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NAREIM Dialogues: Fall 2016

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NAREIM DIALOGUES FALL 2016 5 Electrification is perhaps the greatest technological advancement of the 20th century. The electric power grid, the system that delivers electrification, is considered by many to be the largest and most successful machine ever built. But it may be about to die. The Rise of Cheap Solar Power THE UTILITY DEATH SPIRAL The U.S. utility industry spends roughly $95 billion per year upgrading and maintaining the grid. Many observers suggest this is far too little to maintain an effective system and at some point the level of investment will need to increase substantially to maintain service levels. Despite that massive, and potentially increasing, investment retail prices remain low due in part to the huge number of customers served. Utilities can amortize costs across so many customers because essentially every single consumer and business is a customer. Not a bad business model! But what if some of those customers start to find a better deal somewhere else? Customers fleeing the grid could lead to what industry observers call the utility death spiral. Here's how the death spiral works. Solar and energy efficiency technologies become so cheap that power users with the most expensive prices will be economically better off to cut ties with the grid and generate their own power. As those utility customers defect, the cost of maintaining the grid must be absorbed by fewer remaining customers so electricity prices rise to compensate. Meanwhile, solar costs have continued to decline. Now the next group of electricity users find it economic to defect leaving even fewer customers to pay for the grid so prices rise again. This continues until utilities are left with the worst customers and are forced into bankruptcy as they can no longer afford to maintain a massive portfolio of stranded assets. The Edison Electric Institute (EEI), a utility trade group, said in a 2013 report that "the longer- term threat of fully exiting from the grid (or customers solely using the electric grid for backup purposes) raises the potential for irreparable damages to revenues and growth prospects." Other forces are also working against utilities. Investment continues to pour into energy efficiency technologies such as intelligent HVAC optimization software and LED lighting. This is leading utility industry revenues to fall as a percent of GDP. The EEI described the march of energy efficiency as "a meaningful impact on utility load…that will create significant additional lost revenue." As with grid defections, this will lead to increases in per unit electricity costs which will make efficiency upgrades that much more attractive. Other technologies that may enable large scale grid defections are improving at rates similar to solar. Battery storage is a key example. Just a few years ago lithium ion batteries were deemed impossibly expensive for large scale energy storage. But batteries are gadgets and the price of gadgets tends to go down fast; batteries have plunged in price, and are being deployed for large scale energy storage at a rate more than 100x greater than just two years ago. Finally, the U.S. is likely to begin exporting large volumes of natural gas which could lead to large price increases in the most important input for electricity generation. IMPACT ON REAL ESTATE What does this mean for the real estate industry? The first takeaway is that there is a big opportunity available to increase NOI due to the maturity of various technologies. Is it profitable for many buildings to install solar today? Yes. Are there NPV positive (and under 3-year payback) projects in energy efficiency software, batteries, demand response, variable speed chillers, LEDs and the like in your portfolio today? In greater than 80% of the buildings in North America the answer is a resounding "yes." But what about the utility death spiral? What do you need to do about that? First, keep in mind that with new technology the world seems to change only very slowly or not at all until suddenly it's clear that nothing will ever be the same again. Think of television, smartphones, laptops, automobiles, email, nuclear power, air travel…and of course the electric grid. That's happening now with energy. Will you be prepared for a world of suddenly spiraling energy prices? What will happen if several major utilities declare bankruptcy? What if your competitors are completely insulated from energy cost increases? What if the best tenants all demand backup energy under any conditions and an ENERGY STAR score of 90 to boot? On topics such as these, I can only assure you of one thing: expect change, and a lot of it.

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