above is 8 percent. Since the cash-on-cash return of 25.82 percent is greater than the required rate of return of 8 percent, the investor will move forward on the sustainable initiative.

The cash-on-cash return is different from return on investment (ROI) because the cash-on-cash return is a snapshot of an annual cash income based on cash invested, whereas ROI takes into account the gain or loss over the life of ownership and divides that gain or loss by the the cost of the investment. However, both the cash-on-cash return and ROI can be misleading as they do not account for the time value of money or the holding period of an investment. A cost-benefit analysis is introduced in a later section in this chapter that takes these variables into account.

7.4 Payback Period Analysis

There are no-cost, low-cost, and high-cost sustainable property management initiatives. No-cost examples include turning off lights and equipment when not in use. Low-cost examples include providing recycling bins to tenants and changing from conventional light bulbs to LED light bulbs. High-cost examples include adding solar panels to the property and installing a green roof on the building. The simple payback period, a calculation that determines the amount of time it takes to recover the upfront costs of an investment, can be calculated for sustainable initiatives that have upfront costs. The formula can be seen below and an example of this formula applied is found in the box below.

Simple Payback Period = Initial Investment Costs / Annual Savings

A discounted payback period analysis takes into account time value of money by applying a discount rate to discount the future cash flows. The discount rate is either the cost of capital or a required “hurdle” rate-of-return metric, which an investment must minimally achieve; otherwise the money will be invested elsewhere. For example, a property company may be paying 5 percent on its debt, so 5 percent is used as the discount rate to represent this cost of capital. Alternatively, shareholders may require a 9 percent return, so 9 percent is used as the discount rate to represent this required rate of return to invest in a project. The formula can be seen below and an example of this formula applied is found in the box below. These calculations can also be done on a financial calculator or financial analysis spreadsheet.

Discounted Payback Period = Preceding Year that Discounted Payback Return Occurs + (Absolute Value of Cumulative Discounted Cash Flow in this Preceding Year / Discounted Cash Flow for the Year After Discounted Payback Return Occurs)

As you can see from the above example, the discounted payback period is greater than the simple payback period because the time value of money is factored in. The time value of money concept is that a dollar is worth more today than a dollar tomorrow because of the opportunity cost of investing the dollar somewhere else. This is why future cash flows are discounted.

7.5 Cost-Benefit Analysis

Both the simple payback period and discounted payback period discussed in the previous section do not take into account the savings once the initial capital outlay is paid back. Therefore, a cost-benefit analysis is useful when taking into account the initial capital outlay and the savings once this initial capital outlay is paid back. A cost-benefit analysis is a decision-making tool to determine if the benefits outweigh the costs of a potential investment throughout the product lifecycle. The net present value (NPV) is a helpful calculation when carrying out a cost-benefit analysis. The investor will move forward if NPV is equal to or greater than zero. If the NPV is equal to zero, the investor achieves their required rate of return. If the NPV is greater than zero, the investor achieves a return higher than their required rate of return. In order to determine NPV, the discount rate, product lifecycle, initial costs, and operating savings are needed. A simple formula for NPV is below:

NPV = Today’s Value of Expected Cash Flows — Today’s Value of Cash Invested

Let’s again use the example used throughout the chapter, but this time performing an NPV calculation as illustrated in the box below.

If NPV is equal to zero, the investor achieves their required rate of return. If NPV is greater than zero, the investor achieves a return higher than their required rate of return. In the above example, since NPV is greater than 0, the project is projected to achieve a return higher than their required rate of return. NPV is also helpful to use when comparing alternative projects because it provides a tangible number for comparison purposes. There is an NPV function in Excel, but Excel does not take into account Year 0 in the calculation, so the result in Excel will differ from the manual calculation if there is cash flowing in Year 0. This can be corrected in Excel by excluding the cash outflow in year 0 when calculating NPV and then subtracting out the initial cash outflow from the NPV calculation in Excel.

Benefit-cost ratio (BCR) is another popular calculation when carrying out a cost-benefit analysis. The BCR equation is as follows:

BCR = Discounted Value of Incremental Benefits / Absolute Value of Discounted Value of Incremental Costs

Let’s again use the example used throughout the chapter, but this time performing a BCR calculation as illustrated in the box below.

If BCR is equal to one, the investor achieves their required rate of return. If the BCR is greater than one, the investor achieves a return higher than their required rate of return. In the above example, because the BCR is greater than one, this indicator also shows this sustainable initiative makes sense from a financial standpoint. The BCR ratio can also be used to compare various sustainable building projects.

As the discount rate rises, the NPV and BCR decrease. As the product lifecycle increases, the NPV increases along with the BCR.

7.6 Conclusion

In review, depending on the calculation used, the sustainable initiative should be pursued if the cash-on-cash return is greater than or equal to the required rate of return, the simple or discounted payback period is less than the allowable payback period, NPV is greater than or equal to 0, or if the BCR is greater than 1. Also, as the discount rate rises, the NPV and BCR decrease, and as the product lifecycle increases, the NPV increases along with the BCR.

A property manager who can perform financial evaluations is essential in the sustainable building initiative decision-making process. By understanding the statement of cash flow and various financial calculations introduced in this chapter, the property manager can determine the financial viability of sustainable building initiatives. These financial results can be shared with property ownership to illustrate which sustainability building initiatives make sense financially. However, it is important that the property manager be cognizant of the property owner’s goals and objectives as these can affect which analysis is relevant. For example, if a property owner does not plan to hold the real estate asset for a long time period, the NPV calculation may not be relevant, but the payback period may be appropriate to determine if the real estate asset will recover the initial investment prior to the sale of the real estate asset. For long-term property holders, the NPV may be more relevant as it takes into account the product lifecycle. No calculation can capture all costs and benefits due to intangible components, but it is important to also consider these intangible elements during the sustainable building decision-making process.

Figure References

Figure 7.1: Statement of cash flow example. Kindred Grey. (2023). CC BY 4.0

Figure 7.2: Discount rate and product lifecycle in relation to NPV and BCR. Kindred Grey. (2023). CC BY 4.0

Image Descriptions

Figure 7.1: Stacked linear algebraic equation. Everything above NOI is “above the line,” everything below NOI is “below the line.” Above the line is broken into revenues (first 6 lines) and expenses (OPEX). From top to bottom: Gross potential income (GPI). (-) Loss to lease. (-) Vacancy and collection loss. (=) net rent revenue. (+) ancillary income. (+) expense reimbursements. (=) effective gross income (EGI). (-) operating expenses (OPEX). (=) net operating income (NOI). (-) annual debt services (ADS). (-) capital expenditures. (-) replacement reserves. (=) before-tax cash flow (BTCF). Return to figure 7.1.

Figure 7.2: As discount rate increases, NPV and BCR decrease (negatively correlated). As product lifecycle increases, NPV and BCR increase (positively correlated). Return to figure 7.2.