The cost of being green

Environmental impact may be a nebulous concept for some investors, but it is something that needs to be costed by private equity real estate firms. Robin Marriott examines how carbon footprints, sustainability and energy efficiency are having an effect on environmental due diligence.

When buying real estate, it is the hard dollars that still count most. How much rent can be achieved, what will it be worth in five years' time, who will be a ready buyer? “Soft” factors, such as whether the building can achieve a high standard of environmental friendliness, have generally taken second place. However, investigating the business case for acquiring a property and being environmentally-friendly are becoming increasingly intertwined.

Saving the planet may not yet be a high-riding factor in every property transaction, but environmental due diligence experts say an outbreak of regulations mean their work is increasingly focused on green issues on behalf of clients. For their part, private equity real estate firms realize that a property's impact on the climate is now part and parcel of the modern day assessment of an asset prior to acquisition.

It is a relatively new trend and experts that PERE has spoken with have outlined the way environmental due diligence is changing.

Tim Clare, a director at consultant WSP Environmental and Energy, argues that within the past 18 months, the carbon debate has firmly changed the level of interest among property funds.

Though he says the core due diligence work remains determining potential liability associated with contaminated land, the sustainability agenda is creeping in. “Two or three of the larger funds want us to take the sustainability of the building into consideration when we look at them now,” he says.

In the UK, for example, this interest is being heavily driven by new requirements for energy performance certificates, which grade a building depending on how “green” it is.

Expanding green
Real estate funds are not taking notice to earn themselves a “Save the Planet” badge, but because there is an economic value attached to having an environmentally friendly building. Funds know that international banks and other top tier organizations are under pressure over their own green credentials and the choice of building they occupy is one of the few things they can do to improve their environmental performance. So real estate investors have a vested interest in assessing how green a building is before they acquire it or in finding out how much it will cost to improve its energy performance. In addition to working out the immediate attraction of a property to a tenant, real estate funds are also considering the potential for creating premium value for a green building when it comes to the exit. After all, some investors that might buy from a real estate fund in years to come are already saying they will only acquire properties with an acceptably low carbon footprint.

“Two or three of the larger funds want us to take the sustainability of the building into consideration when we look at them now.”

Among European countries, the UK has been an early mover in phasing in energy performance certificates. These certificates, introduced in the UK in June, are based on a European directive that calls for buildings to be attributed a green rating from A to G, with A being the highest standard. An owner of commercial real estate cannot sell the building without a performance certificate and tenants cannot lease a commercial building without one either.

“We have all got to recognize that over time, this is going to become more and more important. No one quite knows what the overall impact will be, but our investors are aware of it and are showing an interest, so we are responding.”

Clare says that his firm has been putting into place energy certificates for entire property portfolios on behalf of real estate funds. But owners of real estate are also asking him, in the due diligence stage of acquisitions, to assess how much capital would be required to raise the building's green rating. This is where the hard dollars of a transaction are converging with green issues. “Within the environmental due diligence work, real estate funds might ask us to appraise the cost benefit of actions to allow a step-up to a higher band of efficiency,” says Clare.

This does not involve a huge amount of extra cost. Instead, experts can model into software programs how changing the boiler type, for example, might improve the rating of a building. “These things have really only just begun,” says Clare, “but we have had some commissions where we have had a look at the energy certificates to see if [the buildings] can be improved.”

This is not the only way environmental due diligence has expanded in recent times to take into account the environmental agenda. Some funds, says Clare, are asking consultants to investigate other sustainability criteria associated with a building such as people's ability to commute to it on public transport. This interest stems both from occupiers wanting an eco-friendly headquarters and from some investors' desire to own a portfolio with a green tinge to it.

Julian Gabriel, a principal at London-based Doughty Hanson Real Estate, says his firm's investors are asking it to report on green initiatives every six months. But he adds that the environmental advisors are also pushing the issue. “The scope of services that environmental consultants are doing now includes sustainability and green issues and what the implications are of buying real estate and costs linked to that,” he said.

“We have all got to recognize that over time, this is going to become more and more important. No one quite knows what the overall impact will be, but our investors are aware of it and are showing an interest, so we are responding.”

Habitat damage
It is not just environmental consultants and investors who are noticing the growing importance of climate change; insurers are noticing the difference too. Cliff Warman, Europe, Middle East and Africa environmental practice head at insurance broker and risk advisor, Marsh, says we are moving towards the environment being “generically valued,” and damage caused to the environment being considered a liability.

Real estate investors have long since had to worry about site-specific liabilities linked to contaminated land, waste, asbestos and so on. However, initiatives that began in the US means funds also have to be concerned about damage to the surrounding habitat.

The US Natural Resource Damage Assessment and Restoration Program is a key initiative being replicated in Europe via the EU Environmental Liability Directive. These programs aim to restore natural resources that have been damaged by hazardous substances released into the environment. “It means owners of real estate have to ask, ‘If I cause a problem to an ecological habitat or a river from my site, what is it going to cost me?’ Historically, it wouldn't have cost [the real estate owner] anything because no one necessailry owned the habitat so there was no claimant. But we are now moving into an environmental regulatory framework where the environment has a value,” he says.

These are examples of the newer kind of environmental liabilities that real estate owners face nowadays. In some situations, the potential liability is great enough that it warrants special insurance. In order to assess which insurance is necessary, the investor needs to have an expert carry out the environmental due diligence. “On softer issues such as environmental responsibility and climate change, the whole world is moving in the same direction,” argues Warman. “That includes Asia.”

That is not to say that in the litigious and heavily-regulated US, environmental due diligence has moved away from site-specific issues. On the contrary, environmental attorney, Andrew Skroback, at Stroock & Stroock & Lavan law firm in New York, points to vapor intrusion at buildings from compounds in the soil as a hot topic.

“On softer issues such as environmental responsibility and climate change, the whole world is moving in the same direction.”

An increasing number of US states are regulating on the issue and in March this year The American Society of Testing & Materials (ASTM) issued a new standard on the assessment of vapor intrusion into structures. The society said regulators have recently threatened to reopen hundreds of previously-considered closed sites as a result of vapor intrusion issues.

“There is more regulation and regulatory guidance coming down the line. As regulation further defines when vapor intrusion may present a risk, clients need to consider vapor intrusion before putting a price on a property,” says Skroback. He adds that potential vapor intrusion and historic underground storage tank issues at large residential buildings in Manhattan led to the seller having to bring the property up to regulatory standards in a recent purchase he worked on.

But Skroback too has noticed how “softer” environmental issues are becoming increasingly important, citing “green hotels” and calculating one's “carbon footprint” as current examples. The environment may be nebulous to some real estate investors, but it is something that has to be costed. The days of only conducting due diligence to discover whether there was costly contamination on a site are not exactly over: but they are probably numbered.