Valuation of "Smart Buildings"

May 2018

An increasing number of houses are being built that can be defined as "smart". There are many definitions of "smart buildings" ranging from buildings with low energy consumption to buildings that have a large number of sensors built-in that can measure parameters such as temperature, air quality and safety. In addition to lower operating costs due to lowered energy costs, "smart buildings" are expected to reduce operating costs overall by making the building management more efficient. The question is, what this means for the valuation of the "smart building".

A valuation of a property can be done with many different purposes. The value can reflect a property value based on a business-economic perspective, but it can also reflect a value from a socio-economic perspective. The former refers to a value that investors, owners, borrowers and / or lenders can relate to, and the latter refers to a value that society in general may be more interested in. A socio-economic value differs from a business value if there are market failures that are not included in prices and rents or costs.

Here, the principle discussion about how the value of the property may be influenced, is based on the direct yield method. Simplified, it is assumed that the value of the property is equal to the gross rent minus operating cost (net operating income) divided by a yield.
Net operating income consists partly of gross rent and operating costs. The rent can be derived from the rental market and is determined by the demand and supply of space. Demand can be said to reflect how much the tenant is willing to pay for surface and is determined by the productivity that the surface can generate, how flexible the surface is, what features it has and the ability to save energy as well as health aspects in the building. In addition, there is also a goodwill value that the tenant may have a willingness to pay for. In the case of "smart buildings", there may be a higher willingness to pay for all of these components compared with conventional buildings. Everything else equal, higher rent leads to higher market value.

Operating costs will also be affected in "smart buildings". Lower energy costs lead to lower operating costs, but maintenance costs may decrease in "smart buildings" compared to conventional buildings. The management of the building becomes more effective, as sensors can identify problems early and thereby reduce the cost of action. In total, this means that the value of the property will be higher as both operating and maintenance costs are lower. Higher operating net assets will be reflected in higher real estate values for "smart buildings" compared to conventional buildings.

However, the value of the property is determined not only by annual operating net, but also the net capitalization factor affects the value. The net capitalization factor is equal to the reversal of the yield, which in turn can be divided into the risk-free interest and risk premium components as well as the expected growth rate. Higher interest rates and risk premiums raise the yield, which reduces the net capitalization factor, resulting in lower expected real estate values. Higher growth rates, on the other hand, lead to lower yields (and higher net capitalization factors), which gives higher expected real estate values all the same.

Risk premium in this context refers to investors' perceptions and preferences for the risk of "smart buildings" in relation to non-smart conventional buildings. The risk can be derived from both the rental market and the asset market. The question to be asked is how risky it is to invest in "smart buildings". If investors find that there is a higher risk, one will require a higher direct yield, which means a lower valuation. The risk premium also depends on the property segment. Office properties have a normal higher risk than residential properties. "Smart buildings" are more technically complex, which can increase the risk of operating the property. A risk component that should not be underestimated. On the basis of a demand perspective, the risk of this type of building could be considered lower as demand for this type of building will increase over time. This would mean that it is risky not to build smart buildings. More traditional construction will then be more risky as society as a whole goes towards more service production. If the building can not answer up to the future demand from users and property owners, the risk premium for these buildings will increase.

The growth component in the direct yield refers to growth expectations in cash flow from "smart buildings" and can be derived from the rental market. How much can net operating income be expected to grow in the next few years? Higher growth expectations allow lower yields, as investors are willing to pay more for today's net operating income.

My assessment is that "smart buildings" should be valued higher both based on higher operating net (higher rents and lower management costs) and lower yield requirements (lower risk premium and higher growth). There are some research studies that support this assessment. Empirical research has shown, for example, a value premium of about 18 percent and a rent premium of approximately 11 percent for "green buildings" (which can be seen as a subset of "smart buildings"). Probably, the valuation will be higher for "smart buildings" than for "green buildings only". The fact that the value increase is higher than the increase in rental indicates that not only operating income is affected but also investors’ assessment of risk and growth.

The social value of "smart buildings" may be higher than the pure business value, as there may be a number of market failures in the rental market. These include, for example, the existence of negative external effects and elements of natural monopoly and collective goods. This may mean there may be grounds for the public to intervene on the market through regulations, taxes or contributions. However, calculating the social values of "smart buildings" is difficult as the knowledge situation is limited. Significant research is being done on smart cities, energy systems and digitization. However, more research is needed about the socio-economic benefits in terms of the added value that emerges when smart buildings are linked to smart cities.