Fidelity International on refurbishing buildings for the future

This article is sponsored by Fidelity International.

Fidelity International has been working with global real estate clients for some years to work out the best opportunities presented by the energy transition in the European real estate space, concluding that the best solution was an approach that targeted climate impact. This is why it has come to the market with its European Real Estate Climate Impact fund, with a mandate to invest in Western European real estate commercial assets that can be refurbished into net-zero carbon spaces.

Adrian Benedict, head of real estate solutions, and portfolio manager Maarten Frouws have witnessed the real estate sector’s progress over the past decade in appreciating that building new, increasingly energy efficient assets is not enough, because over a third of the total carbon footprint of a building is in its construction. Refurbishment is therefore vital.

Why focus on sustainable real estate?

Adrian Benedict: The role of real estate is now being questioned in a way that it has not for a generation. It has always offered two powerful attractions – diversification and a steady income stream. But those attributes no longer seem unique as we witness a significant rise in other alternative asset classes offering similar advantages, most especially private credit and infrastructure.

But after much reflection we concluded if we were able to offer investors a climate impact fund tackling the significant problems in the built environment and solving them, and one which was able to measure and quantify the beneficial financial impact of those improvements to occupiers, then we would have a winning proposition.

Maarten Frouws: In addition, we were persuaded by the fact that the demand for energy efficient buildings has never been higher, and that we would be starting from a very good place in valuation terms. Real estate markets are currently bottoming out, having seen a decline of 25-30 percent in pricing in the value-add space from last year’s peak across Europe.

What are the significant problems in the built environment you refer to?

AB: The built environment contributes something like 35-40 percent of global carbon emissions. But at the individual city level you find that that number is more like 60 or even 70 percent. So, it is not surprising that more national governments, and particularly politicians and local authorities at the city level, are increasingly looking at a way to achieve net-zero goals through changes in the built environment.

We want to be part of that by turning a threat into an opportunity. Our focus is refurbishing existing buildings rather than acquiring new ones that are already green. In other words, we have a brown into green strategy. We think that we can leverage a number of our capabilities that will help clients deliver their net-zero ambitions not by 2050, or 2040, but in the next three to five years.

How will you go about delivering that?

MF: The sweet spot of this strategy is that the vast majority of companies which are looking to rent space have their own net-zero carbon commitments and are therefore determined to occupy energy-efficient properties. The imbalance in a strong demand for green buildings and a shortage of supply is driving a green premium in rents.

We will demonstrate climate impact to our investors in a measurable and quantifiable way in our properties. Our aim is for every asset we purchase to have them on an accelerated pathway to net-zero carbon emissions by 2030 or even sooner, by dramatically improving the energy consumption of buildings through initiatives such as removing gas equipment and improving insulation.

To give one example, we acquired a property close to St Paul’s Cathedral in London that is about 88,000 square feet in size. We will undertake a series of energy efficiency measures and replace the entire mechanical and electrical system.

The results of these initiatives will be quite dramatic. We are targeting a 70-plus percent reduction in primary energy demand, and the building rating in terms of its energy performance certificate is expected to be upgraded from an ‘E’ rating to an ‘A’.

How much do energy savings move the dial?

AB: You have to consider the context to what we are doing. That building was built relatively recently, in 2004, but we must remind ourselves that energy consumption was simply not in the mindset of the building designers, nor indeed of the original occupiers at that time. Energy costs were just so low they were a tiny fraction of the total cost of occupation. No doubt accountants looking at the project would have said ‘why spend extra to achieve energy efficiency?’ when there would have been so little cost saving.

That pricing position is very different now. Rent is probably only 75 percent or even 65 percent of the total cost of occupying a building as energy costs have become larger and larger.

So, if you are able to reduce those by an amount as significant as 70 percent, and also simultaneously carry out other improvements in the quality of the building to make it more attractive, then as an occupier you will be happy to pay a higher rent. It is a win-win for both the occupier and the landlord.

MF: This is borne out by real world examples. Energy consumption typically represents about 30 percent of the total occupancy cost for a logistics property occupier. For example, in a typical Dutch warehouse, a property of about 270,000 square feet, it was about 8.6 KwH per square foot.

After renovation it is about 65 percent less. With current energy prices we can thus substantially reduce the occupier’s energy bill, and in this example, increase the rent by 10 percent, about 50 percent of the total energy savings, and still allow for the occupier to run the operation at a 10 percent lower cost on the total occupancy.

Like-minded talents are all important, of course. It is no good refurbishing a building to make it capable of being operated at net-zero carbon if the occupier you get in is not using it properly.

Given the strength of this investment case, do you expect dramatic capital flows?

AB: Eventually yes. A number of managers are starting to recognize this as a megatrend which is underpinned by regulation that is driving occupiers toward net-zero carbon compliant space across Europe. At the same time, the existing stock of real estate is still woefully inadequate, and far too many landlords have stuck with net-zero targets tied to 2040, or even later.

This has consequences. There is plenty of evidence compiled by real estate brokers to suggest a 25-30 basis points yield premium on green properties. Eventually, this will translate through into valuations.

In the short term, however, there is a considerable amount of education that is required for investors to be able to appreciate that and the scale of the long-term potential here. We are hampered by the current funding environment, and particularly by the so-called ‘denominator effect.’ The fall in traditional asset class values has meant investors are unable to make many, if any, new allocations to real estate.

This will change when investors are convinced that we have reached a turning point in the fight against inflation, and interest rate rises are perceived as coming to an end. Once we see greater stability, this will translate through into significant capital flows, possibly quite soon, in the next six months to a year.

What we also need is a major shift in real estate investors’ mindsets when it comes to visualizing the potential here. It is important not to underestimate the work that needs to be undertaken as an industry to make this shift in perception, but I believe we are getting very close now.

Data transparency is going to be very important. It is vital that we are able to demonstrate to investors our ability to generate higher returns. Our intention is to be very open about costs and benefits, and we believe by doing that we will win the argument. We are at a crossroads in the real estate sector. This is a generational opportunity.

Could occupiers actually welcome higher rents?

AB: Yes! Historically, as an industry, we have been fixated with rent. But the dramatic rise in energy costs has created an awareness amongst occupiers of their total occupation cost calculations. They are willing to tolerate rent increases if they are seeing a reduction in their overall occupancy costs.

We have seen this in Europe already, where cutting energy costs for an occupier has allowed us to charge more in rent, without the overall cost to the occupier growing.

In essence, we are transferring value from the energy companies and putting savings into the pockets of the occupiers and the landlords. This is why it is wrong for some people to suggest that climate impact measures in the built environment are inflationary simply because they mean higher rents.