Extreme global weather patterns observed in the last few years alongside governments, investors and the general public focusing more on ESG and climate change is pushing the agenda for net zero emissions.  The built environment accounts for nearly 40% of global carbon emissions.  It is therefore natural for the focus to be on real estate when thinking about decarbonisation.  Yet, this has not been the case.

The real estate market has been booming for decades, both in the commercial and residential space.  Bar a few blips such as the GFC and Brexit, property values in the UK have only been upwards moving.  This has lessened the pressure on innovation in the industry – with more than enough demand, prices were always expected to rise, so why mess with that?  Especially considering the costs to make specific ESG and climate improvements on individual properties.

But this is quickly changing, and a large part of this is investor driven.  Investors want to protect the climate, they want to do good and invest in assets that create a positive impact.  This is both from a personal standpoint but also the regulatory need to invest in such assets, particularly for institutional investors.  Either way, this has been evident on the real estate side through increasing investor participation in the GRESB (Global Real Estate Sustainability Benchmark) assessment to demonstrate their sustainability credentials.

On the regulatory side, there is currently a reliance on Energy Performance Certificates (EPCs) across Europe to determine the sustainability of a property.  This awards a property a rating from an A+ to G, which is measured on its energy efficiency.  As of 2018, in the UK, the minimum EPC requirement was an ‘E’ but, by 2025, the requirement will be a ‘C’.  Perhaps the one limitation of this is that the sustainability of a building can simply be determined by its location.  As an extreme, a property rated an ‘F’ may be deemed sustainable in some regions, but it wouldn’t meet the requirement in the UK and would be deemed unsustainable.  Despite this, the EPC process is still a good initial indication of minimum sustainability standards, and it is only moving in one direction, which new builds and standing assets will have to adhere to.

Because of these two factors – regulations and investor demand – sustainable property assets are now coming at a premium.  On the flip side, assets that look poor on the sustainability front look to be trading at an unsustainability, or brown, discount.  Demand for UK assets that have an EPC rating of ‘D’ or below will be lower because they will need to be upgraded to at least a ‘C’ by 2025, and that could come at a significant time and money cost.  As such, holding numerous unsustainable assets now could mean you’re left stranded.  You’ll either have to sell at an unsustainable discount or inject capital and put in considerable time/work to upgrade the properties in question, to avoid impacting returns and IRRs.  It’s also worth noting that with many corporates pushing their agendas on climate change, there is likely to be a green rental premium, which may widen further, for sustainable commercial properties.

As such, investors, when investing in real estate, will need to think about sustainability immediately.  They will need to purchase, develop or refurbish assets to make them sustainable.  While it may not ultimately result in higher investment returns, it will help to avoid any sustainability-related risks and preserve asset values over the coming years.  There are numerous ways to achieve better ESG or decarbonisation standards in the real estate space that investors can think about.

The environment is the first thing real estate investors should consider when thinking about sustainable real estate, given the proportion of global carbon emissions the industry accounts for.  It is also probably the approach that would make a property appear most sustainable.  The obvious way to do this is with respect to new builds.  In the development phase, buildings being built with green materials such as timber would reduce emissions.  Also, once standing, it will be more attractive to have higher EPC ratings across investments, through better builds, insulation, smart meters and various other technologies that aid in energy efficiency.  There are also numerous other property certifications that demonstrate the environmental sustainability of properties that investors can look to obtain.  Net-zero investment strategies/asset management initiatives for all properties will also be an attractive feature for investors, which will help to preserve asset valuations.

The easiest way a real estate investor can improve social standards is to invest in social and affordable housing, which would fall under the realm of impact investing.  With worsening housing affordability and a greater proportion of incomes going into rental payments, this is a key initiative to drive impact.  As such, there are a growing number of investors exploring this space.  Alongside housing provision, improving the community space (i.e. multi-tenant shared spaces, diversity) and health and wellness initiatives, in both commercial and residential properties, would help drive the social agenda.

Real estate that doesn’t attempt to tackle excess emissions or generate positive externalities like the above approaches could struggle.  While it is still early days for real estate valuations to fully reflect sustainable and unsustainable assets, it is starting to happen.  As such, investors have to focus on the sustainability of their assets now.  If not, asset owners could be left stranded with unsustainable assets that don’t attract tenants (and an associated cashflow) and/or suffer on valuations.  In the very worst case, the cost to make these properties sustainable could be so high and/or simply unviable that knocking them down is the only realistic solution.

Chirag Jasani

13 September 2022