IREI: Sustainable real estate the only option if you want your investments to last

22/02/2022

Whether you were persuaded by extreme weather conditions, the data to emerge from COP 26, or David Attenborough’s dulcet tones, there can and should be nobody in any doubt about the importance of carbon emissions, climate change and, to be frank, the future of the planet. There is certainly evidence that financial markets have taken note; according to BloombergNEF, the global issuances of sustainable debt including green bonds and sustainability-linked loans spiked 78% in 2019 to $465 billion, while recent estimates suggest that ESG assets rose by nearly a third between 2016 and 2020 to $35 trillion, according to the Bank for International Settlements (BIS). As frameworks for implementing and understanding appropriate ESG measures become ever more formalised and widely adopted, it is increasingly clear that green is the new black.

For those of us in property, this is not a moment too soon – real estate has one of the highest carbon footprints going, contributing over 30% of global annual greenhouse gas (GHG) emissions and consuming around 40% of the world’s energy, according to the UN Environmental Programme. Decarbonising the real estate sector is vital to reach net-zero emission targets by 2050, and there needs to be as big a focus on embodied carbon and the construction process as there is on operational emissions.

However, some have started to voice concerns that the boom in green assets is now forming a bubble to rival those that led to the dotcom and sub-prime mortgage crashes. Indeed, the BIS has noted that the scale of growth in ESG funds is “comparable [with] the private label mortgage-backed securities” before the 2008 financial crisis. Meanwhile, within a week of COP 26, a group of banks and asset managers, led by HSBC, had already started lobbying to dilute the targets for the banking industry to wind down the financing of polluting businesses. More generally, the risk of ‘greenwashing’ rhetoric means that additional scrutiny and scepticism has firmly entered the conversation when it comes to sustainable investments.

Does this mean investors are set to back-pedal on their enthusiasm for green assets when it comes to real estate? In my view, the short answer is no, and the longer answer is a no with more ‘o’s – even if you were to cast aside your civic and personal responsibility, going green with your real estate portfolio is the only thing to do if the asset class is going to retain its appeal with institutional investors.

If we go back to the basics of why investors like real estate, particularly in times of uncertainty, then the rationale for green real estate becomes clear. We all know that institutional investors like real estate for the role it can play in diversifying a portfolio, thanks to its low correlation to other assets, as well as the fact that it can offer an appealing income and yield opportunity. Not to mention that one of the most important reasons it remains popular with investors in tumultuous times is that real estate values are generally tied to GDP — when the economy grows, demand for real estate tends to follow. Property, whilst not a true inflation hedge, does provide cash flows with index-linked attributes and a degree of inflation protection – this allows rents and sale prices to keep pace with inflation, maintaining the buying power of the invested capital and helping to preserve wealth.

However, for this to remain true – assets need to retain or improve their value, and this is determined by their ability to produce income.

If we think about this in the context of green buildings, the proof of a correlative relationship between a high Energy Performance Certificate (EPC) rating and the level and duration of a building’s income is already there. A recent report by Avison Young, Ten Trends for a Zero Carbon World, stated that since 2016, the average lease signed on EPC grade A and B properties is 20% longer than the average lease length for grade F and G, while the rental premium for those high-grade offices has increased to 165%, up from 38% prior to 2015. From an occupier perspective, being energy efficient can reduce operating costs and, as more and more companies are either obliged or are choosing to report their ESG performance, the large impact that real estate can have on any organisation’s carbon footprint means that property is often a first port of call in a corporate sustainability strategy.

This preference is already making itself known in the London office market and data from Cushman & Wakefield paints a telling picture – just 30.1% of space under offer was new or refurbished at the end of Q4 2008, compared to 71.2% at the end of Q2 2021. On the one hand, this is all common sense – ‘better’ buildings produce better income. However, this is set to change, and the driving force in this conversation is going to move away from achieving this ‘green premium’, and instead focus on avoiding a ‘brown discount’.

Let us not forget that, at its heart, the valuation for a real estate asset is fundamentally based on two key considerations – the amount that an occupier will pay for the space and the amount that an investor will pay to access that income. So, what happens if your assets cannot achieve an attractive rent or, indeed, any rent at all? From as early as 2023, this might be the case for a tenth of London’s office stock alone, according to a report by Colliers. Minimum Energy Efficiency Standards (MEES) for commercial properties will be expanded in 2023, meaning that buildings with an EPC rating lower than E will not be able to be leased. However, that is just the beginning of the end for outdated stock as, by 2030, the minimum EPC rating will move to a B. This is without considering the fact that the regulations and criteria for these grades are not set in stone – what qualifies for the B standard now may only leave you with a C-grade asset in the coming years. If the asset becomes unlettable entirely, then clearly its valuation will plummet.

Even without this forthcoming regulation, there is already evidence of occupiers choosing office space that can attract and retain ESG-minded talent – SEC Newgate’s ESG Monitor recently reported that the environment is the issue that people are concerned about the most, with more than half saying they are highly focused on it. And they are likely to be even more focussed on it with the introduction of new sustainability-driven regulations. For instance, in Bristol, a popular regional office market in the south west, thousands of motorists face being charged more than £400 a year to park at work under proposals to cut air pollution and make car use less affordable – a step Nottingham took back in 2012 – and similar plans are being considered in Oxford, Leicester, Glasgow and Edinburgh. This means offices will need to have best-in-class facilities to ensure air quality and facilitate active commuting.

This means we have a real opportunity to be innovative in the product that we bring to the market. We know that offices will need impressive green credentials to meet changing expectations around sustainability and ESG, reside among the right neighbours, and be supportive of employee wellbeing and lifestyles. To this end, we are ensuring our pipeline of office developments will be futureproof in their ability to attract leading tenants. This means we incorporated leading certifications such as LEED Platinum and WiredScore in the development and construction stage for an asset like Diagrame, an office development in Barcelona. As a result and alongside our joint venture partner, Cain International, we were able to secure its forward sale to a German Institutional Investorin 2020, despite the uncertainty around the office market more broadly at that time. Similarly, our plans to ensure the MILE 22@ Business Campus is LEED Platinum meant it achieved the largest letting to a private business in Barcelona in 25 years. Meanwhile, in Germany, we are realising an opportunity to deliver 80,000 sq m of future- proof office space in Munich – a city that is characterised by low vacancies and stable rental prices – alongside Cain International. The Koryfeum development will target leading ESG certifications, including DGNB Gold and WiredScore and provide flexible floorspace – reducing the cost of refitting and reconfiguring space in the future – and offer tenants a range of campus amenities, including restaurants, sports and recreational facilities, all in a green environment. In Berlin, not only are we targeting DGNB Platinum for Seydelstraße 14, but we are also seeking sustainable financing in line with Green Loan Principles so that the entire process is as ESG- compliant as possible.

Between the expansion of MEES and the number of businesses signing The Climate Pledge, some assets are at serious risk of losing their value if they are not subject to asset management that will make them fit for future occupancy and investment. Going green is not just the right thing to do, it is the only thing to do.