Whats in a Guarantee? 3rd Party Ownership: Success or Failure is based on this one word
by: jon mesquita, mba - diverso energy
“How do I know it’s going to work?” This is a question I hear regularly from developers regarding geothermal heating and cooling, as well as the third-party ownership model. Due to limited experience with the technology, developers are skeptical – and rightly so – that these pipes buried in the ground will provide sufficient energy to heat and cool the building. The concerns are valid, but are fully addressed through the performance guarantee, which if executed properly, shifts the financial, technical and legal responsibility of the performance of the borefield fully to the third-party provider.
The reality is that as we move away from using fossil fuels to heat our buildings, using low-carbon technologies like geothermal represent increased cost, complexity and risk for the developer, the design team and construction team. Third party ownership models serve as a great solution to address these concerns. Condo developers are able to reduce their construction costs and risk as the third-party owner absorbs both of these. In rentals, although access to capital is often not an issue, the risk of experimenting with new technology can very quickly put the project in jeopardy; delays during construction or the system failing during operation are both major risks that are ever present and far outweigh the cost of capital. Peter Drucker, a renowned management consultant said it best… “Do what you do best, and outsource the rest”. 3rd party owners have skin in the game, which any real estate developer will tell you is a key ingredient to a successful partnership and alignment of interests.
Despite this seemingly obvious solution, developers are still hesitant as they are naturally risk averse. This is where the third-party ownership model provides the real value, with a clear and specific performance guarantee. Contractually committed operating parameters provide the owner with the confidence that the heating and cooling needs of the building will be met. Without that performance guarantee, all of the benefits cited previously disappear and you’re left with nothing more than a fancy equipment lease. There is no real commitment or accountability, which puts the whole project at risk. A good performance guarantee will list exactly what the owner can expect, right down to the exact peak heating and cooling loads, as well as total annual loads over the course of an entire year. This is what the mechanical engineer will require to design the building mechanical system and ensure it can adequately heat and cool the building.
Third-party models resonate with developers for this reason. They recognize that if the third-party owner doesn’t meet these stringent requirements, they are no longer required to pay. With millions of dollars invested in each project, the only way they can recapture their investment is if the system works flawlessly, so there is tremendous accountability and pressure on the third-party owner to deliver. As you can imagine, only firms with a long history of developing and operating successful projects are able to confidently deliver. Financial entities who are long term focused (e.g. pension funds) will only partner with firms who have this history and after significant due diligence, trust that their investment is “investment grade” and protected by the capabilities of these firms.
Third party ownership models for commercial development truly offer a true win-win solution if structured properly. In many ways the third-party could be viewed as an equity partner in the project, having invested capital upfront and their return tied to the success of the project. However, without a specific performance guarantee, the developer is robbed of these benefits and the arrangement mirrors that of a design build contract with little or nothing to hold them accountable if the system fails to perform.