Real estate assets run an increased risk of being stranded, as failing to meet ESG regulations enforced by government and desired by tenants will lead to obsolescence.
The pressure has increased in the post-pandemic era and added health and wellness as another area where assets need to be up to date to attract tenants. This is particularly prevalent in the office sector, where occupiers are pressuring landlords to provide the sort of workplaces which will attract staff back from the home office.
Regulation, however, applies to all sectors; European assets will need at least a Grade B energy performance certificate from 2030, otherwise owners will be barred from leasing them.
However, the problem of ESG obsolescence is not just something that will become more significant in the future – it is affecting values right now. Duncan Owen, chief executive of Brussels-based ESG-focused investment manager Immobel Capital Partners, says: “The various certifications and EPC ratings now clearly show the rates of obsolescence and the steps that people need to be taking to improve the building.
“We have been able to underwrite new acquisitions of office assets at 20-25 percent below previous year-end and January valuations, partially due to rising debt costs but also because we are pricing in the proper cost of the green refurbishment.
“This pricing effect hasn’t come in everywhere, it is most noticeable in markets like London, which have international buyers, often with their own sustainability requirements who are pricing in the need to improve sustainability.”
However, all real estate assets will be subject to the same pressure over time, says Joseph Consolo, director of real estate technology service provider Yardi Energy. “ESG obsolescence risk applies to everyone, to every market. It means people that are not interested in your property for a reason. This could impact large institutional investors, a single property owner and everyone in between, in every market.”
Counting the cost
Real estate assets everywhere will need to be improved to meet the challenge of decarbonizing economies, which means electrification and minimizing energy use. There are a number of risks associated with real estate’s transition to net zero, not least the project cost of improvements.
The Urban Land Institute warned of a “carbon bubble” in the pricing of European real estate at its inaugural summit on climate change in Rotterdam in October. CEO Lisette van Doorn said that current building values were “too high” because transition risk costs were not being factored into property valuations in a standard way, if at all.
Van Doorn added that decarbonization activity only focused on higher-value assets, predominantly in higher-value locations, where the cost-to-value ratio of retrofitting is lower. However, older stock must also be decarbonized for Paris Agreement climate goals to be met.
ULI has published draft guidelines to aid the factoring of transition risk into property valuations. The proposed guidance identifies nine transition risks of material impact to real estate assets that can be financially modeled, standardized and communicated: the cost of decarbonization, internal resourcing, energy costs, the carbon price and embodied carbon, as well as the impact of decarbonization on depreciation, changes in rental income and exit value.
David DeVos, global head of ESG at Chicago-based manager LaSalle Investment Management, says awareness of ESG obsolescence risk is patchy. “Today, in many markets, valuations aren’t factoring in the upcoming policy and related transition risks. We are seeing awareness of this in Europe and in pockets of the Americas and Asia. However, quantifying the impact on value is very difficult as it varies by property type and region.”
A further environmental risk factor to consider is climate risk: will an asset’s value be compromised by its vulnerability to floods, fires, rising sea levels or urban heating? This is a substantial challenge for owners of multiple assets in multiple locations, as each building is unique in this respect – buildings on the same street could have vastly different climate risk profiles.
DeVos says: “We are evaluating our portfolios for potential stranding for both carbon and climate, and we are trying to relay the information quickly to our portfolio managers, so that they can evaluate the information and take action if needed. We are trying to understand the costs of mitigating these risks and how to work around tenants to do so. It can be a little complicated.”
The process is compounded by inconsistency in the data needed to make an assessment. “Assessing climate risk is as much an art as science, there are many climate data providers, and they don’t always agree,” he says.
The risks of obsolescence due to carbon or climate are factors in the ‘E’ of ESG, however the ‘S’ also carries a significant obsolescence risk, as occupiers are more focused on staff welfare and staff being more concerned about health, safety and wellness in the post-pandemic era.
Consolo says: “Wellness is linked to the post-covid focus on tenant satisfaction; staff are looking for improved lighting, clean air and walkability. The investment required to make social improvements is less than the cost to make environmental improvements. Many social improvements can be made through policies and processes.”
Occupiers are also seeing more research that links healthier workplaces – those which offer more light, better air and more open space – with increased productivity. Occupier pressure is driving the popularity of wellness certification programs such as Fitwel and the Well Building Standard.
DeVos says: “The health and wellbeing component has had a lot of interest from many stakeholders post-covid, and there has been a level of awareness of the impact on productivity resulting in organizations pursuing health and wellbeing certifications. For example, at LaSalle we received 170 health and wellbeing ratings at 170 buildings globally.”
The pressure for buildings to meet new standards might once have driven a flurry of ground-up redevelopment, however the real estate industry’s new focus on embodied carbon – the emissions generated by construction and materials – is reenforcing the value of older buildings and making investing in them more worthwhile.
This is especially the case in markets where sustainability is a priority. The City of London has refused planning permission for some new builds, while the Netherlands’ commitment to economic circularity by 2050 involves a requirement that the building sector reduce its raw materials use by 50 percent by 2030. Since 2013, all new buildings have been required to conduct a whole building life cycle analysis.
Consolo says: “The focus on embodied carbon does bode well for the existing real estate stock, and I think you will see more people going through refurbs. The building that uses the least embodied carbon is the one that is already there.”
Real estate investors are starting to become more aware of obsolescence and the fear of stranded assets is growing. For example, a recent survey of German real estate investment managers carried out for consultants Aurepa Advisors AG and PwC Deutschland found 65 percent of respondents saw a significant risk that older buildings will be stranded for failing to meet energy efficiency requirements. According to 38 percent of respondents, non-ESG-compliant properties were already more difficult to finance.
While a quarter of the German managers surveyed planned to sell non-compliant assets, there are solutions for real estate owners seeking to keep their portfolios up to date.
Consolo says: “On the environmental side, the simplest thing to do is to stay ahead of the current compliance regulations in your area. And then it is about not just complying with those, but then being open to new technology, whether it be to lower operating costs, find renewable energy sources or enhance control systems for your buildings. Engaging tenants to ensure everyone is pulling in the same direction is also important.”
Not all real estate investors have a focus on ESG, but all will have to meet the requirements of regulations and tenants. A building which is not ESG-compliant will become no more usable than one which does not meet fire regulations. However, stranded assets are not inevitable and obsolescence is avoidable.
Older cities are filled with buildings which have been used for hundreds of years, adapting to the changing requirements of their owners and occupiers. Modern real estate assets should be no different.
The QV1 office tower in Perth, Western Australia, is more than 30 years old. However, that has not stopped it from being a leader in sustainability.
The 40-story QV1 office tower, owned by Paris-based insurer platform AXA IM – Real Assets and Sydney-based Investa Commercial Property Fund, won the sustainability award in the annual RICS Australia Awards for 2022. It has also been awarded a Well Core Gold rating this year and has a 5.5-star NABERS energy rating.
“Consistency in management, investment, thorough maintenance and ongoing efforts to improve efficiencies and sustainability performance is paramount to ensure the asset is future-proofed and remains environmentally responsible,” says building engineering manager Joe D’Alessandro.
Sustainability-improving upgrades include a new elevator system which uses 40 percent less electricity, a rooftop urban farm, complete with chickens and bees, and more efficient lighting and building management systems.
QV1 has also kept up with the wellness demands of occupiers, engaging a new health operator to run onsite fitness and wellness centers, in addition to offering health services including massage, physiotherapy, a nurse practitioner and dietitian. The fitness center now opens 24/7 to reflect changing working patterns and the need for flexibility.