There was an awkward silence onstage during industry body the Urban Land Institute’s Europe conference in Madrid in June, when a member of the audience asked a panel of top real estate executives for their opinion on the costs of decarbonization.
The delegate wanted to know how much capital should be subtracted from real estate values today and was, in essence, concerned about two issues. First: how much it will cost owners to make environmental upgrades to assets and the impact that will have on values – especially in the short term. Second: how much needs to be deducted from current values to reflect climate risk if the owner does nothing.
“How big do you think the price bubble is in real estate?” the delegate asked. “Is it minus 10 percent or minus 30 percent? What’s your ballpark figure?” Panelists – representatives of some of the leading asset managers in the industry – were initially reluctant to field the question. Eventually, Annette Kröger, chief executive officer Europe of manager PIMCO Prime Real Estate, took it on.
“If you have to futureproof an asset, you probably have tenants that stay longer, probably have shorter void periods and, potentially, there is an improvement on the valuation side. But I would struggle to give you a number in terms of the percentage of mispricing,” she said.
Kröger’s unscientific response was unsurprising; she cannot answer this question. Nobody can. The task of quantifying the risks of climate change to real estate assets as a single number, even a set of basic numbers, is not something the industry yet knows how to do. Not the valuers, nor lenders, nor investors.
Currently valuers have no way of factoring in the cost of doing nothing to an asset because the evidence of the impact of those risks is scarce, and it is not information routinely collected by borrowers and lenders. The same problem faces those that do make changes: there is no method to assess how the cost of transitioning assets will positively impact the value of a building.
What is required, say market participants, is an approach to valuation reflective of those risks – which results in a number adjusted to reflect multiple, quantified transition risks. To achieve that, the industry first needs to agree a framework of risks to measure and include in a valuation decision.
This is not a failure by the market but reflects how net zero is such a new concept that accounting, definitions and models are still being assembled and defined. It will inevitably take time for the market to interpret the risks. While aspects are being priced into deals in some markets, it is difficult to determine how much, and it is not standardized.
Mispricing risk
The timing for such complexity to hit the market is not good. As property owners already face the prospect of injecting fresh equity into assets due to falling values and the need to deleverage it comes as a relief to some that such numbers are not yet quantifiable.
But without this assessment the market is at risk of mispricing, or even overlooking risks associated with climate change – a situation about which the not-for-profit ULI is concerned. It warns that the lack of a methodology that would capture the cost of climate risk and apply it to real estate values means there is a ‘carbon bubble’ forming. Current property values, it argues, are too high because the cost of decarbonizing buildings is not being factored into valuations in a standard way, if at all.
According to ULI, the risks in the current valuation system are two-fold. First, valuation numbers do not take account of the cost of transitioning assets to net zero.
Such costs could include bringing an asset in line with minimum energy performance standards, costs brought about by regulation, or the income impact of tenant voids due to renovation work.
“Lenders are financing real estate against a value that isn’t the real value of an asset,” says ULI’s chief executive, Lisette van Doorn. “The value of some buildings are already much lower than its official valuation, as the cost of decarbonization is not incorporated. We should not be pretending this is not happening. These numbers are keeping people asleep.” A second layer of risk concerns the physical impact on buildings of weather extremities, such as heat and rainfall.
Kamil Kluza, co-founder of climate data provider Climate X, believes unquantified climate risk could be as significant for the financial system as the global financial crisis was. The cost of not addressing it could be huge, he says.
“None of this risk is being priced in because we have not had the data. Physical risks are totally unaccounted for. There is a lot of risk that first has to be uncovered and then unraveled. The last time we had this much risk in the system was in the run-up to 2008 and we didn’t know about it until after the event, after the crash. I think the same could happen over this.”
“The last time we had this much risk in the system was in the run-up to 2008 and we didn’t know about it until after the event, after the crash. I think the same could happen over this”
Kamil Kluza,
Climate X
Action but no solution
Lenders vary in their level of awareness and proactivity when it comes to sustainability. At the vanguard is a cohort of market participants, already focusing their lending heavily on sustainable assets, where transition risks are better recognized, and are aware that establishing these numbers is urgent. But while they might have individual methods of valuing assets’ climate costs, these values might not reflect the broader market value that underpins secured lending.
In July, a group of large commercial lenders in the UK, in association with the country’s Royal Institute of Chartered Surveyors, published guidelines to make it easier to understand sustainability’s impact through valuation instructions and reporting – an initiative recognizing that solutions to the problem require collaboration across the market. The aim is to help lenders better understand the market value of an asset in this context. RICS described it as “a useful starting point”.
Its potential solutions include a framework for valuation instructions and reports that facilitate coverage of valuation factors related to a building’s energy performance profile, supported by cost details and other relevant data provided to valuers. The framework also suggests valuers might comment on flood risks and how green certificates – such as BREEAM, LEED or NABERS – might be valued by the market if provided with sufficient detail.
“As an industry, we are grappling with how to do this right now. We are still at the beginning of factoring this risk into valuation,” says Shuen Chan, head of ESG at insurer platform Legal & General Investment Management Real Assets, who works closely with LGIM Real Assets’ private credit teams.
Aviva Investors is another insurer platform with experience of sustainable lending. The firm has issued £1 billion (€1.2 billion) of sustainable transition loans in recent years, in the absence of standardized valuation tools. Gregor Bamert, Aviva’s head of real estate debt, said no “magic bullet” exists that can definitively price in decarbonization risks, adding: “This is complicated. We are trying to understand what the future state of a property will be in a number of years. As a lender we are trying to have as much confidence as we can into the factors which drive value.”
For less prepared debt providers, nerves over the absence of costing clarity are increasing, says Sam Carson, head of sustainability, valuations and advisory services at property consultant CBRE. Carson recently authored a paper with the Association of Real Estate Funds to help clarify a basic framework on how sustainability features relate to value.
A standardized approach is urgently needed, he says, because climate risk is coming upon the industry at “incredible speed,” creating a situation where asset valuations may be at risk of rapid changes, including – due to looming regulation – during the term of a loan.
Despite the urgency, not every debt specialist is cognizant of incorporating climate costs into valuation, particularly at this pressurized moment for the market, with property values gradually correcting and a wall of debt maturities looming. Nick Harris, head of UK and cross-border valuations at property adviser Savills, says climate-related risks are being pushed down the agenda on account of the stress that increasing interest rates are placing on lenders and borrowers. “A lot of lenders are caught up with other pressures over refinancing and loan monitoring – focusing on interest coverage ratio covenants, interest rate rises and keeping borrowers afloat.
“ESG is lower down the list [than it was]. As valuers, we are not being asked by every lender to look at whether a property will run into issues in the future, but whether it is suitable for a three-year loan today.”
He adds, while valuers are being asked to consider an asset’s compliance with certifications such as BREEAM, they are not being asked to comment on wider decarbonization projects.
No evidence
Valuers say they are not presently in the position to factor transition risk into their findings because they need evidence of its impact to incorporate it into market value. As Charles Golding, tangible assets valuation associate director at RICS, explains: “Valuers are observers of the market, not the makers of it. They have a role to play in appropriately covering sustainability impacts in valuation, but this is subject to instructions that facilitate this and evidence that underpins it.” At best, valuers can reflect sustainability features and ESG risk implicitly within the valuation by using comparable evidence – assets with similar qualities and characteristics – to assess value at a specific time.
In some circumstances, where provided with the appropriate level of detail related to, for example, cost implications and energy performance data, valuers can more explicitly factor sustainability impacts into valuation.
Golding, who is leading RICS’s collaboration with lenders over a framework, says it may be challenging to attribute distinct market values to individual sustainability factors because market data is typically represented as an overall price. For example, an asset sale comes with a price record but not the purchaser’s market sentiment related to specific characteristics, such as solar panels, for instance. At the prime end of the market, however, certification schemes are one way of better understanding characteristics.
“If valuation instructions are not developed to report how an asset is impacted by climate transition or physical risks, and how the market is costing that impact, then valuers may be limited in what they can provide, and lenders might not get the advice they need. The draft framework is hoped to help with resolving this,” Golding adds.
In terms of understanding the impact of the costs to value if an owner does nothing, valuations currently do not reflect this. “In a highly regulated market, such as secured lending, which requires a market value basis, valuers cannot provide speculative figures, predictions or calculations solely based on the strategy of an individual investor. Where regulations and instructions allow, and the valuer has been given relevant data, valuers may be in a position to reflect the valuation impact of, for example, a proposed retrofit.”
But, Golding adds: “One cannot assume proposed retrofit costs of an individual owner would directly translate to an equivalent impact on market value.”
Aviva’s Bamert explains the traditional method of valuing property is not explicit or detailed enough to fully capture the costs of climate risk. “You know what rent a building might achieve. But you don’t know why,” he explains, adding: “While ESG is on everyone’s agenda, you don’t know if it has been the primary driving factor in terms of price, or something less significant.”
The difficulty in quantifying sustainability’s impact on value is being compounded by a lack of investment transaction evidence in general, says Bamert. Transactions remain at low levels in Europe, having registered a 64 percent drop in the region during the first quarter of the year compared to the same period in 2022, according to property consultant CBRE.
William Scoular, head of private client real estate at UK- and South African-headquartered bank Investec, agrees low deal volume compounds the problem. Scoular, a former valuer himself, says: “I have sympathy with the valuers because you can’t value sentiment, only value based on comparable [evidence], and there is a lack of comparable [evidence] right now, it is very hard to move the market.”
Benjamin Bouchet, director in the structured finance team at credit rating agency Scope, based in Paris, suspects low clarity on how decarbonization can impact value is compounding the current refinancing gap.
He explains that the large bid-ask spread is the result of current asset values not reflecting the higher interest rates and inflationary environment, but also because the need for “substantial capex” on top is also not factored in. “This is the double layer of complication behind refinancing or loan repayment challenges,” he says. “Some property owners are not taking into account ESG factors and the costs to make a property compliant with regulations or improve sustainable criteria. But for the market to begin moving, it needs to establish those aspects of value. Until then, it will be difficult for transactions to recover.”
“If an owner pushes for those costs to be recognized, they will get a large lump of value knocked off today’s value and it could instantly default the debt”
Jim Gott,
Mount Street
Refinancing challenges
As climate risk builds in the commercial real estate sector, creating problems for the future, Laura Jockers, global head of ESG for manager M&G Real Estate, says there are imminent consequences to what she describes as a “semi-market failure”.
She explains: “We don’t have the quality of information to accurately price in improvements. It is harder to justify decarbonization initiatives to a building when those improvements will not lift a valuation.” The effect is that borrowers are not incentivized to improve their assets, leaving swathes of buildings vulnerable to obsolescence. “There will be many buildings that are not viable to refurbish because the value gain is not recognized.”
Scoular does not agree that issues around valuation will demotivate borrowers to upgrade properties, but says it is potentially the case that assets are overvalued because the full cost of obsolescence is not yet factored in.
Gathering information on the likely cost of decarbonization is possible from sources other than valuers – from building surveyors, for instance. But it is not a fact-finding mission all borrowers – many of which have stretched capital structures – are likely to instigate, says Jim Gott, head of asset surveillance at loan servicer Mount Street. “The amount of money a borrower might need to spend on transitioning a property could make a building unviable, turning an asset into a liability. If an owner pushes for those costs to be recognized, they will get a large lump of value knocked off today’s value and it could instantly default the debt.”
For any lender not in a position to take a long-term view, that is an issue. In addition, such changes may eventually improve the asset’s rental potential, but it may not be enough to cover those initial up-front costs.
Bamert, however, takes a more optimistic view. He says the current slowdown in the market is pushing owners to confront transition risk because lenders will increasingly only finance properties with ESG-focused business plans.
This view is evidenced by CBRE’s survey of French lenders, published in July, which revealed that in response to rising interest rates and recession fears, most debt providers now consider green criteria in their credit decision-making, and indicated that borrowers meeting these standards could receive better loan-to-value ratios and incentives regarding margins.
Bamert says the challenging environment means conversations around these issues are more regular than before, which will ultimately persuade the most reluctant of borrowers to focus on transitioning assets. “One thing that has come out of this crisis is that, unless there is a very clear plan and commitment over improvements, there is no refinance. This has been a big shift. Before, the terms might have only just been different for a brown asset.”
Stick to the plan
While quantifying all the benefits of a borrowers’ ESG business plan is not yet possible, argues Bamert, he says the willingness of owners to take assets in the right direction makes lenders more comfortable and thus more willing to lend. “We don’t have time to wait until we have all the answers to the questions around valuation. A business plan might not be able to quantify all the benefits in terms of value, but the plan does show the asset is going in the right direction. Even though we might disagree on the precise impact on value, this is something, as a lender, we are willing to take a view on. You know that the sponsor who creates greener assets will have assets that are less risky.”
Dan Riches, co-head of real estate finance at M&G Real Estate, another UK insurer platform, agrees that the decision to refinance is likely to be binary regarding sustainability. “If I see an asset that is at risk of becoming stranded but has no coherent ESG business plan, we’re highly unlikely to lend against it. However, we are certainly willing to finance assets of that type which have credible and funded business plans creating an asset which satisfies regulatory and occupier ESG requirements. In my opinion, these types of projects are one of the most attractive lending opportunities today.”
However, CBRE’s Carson is skeptical that cash-strapped borrowers will provide the thorough business plans lenders require. Assessing the costs of capital expenditure alone, he argues, is something requiring high levels of expertise. “Capex is a massive consideration in terms of the impact it will have on valuations. Lots of ESG consultants don’t understand enough about real estate to interpret what this means, and it is not easy for anyone to get that right. For the less well-capitalized borrower, the harder it is. These sponsors don’t have sustainability teams to manage that process. Moreover, they need values to be as high as possible in order to secure the right LTV. The incentives to nail these details just don’t exist.”
It is a view shared by LGIM’s Chan. “We are only at the start of the process of capturing the right data, and this goes above and beyond the day-to-day responsibilities of running a real estate company. This is a lot for an organization to take in and there is a shortage of skills to help implement decarbonization objectives.”
Assets in secondary locations are also likely to suffer. In these locations, it is harder to prove that rents can be increased enough to cover the costs of decarbonization without the evidence. The expense of such initiatives, says Gott, is the same whether in a gateway city such as London or Paris, or a lower-rent regional location. “How will landlords justify the costs of transitioning assets when they need to spend €200 per square foot and if the occupier in that location is not prepared to pay the higher rent?”
For these reasons, says Carson, the use of a standardized industry framework around climate cost is critical to provide a benchmark that can be used by everyone, no matter how deep their pockets. “This is where the greatest risk lies and that is a risk of multiples that could turn into a refinancing nightmare. We need guidance for the whole market as quickly as possible.”
To address the challenges, ULI published a list of 12 transition risks in June, which it believes should form the basis of an industry-wide framework to assess transition risk. Eight of these can be quantified today, says the organization, and can be incorporated using a method of valuation, known as discounted cashflow (DCF), to develop a valuation of a building that is adjusted for transition risk. DCF is a valuation method – commonly used in North America and Asia-Pacific but less in the UK and continental Europe – that estimates the value of an investment by incorporating its expected future cashflows.
The risks that ULI says can start being quantified now are the costs of keeping an asset in line with minimum energy performance standards, the financial risk associated with embodied carbon emissions, obsolescence and depreciation, and the costs of tenant voids. Van Doorn says: “We are trying to incorporate transition risks into property valuations in a transparent way and for these factors to be incorporated in a way that offers the valuer more information.”
She adds that valuing cashflow is a crucial step in better understanding the value that decarbonization brings, because capex invested today could improve income over the long term. An example of this is improving energy performance. If a building has lower occupational costs due to retrofitting, then tenants are less likely to leave or they would be easier to replace. As an owner, operational costs would be lower. “There is an obsessive focus on costs and capex but we also need to think about the value impact, and decarbonization of a building should be seen as an investment also contributing positively to the return, by increasing/stabilising income and adding to the liquidity of an asset. The driving force of change will be the tenants.”
“We won’t see large-scale transformation without that valuation piece… It is still very nascent for investors and not even as advanced as this on the debt side”
Laura Jockers,
M&G Real Estate
ULI’s sense of urgency is shared by sustainability specialists in the market, who add that borrowers have a responsibility to help support the development of valuation standards by willingly collating and sharing information.
But for guidelines to succeed, van Doorn believes owners should use the current market correction to effectively cost climate change into their assets, even if it has a detrimental effect on current values or makes financing harder to secure. “The market is at a standstill anyway and so use this time to get up to speed on what is needed.”
Chan believes ULI’s work is potentially ground-breaking, but says collaboration is key to its success: “All stakeholders – valuers, lenders, owners – need to be aligned, everyone has to be brought along at once.”
Jockers is also adamant that current approaches of valuing the costs of decarbonization will not help achieve wide-scale decarbonization: “We won’t see large-scale transformation without that valuation piece.” She believes there is much work to be done: “It is still very nascent for investors, and not even as advanced as this on the debt side.”
For Carson, the ULI metrics are aspirational and currently very difficult for most to interpret. Instead, he says, the industry’s first step is to agree on basic metrics that are achievable by everyone – which his paper intends to do.
Carson recommends market participants should report evidence on three transition risks as standard in valuations: energy performance certificates, green certificates such as BREEAM, and localized physical risks, such as flooding. With this information reported consistently, valuers would then be able to apply those risks to asset values. “When reporting market comparables to their clients, valuers will then be better able to comment on target buyer priorities for a given asset.”
Meanwhile, lenders will be required to finance real estate by doing more homework on risk than ever before. As for the audience member at the ULI conference, maybe one day he will get his answer. Until then, it is critical to everyone to keep asking the question.
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