Dollars and Sense
February 01, 2004
Appeared in Consulting-Specifying Engineer
When it comes to the design of many commercial buildings, a number of owners believe that future capital generated by their buildings will offset increasing operating and maintenance costs. Future anticipated O&M costs are therefore of little concern and are often not included in initial capital cost evaluations. In the cases where such concerns are actually on the development team’s minds, the delivery shifts. The developers believe they can upgrade selected systems later, allowing them to establish low construction budgets in an attempt to profit immediately on an early sale.
But when it comes to technology investments for intelligent building projects, new realities are driving owners and developers to reassess financial budgeting strategies Consequently, many will be faced with the prospect of developing an entirely new approach. This new plan will require a shift in financial commitment to life-cycle budgeting, and even more importantly, a willingness to recognize that any initial up-front investment in building technologies that reduce overall energy use will provide significant future value and return on investment.
What is life-cycle costing?
Life-cycle cost (LCC) procedures are an offshoot of a financial technique known as benefit-cost analysis, which evaluates investments over time by comparing all present and future benefits with present and anticipated future costs. LCC began as a tool to measure the effectiveness of energy conservation measures in federal buildings. Consequently, the U.S. Dept. of Energy’s Federal Energy Management Program (FEMP) established rules and procedures for all federal agencies to follow in evaluating the cost-effectiveness of energy conservation projects in federally owned buildings. These rules are published in the DOE’s Code of Federal Regulations, 10 CFR 436, Subpart A.
Under the sponsorship of FEMP, the National Institute of Standards and Technology (NIST) developed computer software programs that evaluate life-cycle costs for buildings and building systems. For example, NIST’s Building Life-Cycle Cost (BLCC) program is traditionally used in federal building projects.
In addition, the American Society for Testing and Materials has published several standards to measure life-cycle costs, benefit-to-cost ratio and financial payback on investments.
But LCC is very different from the traditional simple payback costing method that is often used in construction and which primarily aims to determine how quickly an initial investment can be recovered. This method usually ignores all costs and savings realized after payback is reached. In addition, simple payback does not compare different energy conservation measures with associated operating costs. It also ignores anticipated energy savings resulting from intelligent building design, as well as the time value of money against an initial cost investment. As a result, this method should not be used when long-term profitability is sought.
The intelligent building concept was developed in the early 1980s as a way to offer enhanced building services in a competitive real estate market, based upon tenant demands and expectations. An intelligent building can be defined as a building that is capable of providing flexible building systems that supply greater telecommunications capabilities, environmental comfort, security and safety, while allowing owners and developers to profit financially from reduced energy consumption and operating and maintenance costs.
Despite these benefits, simple payback costing remains dominant because owners and developers usually establish construction costs based on available capital. Because there is often insufficient capital to build the desired intelligent building, new projects are constructed to conserve energy at the lowest initial capital cost, and energy conservation is viewed as secondary to initial capital cost.
LCC, on the other hand, financially measures the net present value of owning, operating, repairing and maintaining a building against its future value over an extended period of time. When applied to intelligent building design, LCC provides a means for the teams designing these buildings to evaluate multiple measures that will achieve energy conservation, occupant comfort and safety within the economic constraints often found in construction projects.
The right credentials and information
A primary step for consulting engineers to convince potential clients to invest in intelligent, LCC-driven buildings is to first show the owner that they are the right company for the job. The design team should have specializations in science and technology, lighting, energy, security, life safety and sustainable design. The firm should be familiar with the coordinated effort required to provide a “holistic” approach. The engineering team should also value the importance of designing building systems that interact seamlessly, while mutually sharing resources. As a general rule, in order to promote energy efficiency and conservation, the design must be treated as a unified whole rather than as a series of single elements.
Ultimately, selecting energy-efficient equipment—choosing the proper chiller, correctly sizing the cooling or specifying the right lighting control system—will directly impact life-cycle cost projections.
Once credentials have been established, it’s then the firm’s obligation to deliver numbers that mean something to the owner. Early in the design process, the consulting firm should present multiple energy saving options, along with how they individually and collectively impact LCC. It’s also here where engineers should refer to studies that have proved that energy-saving measures are more difficult to add later. The team also needs to clearly emphasize that the benefits of LCC can be quickly diminished if specified systems fall victim to value engineering or if equipment substitutions are enacted during construction. Both can have an unfortunate negative effect on intelligent building life-cycle costs.
Delivering the numbers
For the design professional who is seeking to effectively design intelligent buildings, and pitch them to owners using an LCC analysis, the following steps should be followed:
- Estimate capital costs. Determine total capital cost expenditures, not
including operating funds. Capital costs include the initial investment
and any capital
replacements. This also covers all costs necessary to complete the project,
including design and construction fees, which must comply with capital
amortization accounting rules.
- Estimate capital equipment replacement (retrofit projects only). For
each major system that will need to be replaced or upgraded, determine the
cost of replacement, including materials and labor, in present dollar value.
Determine the time duration—in years—when the replacement will
- Estimate projected annual operating expenses. Estimate ongoing operations
and maintenance expenses. These include utility costs such as for electricity,
steam and gas. In addition, estimate shared utilities expenses, service
management fees, insurance and other miscellaneous annual expenses.
- Estimate time value of money invested. This involves the estimated calculation of the following financial items:
- Duration of analysis period. Determine the projected number of years a life-cycle cost analysis will cover.
- Market capitalization rate. Use current capitalization rate tables for similar projects. This is the rate that indicates the expected annual return on investment and is used to determine the value of real property through the capitalization process in which project income before debt service is divided by the capitalization rate.
- Discount rate. Use the discount formulas printed in the annual supplement to NIST’s Energy Price Indices and Discount Factors For Life-Cycle Cost Analysis to determine the discount rate of interest, reflecting the investor’s time value of money. Discount rates reflect the time value of money, apart from changes in the purchasing power of the dollar, and are used to discount constant dollar cash flows. Nominal discount rates do include changes in the purchasing power of the dollar and are also used to discount current dollar cash flows. • Loan rate. If the project is being financed, determine the loan interest rate.
- Loan term. Determine the number of years over which the loan is scheduled to be repaid.
- Loan to value. Determine the loan-to-value rate. This ratio, expressed as a percentage, is the total amount financed at the beginning of the loan period, divided by the project value. The project value for owners is the loan amount, divided by the construction cost. Project value for the developers will be the anticipated project income before debt service divided by the capitalization rate.
- Energy inflation rates. Consult NIST’s supplement, as referenced above, to determine energy inflation rates
- Estimate income from tenant lease. For each tenant, determine the cost
per sq. ft. Then, calculate annual lease income from each tenant. Finally,
determine the average vacancy rate by dividing the total unleased area by
the gross floor area. Using all the information above, the present value
cash flows over the period of the financial analysis will determine the net
savings, or losses, from one or several energy conservation applications,
also known as the life-cycle cost.
- Compare life-cycle costs. The final step involves repeating steps 1 through 5 to compare life-cycle costs for various design options.
Making smart decisions
Traditionally, technology investments in construction projects are decided upon and primarily viewed as an expense issue because the sole emphasis is on initial capital costs. Recognizing that intelligent building technologies inherently save money and add value throughout the life of a building, technology investment decisions must be made on the basis of a cost-benefit formula. A life-cycle cost model provides both a rational and viable way of quantifying true return on investment for long-term financial investors in intelligent buildings.