Pursuing real estate’s green premium

Investors and managers are creating value with a range of ESG and sustainability initiatives.

Commercial real estate buildings are one of the largest global producers of carbon emissions, with all property collectively responsible for 37 percent of total carbon emissions and 34 percent of energy consumption, according to global brokerage CBRE. As such, greening of the built environment can make a huge contribution to a more sustainable future and help owners and occupants meet ESG targets, but those same improvements also make financial sense as part of a value-creation strategy. As with many initiatives, the development of a more environmentally friendly commercial real estate sector can only really be sustained if it is financially viable.

Green buildings have been proven to perform better, stay leased longer, command higher rents, have lower operating costs and sell at higher prices – the same goals of any value creation strategy. However, despite the plethora of green building initiatives available to owners and investors, there is little consensus on the best approach. Each building, and each strategy, is different.

“Given the scope of the opportunity, there is a great deal of interest in green building strategies,” says Arjun Jairaj, an investor at venture capital firm A/O PropTech. “Even in the office submarket, which has not fully recovered since the pandemic, there’s been a flight to quality, with assets possessing strong ESG credentials commanding a premium.”

Investors and managers rarely need to choose between prioritizing their own economic wellbeing or safeguarding the environment anymore. More than just a regulatory necessity, lowering emissions across the built environment can create additional value for all stakeholders.

Spoilt for choice

Value-add strategies are increasingly commonplace in the commercial real estate space, and the sustainability movement is well established across industries.

James Magor, director of sustainability at global investment firm Actis, explains: “Broadly, the industry is consolidating around energy, water and embodied carbon. Green building initiatives that drive improvements in those areas are likely to be important factors in valuation.”

Far from being a luxury, a building’s ESG and sustainability credentials are increasingly viewed as a necessity for driving occupier interest and investor return. Global real estate services company JLL has found that sustainable buildings are more likely to attract tenants seeking reduced operating and energy costs and employee wellbeing. Capital values for buildings are 20.6 percent higher on average as a result of Building Research Establishment Environmental Assessment Method (BREEAM) certification, with rents found to be 11.6 percent higher. Similar results have been shown for buildings with higher Energy Star ratings and LEED certifications from the USGBC.

Stéphanie Bensimon, head of real estate at private equity investment company Ardian, notes: “Popular green building improvements currently focus on enhancing energy performance, which boosts asset value by reducing operating expenses and delaying obsolescence. Key measures include upgrading building envelopes and installing heat pumps to cut energy needs and support decarbonization.”

Widely adopted energy-efficient solutions include LED lighting with daylight and occupancy sensors, photovoltaic rooftop solar panels for reduced reliance on fossil fuels, advanced building management systems for operational efficiency, ventilation upgrades and controls with CO2 sensors, high-performance windows and low-flow fixtures to conserve water and energy.

Evidence suggests real estate developers around the world are cottoning on to the financial benefits that come with more ESG-focused buildings. In Singapore, for example, 95 percent of the city’s Grade A office stock is green-certified, boosting a rental premium of around 18 percent, according to global brokerage services firm Savills.

The commercial real estate sector has shown a willingness to embrace sustainable innovation in a variety of forms, whether it focuses on energy efficiency upgrades or EV parking spaces for employees. Today, there is a range of sustainable building initiatives to choose from.

Carthage Murphy, head of development management at European residential real estate investor IMMO Capital, says: “The key is to begin with the simple steps that give the greatest return on investment.”

A tall order

The scale of the decarbonization challenge for the built environment can sometimes appear overwhelming for owners and operators. Things are made more difficult by the fact that, as Ardian’s Bensimon says, green building initiatives “may not always be feasible.”

Murphy agrees: “There is currently a lot more green funding than there is a verifiable green pipeline of projects.”

To meet climate targets, Savills reports that 1.4 billion square feet of retail space must be upgraded by 2030 to achieve an energy performance certificate B rating – a feat deemed unlikely to occur due to the exit of institutional investors and other difficulties ranging from macroeconomic trends to energy price inflation.

Making the size of the task facing developers greater still is the fact that, to be truly sustainable, a building cannot focus solely on environmental matters. ESG criteria also depend on taking care of the tenant experience and answering occupant’s concerns on the social and governance fronts.

Bensimon says: “Improvements that enhance occupant wellbeing and benefit the surrounding community are valued highly. These include creating green spaces, developing smart buildings, improving acoustics, air quality, water systems and promoting green mobility with facilities for bicycles, electric vehicle charging and car sharing.”

Complicating matters further is the conundrum of whether to retrofit aging buildings with sustainable innovations or tear down and build new. During a retrofit in Atlanta, JLL was able to divert 93 percent of waste by recycling and donating building materials rather than disposing of them. In the southern hemisphere, where markets are less mature, building anew may be a more likely path to sustainability.

Jairaj admits: “In some parts of the world, the emphasis is on new construction rather than retrofits. Designing buildings to be more energy efficient or making them using bio-based and sustainable materials are proving viable options.”

A rendering of LaSalle Investment Management’s timber hybrid office in Munich

Trying a new approach in Germany

LaSalle Investment Management looks to capitalize on ESG and green building improvements in Munich’s in-demand Westend office submarket

Situated at Elsenheimerstrasse 31 in Munich, Trí is the city’s first timber-hybrid office. The property originally consisted of two buildings constructed in 1976 and 2011 totalling 24,363 square meters (262,241 square feet). Believed to be under-rented at the time of acquisition, LaSalle Investment Management purchased the property in 2022 with the ambition to tear down the existing buildings and redevelop the property to modern standards alongside Accumulata Real Estate Group. Sustainable design is a core part of this process and Trí was constructed with reclaimed concrete and timber.

The property will also utilize a photovoltaic system for electricity generation, more efficient HVAC and a groundwater heat pump. The property is predicted to deliver an operational carbon savings of 60 percent, use 70 percent less regulated energy and produce 22 percent lower embodied carbon than other sustainable buildings. The project received DGNB Platinum pre-certification by the German Sustainable Building Council.

In addition to the building’s sustainability credentials, LaSalle’s investment rationale on behalf of Encore+, its flagship pan-European fund, was also driven by Trí’s experiential potential. To meet the goal of creating the office of the future in Munich’s Westend, Trí will offer several multifunctional spaces including a café and landscaped rooftop terrace, as well as wellness amenities and a yoga studio.

In a statement, David Ironside, fund manager with LaSalle Investment Management, says: “The first of its kind in Munich, its design in accordance with circular economy principles and resource-conserving operation will serve as a benchmark in sustainable real estate. We expect the property to be extremely well placed to meet the ever-evolving demands of future occupiers around sustainability, quality, amenities and infrastructure, while providing attractive, long-term returns for our investors.”

Reducing risk

Given that regulatory shifts will make the greening of commercial real estate assets mandatory, instead of questioning whether they can afford to pay for more sustainable buildings, many investors might instead ask whether they can afford not to. An empty and obsolete building or portfolio would cost significantly more than the vast majority of green building improvements today.

It comes as no surprise then that 32 percent of European investors admit they are willing to pay premiums for ESG-friendly assets in a European investor intentions survey conducted by CBRE, with more than half of those willing to pay premiums in excess of 20 percent. CBRE’s report continued that 67 percent of European investors and occupiers are willing to pay a premium for building features that improve the physical and mental health of employees or have health and well-being certificates.

Brian Chinappi, head of real estate at Actis, says: “We’re at a point with most asset types and in most markets where it’s no longer more expensive to build green. More importantly, the risks to occupancy and exit of not doing so is too great. Admittedly, if you want to do something more innovative, you may encounter delays, regulatory challenges and additional costs. Detailed sustainability reviews and cost benefit analyses are essential when you’re looking to push the envelope but more generic green building initiatives are pretty commonplace now across markets.”

The upfront costs of investing in green buildings, whether through retrofits or new assets, should be a core concern of real estate investors, but in Murphy’s view can be mitigated through “good planning, knowing where to get the right advice and making sure that users understand how to make the best of any improvements.”

However, there is another risk that investors should be wary of before making any capital commitment to sustainable buildings. Greenwashing is the perception that businesses are seeking to jump on the ESG bandwagon, putting profit before planet in a deceptive manner and are unlikely to deliver long-term value.

“Tenants and investors today are highly attuned to greenwashing,” says Actis’ Magor. “If you’re using, say, superficial green design measures for points-scoring, people are starting to see through this.”

The pressure is on

As the energy transition intensifies, it is likely that building owners and investors will increasingly be left with little choice but to embrace these net-zero targets or end up with stranded assets on their books.

However, the impetus to embrace sustainability is largely not driven by regulatory ultimatums but by a desire to leverage building assets to deliver the best outcomes for clients.

Jairaj adds: “The cost of upgrading built stock to meet global net-zero targets is estimated to be over $83 trillion until 2050. This huge spend and the risks to non-compliant assets will create opportunities for investors who have the pools of capital to finance these measures, and the expertise to execute these retrofits on time, within budget and at scale.”

Further government intervention could serve as a guide for investors, as could the standardization of regulatory mandates around data collection and tracking. Data will become increasingly important in demonstrating a building’s ESG performance and compliance. Even when not mandated, transparency will become key in meeting tenant and manager demands in addition to driving higher valuations.

Murphy says: “In terms of value add, the relevant legislation, programs and data are dependent on your sustainability strategy. Keeping on top of both existing and incoming regulation is key. In order to remain flexible, effective data collection throughout the investment is needed so you can adapt to changing benchmark processes.”

It is difficult to say with certainty how the valuation of commercial building assets will change over time. A look at how work patterns shifted because of the pandemic and the subsequent impact this had on the retail, hospitality and office sectors is proof of that. Even accounting for market volatility, the green premium is unlikely to disappear. For real estate investors, it becomes which ESG value-add strategies to pursue and what returns they are likely to generate.