Fidelity International: Value-add goes green

This article is sponsored by Fidelity International.

Repositioning buildings to make them more sustainable and, ultimately, increase their value is, more than ever, an opportunity for investors looking to deploy capital through value-add, core-plus strategies, says Maarten Frouws, investment manager at Fidelity International.

What impact has the economic climate had on your approach to value creation?

The environment is obviously challenging. Last year saw multiple crises, with Ukraine followed by the energy crisis, the high inflation environment and subsequent interest rate hikes. Private markets are usually slow to adjust, but we have already seen a remarkable repricing of real estate in Europe, faster even than during the 2008 global financial crisis. It’s a challenging time but one that provides opportunities too, particularly around value-creation strategies.

Meanwhile, higher energy costs have increased awareness about the need for the energy transition. Beyond the environmental need, there is now also a financial incentive to improve the energy efficiency of the built environment for occupiers as well as investors.

Is the repositioning of assets still a fruitful strategy, then, despite the higher cost of finance?

The rapid repricing that we have seen in the market – as high as 20 to 30 percent in only six to nine months – is unusual for real estate markets, and this is really helping the case for repositioning. On the one hand, we can create a real saving because of those high energy prices. But mainly, the impact of higher rates and the higher cost of physical and other improvements is being offset by the extent of the repricing we have been seeing.

We should see a fundamental strengthening of terms in 2023 and a period of more rational pricing, creating potential for more differentiated returns between sectors, property types and locations. With markets bottoming out, it’s going to be an interesting and, we think, rewarding time for value-add, core-plus strategies for those with long-term capital to deploy. This is a time when experience of investing through multiple cycles really counts.

When it comes to value creation, is ESG still one of the main areas of focus?

Absolutely. Sustainability and energy efficiency is the biggest differentiator between buildings, and more important than ever right now with high energy costs and evolving regulations ramping up sustainable standards. It’s a risk but it’s also an opportunity. Some buildings will become stranded as landlords will no longer be able to lease them unless they meet minimum standards. Whether or not you believe in a so-called ‘green premium’ for ESG-friendly real estate, you really want to get ahead of the changes. If you get left behind or do nothing, you will definitely face a ‘brown discount’.

Currently, we see a big supply/demand mismatch: there is a strong demand for properties that meet sustainable standards, but there is a very limited supply of properties with the strongest ESG credentials. In Europe, less than 20 percent of existing real estate stock meets net-zero targets. You cannot just focus on new build to decarbonize, especially since over 95 percent of the real estate market is already built. You really need to focus on the existing stock and make sure that you look at refurbishment.

“This is a time when experience of investing through multiple cycles really counts”

Fidelity research shows that much of today’s stock is still fit for purpose and will be for many years to come. But if we are to meet the climate goals it needs to become more operationally efficient. On top of that, refurbishment emits about 50-75 percent less carbon than new build, whereas with new build you introduce a lot of embodied carbon to the built environment. Carbon dioxide emitted from materials like steel, concrete and glass makes up roughly a third of the life-cycle emissions of a building, on average.

Unlike other sectors of the economy, we already have the technology that is needed to make this transition happen. We just need the capital. We believe this adds up to an investment opportunity that is not only beneficial for today’s investors but, potentially, for future generations as well.

Could you give an example of a refurbishment you have done to improve a building’s ESG credentials?

We recently refurbished an office building in a very strong sub-market in Paris, Boulogne-Billancourt. We bought the asset a while back and then, in the middle of the pandemic, the existing tenant gave notice on the lease. It was in October 2020, and we decided to launch a refurbishment at risk with a substantial focus on ESG. Even though it was a very good asset, developed relatively recently in 2005, we decided to run a capex program that would significantly improve the energy efficiency of the asset. This included removing the asset from the gas grid, installing a heat pump on the roof, and re-lamping to LED lighting. The net result was a substantial energy reduction for the property.

We started the capex program, which lasted about 12 months, on the day the tenant left. In parallel we started the marketing process. The profile of the asset, with high ESG credentials, really appealed to tenants. Within three months or so, our team on the ground had multiple interested potential tenants lined up. And, well before completion of the work, we were able to sign a lease at a rent level which was above the quoted market rent, as the improvements we had made to energy efficiency meant a lower total cost of property for the tenant that was going to occupy this building. This is a clear example that demand for assets with strong ESG credentials is very high, and you can make a real success out of it.

How have you found engagement with your tenants to find ‘green’ solutions as part of your active management?

We are engaging with our tenants across the board to improve ESG credentials for assets we have under management. Again, the rising energy cost is really helping because of the awareness it generates with our tenants. We see more and more tenants signing up to net-zero carbon commitments themselves, which is great because it was typically us asking tenants to co-operate to improve the use of the buildings. On occasion, tenants now come to us asking for help to improve the properties they occupy. And this ranges from ways to use the property to looking at physical solutions like applying solar panels or re-lamping to LED lighting.

“Sustainability and energy efficiency is the biggest differentiator between buildings, and more important than ever right now”

A good example is a healthcare operator that, when we acquired the asset, was not very keen on ESG and did not really see the need for improvements. But we engaged with them, and works are ongoing now to improve both the EPC and other ESG ratings of their asset. And what helped to convince them in the end was the combination of these meetings, where we explained the situation and set out the business case, and regulatory changes which were actually happening. Now, these ESG improvements have gone further than we thought this tenant would be willing to go to.

What role does data play in the value-creation process?

Data is key. We have always been extremely data-driven at Fidelity, putting a considerable emphasis on the range of data, as well as the quality and the timeliness of data analytics across the lifecycle of each investment. And, particularly important when it comes to sustainability, there is a broad set of quantifiable metrics that you can measure.

But first you need to establish a baseline, otherwise you do not know what you are working from. You need a baseline to create a pathway, and then improve efficiencies through refurbishment and the use of the building or just through building maintenance during your holding period. We use science-based targets to help in the process. We apply tools like GRESB, BREEAM and decarbonization pathways set by CRREM.

Technology is helping us significantly with real-time measuring of emissions in a building. Automatic metering, for instance, is very helpful. And this also helps with conversations with our tenants, as it can really bring to life what is happening in their property, creating awareness and making sure that buildings are properly used. Better information really helps us manage our risk effectively and provide transparency to our investors. It is also a very powerful tool when working or negotiating with our tenants.

It is clear tenants are demanding ‘green’ buildings. Do you also expect to see increasing focus on the total cost of occupancy in this environment?

We are already starting to see this, especially given the sharp increase in energy costs. Typically, we have seen tenants pretty much focused on rents only. But since, depending on location and asset type, 25 percent or more of occupancy costs were energy related even before the recent spike in pricing, improving energy efficiency and utilizing any potential for onsite energy generation can translate into major savings for occupiers. In turn, this supports a rental premium for the properties or, at minimum, avoiding a brown discount.