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Think 'Sustainable' as Commercial Real Estate Heats Up

Chat Reynders

While the past four years have been marked by a consistent lag in the commercial real estate sector, we are beginning to see what looks like a sustainable recovery. The steady depreciation, partly caused by cross-sector economic woes, has kept pricing down, while at the same time, a burst of growth has companies seeking new or expanded homes.

While many will attempt to play the trend through financing options or through asset purchases, at our firm, my partner Patrick McVeigh and I believe real estate infrastructure investments focused on energy and carbon efficiency represent a better, less obvious, and more powerful growth opportunity. There are two main rationales guiding this direction:

  • Sustainability has become a driving factor in development as buildings represent one of the highest contributions to carbon emissions. Indeed, Deloitte noted in a March report that "by 2015, an estimated 40% to 48%of new non-residential construction by value will embed sustainable building practices (e.g., USGBC LEED). In addition, the sustainable construction portion of the largest non-residential retrofit and renovation activity will more than triple, growing to 25% to 33% of the activity by value."

With CRE (commercial real estate) leaders focused on blazing a trail to more sustainable practices, infrastructure providers may experience an influx of demand.

  • My firm has also completed an analysis using data from the US Bureau of Economic Analysis (BEA) that shows investment in non-residential structures is at historically low levels vs. the depreciation taken on non-residential structures (see chart below). This suggests that there is a great deal of pent-up need for updates in commercial real estate. When combined with sustainability imperatives, this creates a dynamic demand catalyst for everything from new HVAC systems to lighting, wiring, and other smart building technologies.

Many of the companies that interest us in this space are trading at historically low P/Es. Johnson Controls (JCI), for example, has growth opportunities in a number of operating segments, including CRE efficiency. The company participated in a 2011 energy efficiency project for the Empire State Building, which resulted in a 20% reduction in energy consumption since the changes. The building is expected to save enough to pay for the energy retrofit in three years.

Johnson Controls faces near-term pressures as the European economy leads to restructuring charges. However, we believe that there are opportunities in fiscal 2013. The building efficiency segment should benefit from continued retrofitting. Additionally, Asia's commercial construction market is projected to increase by 5% this year; offsetting a flat construction environment in mature markets (emerging markets represent 25% of sales in the building efficiency segment).

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United Technologies (UTX) also stands to benefit from activity in the sector, especially through Carrier, its Climate, Controls, and Security arm. Carrier accounts for 31% of overall revenue and 31% of overall profit, and has maintained its standing as the world's largest provider of HVAC systems designed for both residential and commercial applications. The Carrier operations also provide transportation refrigeration solutions; such as those used in the food industry. Fire & Security operations provide products such as intruder alarms, access control systems, and video surveillance systems.

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United Technologies has a range of energy-efficient offerings that could remain in demand due to the cost savings associated with lowering energy consumption. For instance, United Technologies says its new home heating and cooling unit "delivers up to 69% higher heating efficiency than any ducted, air-source heat pump on the market."

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Encore Wire (WIRE) is another promising play in the space. The company manufactures wire for interior electrical wiring in commercial/industrial buildings and residential housing. Because sales of electrical wire and cable products track construction and remodeling activity, Encore Wire stands to benefit if commercial construction recovers from historically low levels.

Encore Wire has encountered little competition from foreign imports of cheap building wire, which it attributes to the low percentage of labor costs involved in wire manufacturing and the high freight costs to import wire. Adding to its appeal, Encore Wire has straightforward operations and was named one of Forbes' "100 most transparent & trustworthy businesses."

All of the specific securities identified in this article are current recommendations of Reynders, McVeigh Capital Management, LLC ("RMCM") on behalf of its advisory clients. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for RMCM's advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. Past performance is no guarantee of future results.

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