TEN TRENDS FOR A ZERO CARBON WORLD
09. Dollars and sense
Occupiers and investors are now more attuned to the importance of sustainability, meaning the impact on real estate values is becoming more apparent. As regulations are tightened and the various costs associated with a higher carbon footprint rise, differentials in value will be exacerbated as demand increasingly gravitates toward the greener end of the market.
The value of most commercial real estate is fundamentally based on two factors: how much an occupier will pay to make use of the space, and how much investors will pay to secure the rights to that income. Within this simplicity lies a multitude of drivers that influence these two variables – almost all of which are impacted by sustainability issues in one way or another.
From an occupier perspective, sustainable buildings1 offer several benefits. Being energy efficient reduces operating costs, while designed-in flexibility reduces the cost of refitting and reconfiguring space. As increasing numbers of companies report on their ESG performance, demonstrating a commitment to sustainability is becoming more important to customers and employees2. Given the huge impact that real estate has on any organisation’s carbon footprint, property is typically an early target for action in any corporate sustainability strategy.
As a result, occupiers are already demonstrating a preference for green buildings in their leasing choices. In the UK and Europe, non-domestic buildings must have an Energy Performance Certificate (EPC) before they can be sold or let; this assigns a grade ranging from A, the most energy efficient, to G. We have analysed the EPC ratings and rents achieved in a sample of 65,000 leasing transactions in the UK across a range of sectors; the results show a clear correlation between a building’s EPC rating and its rental value.
There is a clear correlation between a building's energy performance certificate rating and its rental value.
UK RENTAL VALUE & EPC GRADE CORRELATIONS, OFFICE, INDUSTRIAL & RETAIL ASSETS
Source: Avison Young
Moreover, this relationship is getting stronger over time. In 2016, the UK government announced Minimum Energy Efficiency Standards (MEES) making it unlawful to renew or grant a lease on buildings with an EPC below grade E, with a timetable for further tightening of the restrictions baked into the legislation. As a result, there was a clear strengthening of the EPC-rent relationship post 2016, which is most evident in the office sector. Prior to 2015, EPC grade A properties typically attracted a 38% rental premium over Grade G assets; since 2016, this premium has typically increased to 165%.
Clearly there are other factors involved in determining the rent an occupier will pay including building age, location, and quality – but further analysis confirms the better performance of higher rated EPC buildings even when these factors are controlled for3. With minimum standards set to increase in 2030, higher-rated properties will only increase in attractiveness. Similar, yet more stringent regulations are due to take effect in the Netherlands for office buildings from 1st January 20234.
For investors, this translates into improved rental performance over time. Properties that achieved the highest EPC grades (A and B) have demonstrated significantly stronger rental value growth than other grades over the past 10 years. The benefits to asset owners are compounded because occupiers are not only prepared to pay more for a more efficient building – they are also prepared to commit to it for longer. Since 2016, the average lease signed on EPC grade A and B properties has been 114 months, 20% longer than the average lease length for grade F and G properties of 95 months.
The benefits to asset owners are compounded because occupiers are not only prepared to pay more for a more efficient building – they are also prepared to commit to it for longer.
SUSTAINABILITY PREMIUM IN UK OFFICES
We believe it is highly likely that occupier demand for sustainable buildings will significantly outstrip supply in most western markets over the years ahead. This will happen at different times and to different degrees, but the direction of travel will be universal. Demand for existing buildings that are already on a decarbonisation pathway will rise and those being developed will see significant pre-letting interest as companies plan to meet their own carbon targets. The differential in rents and lease lengths between green buildings and the rest of the market will therefore continue to widen.
If occupiers are prepared to pay more and take a longer lease on an energy-efficient building, one would expect investors to pay a premium price for such buildings. In the United States, we have analysed pricing data from 137,000 office building transactions totalling in excess of $1.2 trillion over the last ten years and have identified a clear premium for LEED5-rated buildings. In the early part of 2021, the average transaction cap rate for LEED-rated assets stood at 5.5%, 100 basis points below the wider US office market. The top quartile of LEED offices also trade at a significantly lower cap rate than the equivalent cohort of non-LEED buildings.
LEED OFFICES BOAST BETTER CAP RATES THAN THE WIDER OFFICE MARKET IN THE US
Our findings support the growing body of international evidence pointing to the impact of sustainability factors on real estate values. Various research projects confirm that green building certification is typically associated with lower vacancy rates6 and a rental premium7. Across 13 studies examining LEED and Energy Star certified properties in the US and Canada between 2008 and 2015, occupancy levels were higher by anything up to 18% depending on the market and sector8. Similarly, 24 rigorous academic analyses identify capital value premiums ranging from 5% to 43% for assets with green accreditations across Australia9, Germany, Switzerland, the UK, and US.
Staying ahead of the curve
The concept of a “green premium” is actually starting to diminish in importance; but only because it is being replaced by a “brown discount”. As changes in attitude become embedded in market behaviour, energy-inefficient buildings are, and will increasingly be, viewed as substandard. Would you think about “paying a premium” for electric windows and power steering when buying a car – or would any car without these features be worth far less, because they are now considered standard?
The second-hand car analogy is perhaps appropriate given that many governments are now announcing plans to ban some older vehicles altogether10. Whether falling victim to New York-style fines11 or UK and Netherlands type leasing bans, energy inefficient buildings will be increasingly unattractive to own. Occupiers can move elsewhere but investors face being left with “stranded assets” that have been overtaken by market or legislative standards and which will suffer diminished – or even negative – value as a result.
This “transition risk” arising from the shift to a low carbon economy has a dynamic element which is extremely difficult to quantify given that it varies from one place to another, and over time, as markets and governments adjust at differential rates. In Europe, the Carbon Risk Real Estate Monitor (CRREM) project, funded by the European Union, provides a model allowing investors to identify the buildings most at risk and prepare them for adaptation12. Crucially, rather than relying on current emission standards, this considers the likely future trajectory of building performance standards needed to achieve the EU government’s stated ambition of decarbonizing the real estate sector by 2050. This allows investors to plan what they need to do to meet today’s standards, but also what will be needed in future.
As changes in attitude become embedded in market behaviour, energy-inefficient buildings are, and will increasingly be, viewed as substandard.
CARBON RISK REAL ESTATE MONITOR
Whether driven by government or the market, sustainability credentials are becoming an increasingly important determinant of value in real estate. As our various Trends articles illustrate, the carbon agenda is impacting every aspect of the design, construction, operation, management, occupation, and ownership of buildings. Understanding how this is playing out across the real estate value landscape is becoming fundamental for everyone involved in the sector.
1For a concise and authoritative summary of what makes a building sustainable see https://www.worldgbc.org/what-green-building 2See (Work)force of nature 3https://www.egi.co.uk/news/epcs-can-sustainable-offices-bolster-profits/ 4Leskinen, N., Vimpari, J. & Junnila, S. (2020). A Review of the Impact of Green Building Certification on the Cash Flows and Values of Commercial Properties. Sustainability volume 12(7). Available at: https://doi.org/10.3390/su12072729 5https://www.lexology.com/library/detail.aspx?g=dc647d90-b78c-4c89-b94e-6753a33291d1 6LEED (Leadership in Energy and Environmental Design) is the most widely used green building rating system in the world and is particularly prevalent in the US. 5 Devine, A. & Kok, N. (2015). Green Certification and Building Performance: Implications for Tangibles and Intangibles. Journal of Portfolio Management volume 41(6). 7Ott, C. & Hahn, J. (2018). Green pay off in commercial real estate in Germany: assessing the role of Super Trophy status. Journal of Property Investment & Finance. 8Leskinen, N., Vimpari, J., & Junnila, S. (2020); A Review of the Impact of Green Building Certification on the Cash Flows and Values of Commercial Properties. Sustainability, volume 12(7). Available at: https://doi.org/10.3390/su12072729 9The National Australian Built Environment Rating System (NABERS) system is based on actual performance of a building rather than its design, distinguishing between individual tenancies and common parts. It is becoming more widely utilised around the world. 10https://www.gov.uk/government/news/government-takes-historic-step-towards-net-zero-with-end-of-sale-of-new-petrol-and-diesel-cars-by-2030 11https://www1.nyc.gov/site/sustainablebuildings/ll97/local-law-97.page#:~:text=Local%20Law%2097%20is%20one,reducing%20emissions%20in%20the%20nation.&text=Under%20this%20groundbreaking%20law%2C%20most,coming%20into%20effect%20in%202030. 12https://www.crrem.eu/