Fidelity on delivering ‘the green premium’

Adrian Benedict discusses how the ability to capture a green premium will see European investors through any current difficulties, which are just a ‘transition phase’.

This article is sponsored by Fidelity International

Fidelity has long worked with portfolio companies to improve ESG standards and is escalating its efforts in the current environment. It recently moved its own net-zero operational emissions goal forward by a decade to 2030, by meaningfully reducing its carbon footprint rather than simply relying on carbon offsetting.

In selecting investments, the firm seeks to anticipate how global themes such as climate change, water scarcity and the transition to a circular economy may impact business models. Adrian Benedict, the head of real estate solutions at Fidelity International, says this increases opportunities in an uncertain investment climate.

How is the current market affecting real estate investment?

Adrian Benedict

The current environment of rising interest rates and squeezed liquidity is intimidating for many investors, but not for those of us who have seen multiple cycles.

In recent years, a lot of portfolios did surprisingly well simply because of the abundance of capital. I expect us to see a return to value and consistency and this is a good environment for investors who have a clear idea of what real value looks like. As such, this is a highly opportunistic environment, not in the sense of more high-risk, opportunistic real estate environments – although there may be opportunities there – but in that there is much more investors can do in the core value-added space.

This is particularly the case in the area of sustainable real estate investment. Investors increasingly see the opportunity to capture a green premium, thanks to a radical change in perception. This current environment is just a transition period.

What changes in perception have you seen?

There has been a realization across the sector that our own contribution to emissions is so significant that we simply have to take action. The built environment contributes 27 percent of global emissions with construction and materials adding another 20 percent.

At an individual city level, it appears even worse. Some recent studies suggest we can be responsible for something like 60 to 70 percent of emissions. The opportunity now is establishing how we can make a real significant contribution to reducing that number.

Everyone is talking about net-zero targets for the industry, generally to be hit in 2040 or 2050 in most cases. We are trying to move even faster. While many are targeting a reduction of 30 percent in emissions, we are targeting a much more aggressive reduction, in the region of 50 to 60 percent.

In this regard, working closely with your occupiers is vital for achieving success. This will become even more urgent as companies move towards Scope 3 compliance. We are still a long way from having the technology necessary to fully understand the implications, but what we can do is talk to tenants and measure what is happening in a building.

In the future we will also look at occupiers’ emissions as they come and go and bring proximity to public transport into our considerations when assessing a new development.
The other major change has been a proper understanding of physical climate risk.

Obviously, we are investing in assets which you simply cannot move and this means location risk is “locked down.” Real estate investors have worried about flood risk for years, but now we are worrying about unseasonal weather temperature variations and climatic disaster events.

We have seen a much greater appreciation of the impact of climate change on this individual location risk and it is not surprising that we are seeing a number of businesses looking at new ways to assess it. We work closely with them to leverage their analysis and to see what we can do to better construct portfolios in the future which are less risky.

Fortunately, we are able to make assessments with a much more granular level of detail. It used to be the case that in looking at a location the ‘resolution’ was accurate to just one kilometer. Now it is closer to 10 square meters. This is enabling us to have pinpoint accuracy in our predictions.

Going forward, physical climate risk will be a core part of the real estate decision making process.

What would be a real-world example of the green premium?

There are many. In Paris, we had a building that was 16 to 17 years old and suffering reduced tenant demand. Occupancy was less than 60 percent. With capital expenditure that represented only 9 percent of the property’s value, we were able to upgrade the building and find an ideal tenant who welcomed the new look building’s contribution to their own net-zero plans. The building is only 10,000 square meters but it effectively became their corporate headquarters.

In terms of rental, we have seen a 10 percent uplift and the valuation has gone from something like €70 million to €100 million. This is the opportunity we are talking about.

Is a greater appreciation of embodied carbon another important change? Where does that lead the industry?

It absolutely is. Taking this into consideration will lead real estate investors to radically change their calculations on new build. With our present construction techniques, it is simply impossible to build new developments without major emissions.

This has led us to prioritize refurbishment of existing buildings and to demonstrate that they can still be economically viable with a substantially reduced carbon footprint. Refurbishing existing developments can often mean something like a third of the carbon footprint of building a new development.

There is clearly a massive refurbishment that must be undertaken. In Europe, less than 20 percent of the existing real estate stock meets the demands of net-zero targets. Of course, this means there is a sizable opportunity.

With relatively modest capital expenditure of something like 10 to 30 percent of the value of a building you can get very significant improvements in valuation. This is the iconic green premium.

With energy prices rising in the way they have done recently, your ability to do so is even easier. The cost of refurbishment can also be fairly modest, as the only element that actually needs to be replaced is electrical machinery. You do not need to upgrade the fabric of the building just to improve its energy efficiency. A lot of buildings which would appear to be high up the risk curve, can in fact deliver outsize returns with relatively modest refurbishment.

“In Europe, less than 20 percent of the existing real estate stock meets the demands of net-zero targets”

This is another reason to be particularly excited about the next few years and why we are directing significant capital into this segment of the market. There is a mismatch between what occupiers increasingly demand and what the listing stock offers.

While a green premium is achievable for investors, can they also avoid the danger of ‘brown discounts?’

Indeed. Investors are now very much aware of the dangers of the rising brown discount as well as the benefits of the green premium. There is obviously a very significant risk of stranded assets, so the important point is that we can take mitigating actions such as refurbishment.

By focusing on this issue, wise investors have constructed relatively young portfolios, by which I mean buildings that are only five to seven years in age. A lot of older portfolios unfortunately have that risk embedded in them. Younger ones are less exposed to the danger of stranded assets.

Of course, this is likely to be different for different sectors in different geographies. Fortunately, in Europe we are very focused on net-zero goals. In Europe tenants are very co-operative, particularly as we see the roll out of the EU Taxonomy.

What are the key success factors then for investors?

Credibility is the single most important factor. We have to consider how we build and enhance it, being ever alert to the danger of greenwashing. Transparency is vital. We need to show investors how we measure sustainable efforts.

It is important to develop very broad and quantifiable metrics to measure, so we can explain to investors how we budget for sustainability in our developments: publishing a baseline and determining a pathway, while at the same time permitting full vetting in all of our buildings during every stage of refurbishment.

We are very much believers in the institutions driving better science-based targets. The likes of CRREM, GRESB, BREEAM are key. Fortunately, technology is also helping us significantly with real time measurement of our emissions in a building.

Information is so powerful. Tenants don’t make stupid decisions, but they can make ill-informed ones.

Tenant co-operation is obviously an important key to success here, so investors must have an in-depth understanding of them. In our own case, this is helped by being part of a large asset management house. We are able to lean on the research and leverage our inhouse capabilities when choosing which occupiers to work with. And when negotiating with them.

Ultimately, sustainable real estate investing is all about creating the best building, because that will secure the best tenants. I understand why a lot of real estate managers are apprehensive about the challenges ahead, but occupiers are increasingly demanding these changes and we need to be able to respond to them and to evidence that we are doing so.

It is a really exciting journey investors are going on. We just need to start with the first steps.