Life Cycle Cost Analysis Methodologies and Applications of Value Chain-Based Sustainable Design Decision Metrics
By Kristen Hunter, M.Des Real Estate and Project Management ‘10
To enhance the decision-making and project management utility of Life Cycle Cost Analysis both in the institutional and private sectors, a multi-faceted sensitivity analysis protocol is proposed. Potential applications include: risk management; identification of root causes of cost differentials between conventional and sustainable alternatives; and the development of contracting standards to promote greater cost competitiveness.
Life Cycle Cost Analysis (LCCA) is vital to sustainable design and construction decision-making because of the prevailing perception of, and concern over, the greater expense associated with green building. Private sector developers and investors have lagged behind the public and institutional sectors in the adoption of sustainable building features because the additional investment typically is deemed economically unjustifiable. Colleges and universities, by contrast, have become environmental stewards out of pragmatism as well as principle. As institutions charged with educating future leaders, they are obliged to demonstrate their own dedication to contending with the most critical of contemporary challenges. Moreover, since higher education institutions have extensive real estate assets, their ideological commitment to sustainability is paralleled by the imperative to reduce facility construction and operating costs.
Within the institutional context, LCCA is an indispensable tool for minimizing expenditures pursuant to budgetary constraints, and for determining funding allocations to multiple sustainability implementation strategies. It is equally critical in assessing the cost-benefit ratios of the various tiers of the LEED rating system and evaluating value engineering alternatives. Moreover, LCCA also is a mandatory component of many grant and subsidized loan programs that underwrite the costs of green building technologies. In sum, LCCA enables institutions to derive the greatest value from the scarce resources allocated to sustainable building practices.
University leaders in green building currently use an array of LCCA methodologies that include simple payback, discounted payback, net present value, and adjusted internal rate of return measures. These metrics, however, are not commonly subjected to sensitivity analysis and therefore represent best case scenarios that do not adequately account for discrete cost drivers and potential risks. To enhance the decision making and project management utility of LCCA, a multi-faceted sensitivity analysis protocol is proposed, consisting of: value chain-based investment cost disaggregation; computation of probable annual savings; partitioned return ratios; and incremental investment analysis. In addition to providing a more realistic assessment of the true costs of sustainable design alternatives, this data also can be applied to risk management as well as the development of contracting and procurement standards intended to induce vendors, contractors, and service providers to realign their cost structures in exchange for greater market share commitments.
The adoption of more fine-grained LCCA computations by the insitutional and public sectors will yield data that potentially can be harnessed to isolate root causes of cost differentials between standard and sustainable alternatives, incentivize vendors and contractors to become more cost competitive, and document the resulting decline in price premiums. Assuming accumulated data were pooled and made widely available, the private sector could more accurately identify green building strategies that meet its shorter-term payback calculations and higher yield thresholds. As economies of scale emerge in sustainable building construction, the LCCA methodology proposed herein for the insitutional sector will become increasingly relevant to private developers, owners, and operators.
The “green premium”
As recently as 2001, a survey of California developers “estimated that green buildings cost 10% to 15% more than conventional buildings.” Statistical studies, however, have demonstrated the widespread adoption of sustainable building practices has, at a minimum, reduced the cost premium to levels significantly below the above-cited expense levels and, in fact, may have eliminated it altogether. A 2003 study commissioned by the California Sustainable Building Task Force revealed an average cost premium of 1.85%, although there was considerable variability depending on the level of LEED certification sought. The findings also indicated that the cost premium tended to decline over time as participants gained greater facility with green building; the 2003–2004 trend reversal was attributed to ongoing project cost estimates, which tend to overstate the eventual cost premium.
More recent studies, by contrast, have concluded when building cost data is segmented by program, the disparity between buildings explicitly designed to meet LEED rating criteria and those that were not was negligible. Program-segmented analysis indicated that program was a more significant cost determinant than sustainability, and that superior LEED rating categories were not necessarily correlated with increased expense.
Methodological discrepancies aside, both studies demonstrated that commissioning and monitoring were the most significant cost components of sustainable projects. Davis Langdon further documented that the majority of LEED credit items entailed minimal or no additional costs. Only water storage, roofing, lighting, and glazing generated additional costs, while most other expenses associated with credit achievement resulted from soft costs or unavailability of local services. Of those items, water storage cost-benefit ratios generally were unfavorable due to the relatively low cost of water services. By contrast, energy savings were the most signifcant tangible return component. The LCCA methodology enhancement proposed herein isolates these cost drivers so that soft and hard cost effects on return metrics can be separately quantified and managed.
Higher Education Institutions’ Leadership in Sustainable Design
Over the past decade, higher education institutions, enrollment growth trends notwithstanding, increasingly have been competing for prospective students on the basis of campus amenities. In particular, the quality of residential housing options now figures prominently in a prospective student’s selection criteria. The need to reduce operating expenses is particularly acute for this new generation of student housing, which typically boasts luxury amenities entailing significantly greater upfront and life cycle costs.
In addition to the expectations of their immediate constituents, higher education institutions also must fulfill government mandates and demands of community stakeholders. In certain jurisdictions, the government has stipulated LEED-based performance standards, whereas neighborhood residents’ assent to public approvals may be contingent upon additional commitments articulated in benefit agreements.
As a result, higher education construction has become the fastest-growing segment of the green building sector. While the initial results of these efforts have been mixed, of the 300 colleges and universities whose sustainability programs are evaluated annually by The College Sustainability Report Card, 51 have earned exemplary ratings for their leadership in green building, and 57% have “adopted campus-wide green building policies that specify . . . minimum performance levels.” This third-party rating system, now in its fourth year, offers greater transparency and benchmarks against which to compare the respective performance of schools, which increases the likelihood performance expectations will continue to intensify. Indeed, an institution’s record of commitment to sustainability now is subject to greater parental and student scrutiny in their evaluation of prospective schools. Environmental stewardship, therefore, has become another arena in which colleges and universities vie for prospective students.
Prevailing Life Cycle Cost Analysis Methodologies and Metric Applications
Colleges and universities, as the leading proponents of green building in the United States, are uniquely positioned to utilize LCCA techniques to best advantage. As long-term owner-occupants and operators, institutions enjoy greater investment longevity than their commercial counterparts and do not have to surpass prevailing industry hurdle rates, enabling them to embrace more innovative approaches. Schools with large real estate portfolios can achieve economies of scale in the retrofitting of existing buildings, new development, and procurement and contracting, based on depth of experience working with providers over multiple projects. In addition, colleges and universities benefit not only from the comparison of actual versus budgeted costs of previously completed projects, but also from the compilation of historic operating costs that in turn increase the accuracy of calculations. Continuous innovation in green building likely will result in the waxing and waning of the green premium as the prices of widespread technologies decline, only to be superseded by revolutionary, higher-cost products in a cycle of creative destruction. Consequently, LCCA will continue to be an indispensable investment assessment tool.
Approaches employed by two prominent universities and the federal government were examined to derive an LCCA best practices standard. Harvard and Stanford universities consistently have been lauded for their sustainable building endeavors and offer ample documentation of their internal LCCA calculation processes. Harvard employs a rigorous methodology utilizing all of the return metrics mandated by the Federal Energy Management Program. Stanford varies the length of the analysis period in accordance with building typology and further refines its investment horizon calculations by using a higher discount rate for analyses spanning five years or fewer. Taking all three methodologies into account yields the compilation of current best practice metrics shown in Figure 2.
Value Chain-based Life Cycle Cost Analysis
All of the LCCA metrics enumerated above exhibit two critical deficiencies that compromise their utility as predictive decision-making and project management tools. Hard, soft, and one-time costs are distilled into a single initial investment figure, while anticipated annual savings are treated as definite amounts without consideration of possible price volatility (other than the consumer price index-based inflation rate). As such, existing LCCA techniques omit a critical aspect of financial analysis: sensitivity analysis. Determining return and payback period tolerances to changes in utility costs and components of upfront expenses is vital to proactive project management and capital planning. To rectify these shortcomings, a sensitivity analysis consisting of value chain-based initial cost disaggregation, calculation of probable annual savings, a partitioned rate of return, and incremental investment analysis should be adopted.
The rationale underlying the value chain approach is to quantify the contributions of each individual element affecting the total investment return to determine where the greatest value or opportunity resides. Based in part on Kats’ and Langdon’s classification of the major drivers of green building costs, value chain components are proposed in Figure 3.
Of the six cost drivers identified in Figure 3, the risk-adjusted bid premium is most amenable to cost reduction strategies. As contractors gain greater familiarity with green building technologies and techniques, their contingency allowances eventually will attenuate with increased proficiency and an expanding track record of completed projects. Because universities and colleges routinely add facilities and upgrade existing ones, they can develop a network of preferred contractors. Institutions typically establish long-term relationships with this network over multiple projects, but keep contractors competitive by distributing the award of concurrent projects among different bidders. Institutions can accelerate bid premium reduction by documenting actual contingencies on their completed projects to use in contract negotiations on future projects. Alternatively, if just beginning a green building program, they may benefit by referencing results of comparable projects undertaken by other institutions.
Similarly, to the extent architectural and engineering soft costs reflect inexperience with designing for new technologies, these costs may decrease modestly as expertise becomes more widespread. As with contractors, working with a preferred network of professionals can leverage accumulated experience on past projects to drive these costs down more quickly than in the industry as a whole. It is conceivable that experience also will yield cost savings in the documentation of LEED credits. More importantly, however, if LEED accreditation is not needed or desired, this expense can be clearly identified and eliminated. Additional expenses due to insufficiency of local suppliers and disposal services also will tend to decline over time with the development of a critical mass of green building projects in the region.
The first four links in the value chain, therefore, offer prospects for cost reduction, either as the result of an institution’s own initiative or the general proliferation of green building expertise and availability. Subsidized loans and grants can further alleviate upfront costs, but commissioning and monitoring, reputedly the most costly components of green building alternatives, have the greatest direct impact on annual cost savings over the life of the project. Of the value chain components, it is also the cost center that is least amenable to reduction without sacrificing long-term cost savings. Cost containment of the five other upfront cost drivers, however, can mitigate this otherwise largely fixed expense.
Not only does the value chain highlight potential cost savings strategies, but it also provides a reporting framework to help subsequent users of the data distinguish among those upfront costs that will be applicable to future comparable projects, as opposed to those that may decrease as green building becomes more commonplace. The yield achieved as a result of reductions in the upfront cost components, however, also will depend on the projected cost savings over the investment horizon. The reliability of these projections depends on the accuracy of anticipated operating expenses. Conventional sensitivity analysis computes the effects on returns of percentage increases or decreases above or below values stipulated in the base case. This results in a bounded range of possible return values, but does not offer any insight into the probabilities associated with these scenarios. A more nuanced approach entails determining the probability associated with each potential outcome and then computing a weighted average to determine the probable value.
Sensitivity analysis, with or without calculation of probable values, is essential to LCCA because the default inflation index assumes past trends will continue in the future, and therefore does not anticipate the risk of utilities price volatility. More importantly, the performance of sophisticated energy-efficient buildings depends in large part on commissioning, monitoring, and knowledgeable maintenance personnel. Deficiencies in any of these areas can degrade performance to sub-specification levels, which will significantly diminish anticipated savings and result in protracted payback periods and reduced yields. In practice, some deviation from anticipated performance levels is to be expected at the outset as adjustments are made and staff become more familiar with system operations. Probable operating expense
values can be calibrated to account for these “break-in” periods.
The exercise of determining the probability of each possible expense outcome
is, in itself, a risk management tool, because it forces project managers to identify and quantify risks internal to the project, as opposed to external risks beyond the control of the project team. This information then can be used to share or, better yet, transfer the risks identified. For example, based on these probabilities, contract incentives and penalties may be structured to offset savings unrealized due to sub-specification performance or, conversely, allow participation in a percentage of savings that exceed expectation. Furthermore, operating expense volatility may prompt a college or university
to consider purchasing forward contracts to hedge probable expense spreads that surpass a pre-determined margin. In the event risk transfer is not feasible, at a minimum, using probable values will generate a more realistic operating budget target, provided the underlying amounts and probabilities are well founded.
These more fine-grained initial investment and operational savings figures can be input into the existing LCCA payback and net present value calculation methodologies outlined above. Value chain-based initial cost disaggregation isolates cost drivers accounting for the most significant upfront investment costs, savings in any of which will result in a shorter payback period or higher NPV/ IRR/AIRR given the same probable operational savings over the holding period. The resulting information may then inform negotiations with professionals, contractors, and vendors in the course of budget reconciliation. Grants and/or subsidized loans for sustainable features, distinct from project financing, must be accounted for by reducing the upfront equity contribution and subtracting debt service from anticipated savings over the loan term. Determining suitable yield-to-payback period ratios according to both program type and project scale may further refine existing LCCA methodologies.
In the institutional sector, IRR or AIRR calculations treat sustainable design investments and attendant cash flows from savings as if they were a stand-alone investment, separate from the project as a whole. This approach makes the tradeoffs between base case and sustainable alternatives more obvious.
Since the so-called “green premium” is a small fraction of total project costs, even significant upfront or operational cost savings will produce only meager yield increases. The impact of any individual sustainable design element on overall project returns, therefore, will be virtually imperceptible.
Private sector developers and investors, particularly of for-sale properties, typically will realize less direct benefit from long-term operational cost savings since many or all of these expenses typically are passed through to buyers or tenants. Nevertheless, green buildings can command higher rents and sale prices, increased leasing and sales velocity, and higher occupancy/lower turnover ratios. The magnitude of the resulting increased
cash flows in investment returns (including any direct savings accruing to
the owner) can be discerned by comparing base case and “sustainable case”
partitioned IRRs. For the base case, calculate the present value of the future
operating and reversion cash flows by discounting them at the internal rate of
return (IRR), then sum the present value of the operating cash flows and compute it as a proportion of total project cash flows (operating income plus reversion value).
In the sustainable case, by contrast, the same procedure outlined above for
calculating the present values of the future operating and reversion cash flows
should be followed, but it is also essential to account for the green building contribution to reversion value by computing the operating cash flow differential between the base and sustainable cases in the terminal year, capitalizing this amount at the overall cap rate, and discounting the capitalized figure to a present value using the internal rate of return. This sum then is added to the sustainable case operating cash flows to determine the yield impact of the sustainable alternative as shown in Figure 4.
The partitioned IRR calculation is most germane in the private sector, where disposition usually is anticipated as part of the return analysis, whereas institutional owner-occupants base investment decisions on indefinite ownership. Private sector developers and investors can combine payback analysis with partitioned IRRs to identify green building strategies that not only generate savings offsetting initial costs, but also increase overall yield, albeit modestly. The discrepancy between green building premiums and the effect of these additional features on investment returns highlights the greater
pressure on sustainable alternative upfront investments in the private sector,
where higher discount rates diminish the value of future operating and reversion cash flows relative to first costs.
In the private and institutional sectors alike, embedding sustainable design initial costs and the resulting operating period savings in overall project return calculations trivializes the impact of sustainable design decisions since the cost and savings components are negligible in relation to total project costs and cash flows. By utilizing incremental investment analysis in conjunction with the aforementioned methodologies, however, it is possible to assess costs and benefits at the scale of the additional investment.\
To do so, the additional cost of the sustainable element(s) is input as an initial
cost (CFo); annual savings are represented as periodic cash flows (CFj);
and the reversion value component attributable to capitalizing the additional
income derived from the sustainable feature(s) is accounted for by adding it
to the final year’s cash flow (CFj). Following the example above, the benefit
of the incremental investment is computed in Figure 5 below. Holistic analysis reveals, the additional investment in sustainable design produced a meager 100-basis point increase in the overall yield, and a 51-basis point increase in the return attributable to sustainable case cash flows. By contrast, incremental analysis demonstrates that the sustainable feature generated a 36% return as a stand-alone investment. On purely financial grounds, the 100-basis point overall return increase might not be sufficiently compelling to warrant the additional cost, but by isolating the incremental investment, it is apparent the additional initial cost generates a return that would rival any alternative investment.
In addition, in addressing opportunity cost of capital considerations in sustainable design decision-making, incremental analysis also is useful from a portfolio management standpoint. In determining allocation models, diversification objectives place limits on the amount that may be concentrated in any one investment. If the adoption of sustainable features risks exceeding this threshold, the investment nevertheless may be justified if incremental analysis reveals the additional investment can generate a higher return than competing opportunities.
Incremental investment analysis, therefore, may induce the private sector to
aspire to sustainable design standards on par with the institutional sector by elucidating the discrete return potential of additional spending. If these metrics also were to capture increased revenues from higher rents, higher occupancy rates, shorter lease-up periods and increased tenant retention, in addition to operating expense savings, a sustainable design investment that otherwise might have been deemed discretionary, instead would become an imperative.
Application of Value Chain-based Life Cycle Cost Metrics
Colleges and universities facilitate further reductions in initial costs for green building alternatives by exerting their individual and collective market power. Individual institutions can harness the LCCA methodologies proposed herein on a project-by-project or portfolio-wide basis to:
- Educate contractors about sustainable building practices to reduce risk aversion, risk-adjusted bid premiums, and the likelihood of bids exceeding budget parameters
- Focus value engineering efforts on specification changes to reduce hard costs or negotiation to bring soft costs into compliance with the budget, as appropriate
- Modify contracting and procurement standards in accordance with refined data and use purchasing power to persuade vendors to meet capital expenditure approval benchmarks
- Quantify and manage the risks of the building not operating according to specification and structure appropriate incentives/penalties to ensure unrealized savings do not compromise loan repayments or university operating budgets.
The experiences of colleges and universities on individual projects can also be compiled and shared by sector coalitions to further advocacy on a variety of issues. LCCA data can demonstrate the necessity of continued subsidies. In conjunction with preserving access to funding, this information can also be harnessed to lobby the industry for cost-saving innovations that will result in widespread adoption of green building practices. The resulting increased demand will improve economies of scale and reduce prices to marginal costs. Sector-wide LCCA data also provide a framework for regulators considering enacting sustainable design mandates and for community activist organizations negotiating community benefit agreements. Finally, the pioneering work of the university green building vanguard can be adapted for use at less-well-endowed institutions, as well as in the commercial sector, to promote implementation of sustainable design practices and improved outcomes.
In the short-term, institutional green building metrics can assist private sector developers and investors to select cost effective schemes by providing reliable initial cost and operating period performance benchmarks. In the long-run, however, colleges and universities can leverage their comparatively greater bargaining power to eradicate much of the perceived or actual “green premium,” thereby making a broader array of sustainable building strategies financially feasible for the real estate industry as a whole. The methodologies proposed herein for private sector application will enable developers and investors to recognize the turning point at which green building benefits yield commensurate investment returns due to initial cost diminution.