The following article appeared in a newsletter provided by the Common Wealth Bank in Australia and is such a thought provoking article I thought I’d provide it here.
Sustainability and Housing
source: CBA
Author: Professor Richard Reed, Faculty of Business & Law, Deakin University, Melbourne
In recent years there has been increasing pressure on homeowners to adopt sustainability and ‘save the planet’, however many homeowners still appear reluctant to spend money on sustainability. For them it is critical there is also a clear financial benefit. It appears the decision to outlay money is directly linked to economic considerations via a cost-benefit analysis, where sustainability is nice but still takes a back seat. In other words, why should I spend money on insulation or a water tank if the financial benefit does not exceed the original financial outlay? To correctly answer this question about sustainability there should be careful consideration given to exactly what financial benefits (and to what degree) can be gained from adopting a higher level of sustainability. Unfortunately most homeowners only equate sustainability to lower energy use (e.g. light bulbs) which eventually results in cheaper electricity bills (note there is research showing that sometimes more electricity may be used since they are perceived to be low energy!). Another financial benefit often completely overlooked are the benefits from using sustainable features to increase the perception of the property and therefore the overall capital value of the home. In other words, a homeowner needs to evaluate how is the ‘capital value’ of a property affected by the level of sustainability by undertaking a ‘before’ and ‘after’ analysis – this is commonly referred to as the business case for sustainability.
For example, the homeowner should ask these questions:
1. Do the sustainable features (or lack thereof) cause my home to be associated with less or more risk from the market’s perspective?
A starting point is to consider what buyers in the marketplace are looking for. In many areas there is now an expectation there will be a water tank in the backyard (much like an ensuite is often a standard expectation). If there are no watertanks, this may decrease appeal (and the perceived value) for the buyer. On the other hand if there are too many water tanks (e.g. 10) this may also detract value (much like having 5 ensuites).
2. Is the level of sustainability reflected in the assessed value of housing in my neighborhood?
It is critical to evaluate how much a typical buyer in my neighbourhood actually cares about sustainability and what type. The local real estate agent would know the exact answer here. There is no point installing a solar panel or full insulation if the market does not fully acknowledge it. It may be nice but ‘does it add value?’ Also it must be remembered that Australia is a diverse country with a wide range of conditions. For example heating is more important in southern states and cooling is more important up north. This also has implications for the design and construction of a wide range of housing.
There are many factors which affect the relationship between sustainability and value which can vary largely depending on a range of influences including:
* the location of the home and the proximity of surrounding buildings, as well as transport and surrounding services and facilities i.e. there is no point having a sustainable home but with high transport costs; the architectural design and age of the home;
* the perception of the market (both buyers and sellers) towards sustainability;
* the prevailing cost of energy, construction and transport;
* and other factors that influence the financial decision e.g. installation costs, maintenance.
It is important to consider the relationship between sustainability and the underlying principles of value listed here, which also affect the highest and best use of the property.
Supply and demand – standard economic theory dictates the price of real estate or property varies directly, but not proportionately, with demand and inversely, but not necessarily proportionately, with supply. Therefore an increase in the supply of an item or a decrease in the demand for an item tends to reduce the price. The opposite conditions produce the opposite effect. This must be factored into the assessment of value for a residential building, where there may be (a) limited supply and (b) increased demand for sustainable accommodation. There are a limited number of sustainable buildings currently in the marketplace, which also ensures that demand exceeds supply. In the future this may change as more sustainable buildings enter the market.
Competition – from a demand perspective this is the interactive efforts between two or more potential buyers or tenants to make a purchase or secure a lease. Sustainability attributes can increase competition via a competitive advantage.
Substitution – when several similar commodities, goods or services are available, the one with the lowest price normally attracts the greatest demand and widest distribution. With regards to sustainability this relates to the original cost of the residential building. For example, what is the trade-off between the cost of sustainable features and the availability of accommodation in an alternative house? On the other hand it is difficult to substitute the benefits offered by a non-sustainable building.
Balance – property value is created and sustained when contrasting, opposing or interacting elements are in a state of equilibrium. This relates to the relationship between different property components as well as the relationship between costs of production (e.g. land, labour, capital and developer’s profit/risk) and the property’s productivity.
Contribution – the value of a particular component is measured in terms of its contribution to the value of the whole property, or the amount that its value would detract from the value of the whole property. It is important to identify which sustainable aspects in a home actually add value and how much, if at all.
Surplus productivity – the net income to the land remaining when the costs of the other agents of production (e.g. cost of land and cost of construction) have been paid. If a residential building has been over-capitalised and too much money was spent on the initial construction cost there will be no surplus productivity.
Conformity – real property value is created and sustained when the characteristics of a property conform to the demands of the market. It is critical to closely examine the market to determine if the home conforms to today’s market expectations, otherwise the value may be discounted if it is perceived as being ‘too different’.
Externalities – factors external to the property (e.g. the surrounding real estate market) can have either a negative effect or a positive effect on its value. The high profile of sustainability and climate change has positively influenced the perception towards sustainable living.
Incorporating sustainability into the family home (note: both detached and medium-high density) has the potential to achieve a high degree of ‘future proofing’. The main question today is:
‘can I afford to increase the level of sustainability in my home?’
However this is rapidly changing to:
‘can I afford not to increase the level of sustainability in my home?’
If correctly adopted, sustainable features have the ability to slow down depreciation and obsolescence in a home over the long-term to varying degrees. These steps must be planned and can both reduce running costs and increase capital value if undertaken correctly.
Relevance to market value
From a market value perspective there are two definitions of value that are commonly used to value a residential building, namely the market approach and the cost approach. According to the International Valuation Standards Committee (IVSC), ‘market value’ is defined as “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion” . Alternatively, the ‘cost approach’ can be defined as “a set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current cost to construct a reproduction of, or replacement for, the existing structure plus any profit or incentive; deducting depreciation from the total cost; and adding the estimated land value”.
The actual difference in financial amounts between these two approaches identifies to what degree the marketplace acknowledges ‘green’ or ‘sustainable’ residential buildings. Therefore the market uses the cost approach or depreciated replacement cost is based on comparing the cost to develop a new property or substitute property with the same utility as the subject property although it is important to ensure this is commensurate with open market value. Traditionally the cost approach (less depreciation) and the market approach would be generally similar for a new house – the incorporation of varying degrees of sustainability may alter this relationship. For example, based on the definition of market value would a willing buyer be looking for a fully sustainable building and be ‘willing’ to pay (or close to) the full cost of construction? Or will there be a perceived degree of over-capitalisation that the market will recognise and therefore refuse to meet? It is important that both buyers and sellers must remain fully abreast of such changing perceptions in the marketplace. Whist it is still relatively easy to overcapitalise in the construction of a residential home (e.g. stainless steel guttering, black water recycling), an increasing number of sustainable features are being sought after by a growing band of ‘willing buyers’. This clearly has an effect on both the market and cost approaches to determining market value – the gap between the two, if any, needs to be closely and continually monitored in each street, neighbourhood and region.
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