Piyasi Mitra reports on how sustainability is lifting real estate returns in the commercial sector.

In a survey of European real estate managers covered by Funds Europe last year, more than half of the respondents saw property values increase by up to a quarter as a result of greater sustainability characteristics.

Data provider Deepki said the higher pricing power of more sustainable buildings triggered a rise in asset values for 250 commercial real estate managers across the UK, France, Germany, Spain and Italy.

So, how does present-day reality compare with the research findings?

The Net Zero Carbon Buildings Standard, a cross-industry initiative that will help standardise specifications, is being developed in the UK at the moment. Given that most UK funds now consider ESG risks as part of their due diligence when buying assets, this is already having an impact on the commercial property sector.

“Corporates are focusing on aligning assets with CSR [corporate social responsibility] commitments that include carbon targets,” says Sam Carson, head of sustainability, valuations and advisory services at real estate firm CBRE UK. For the most part, he adds, city offices are leading the trend.

Buildings that don’t conform to ‘green’ standards are known as ‘brown’ – and as Carson notes, a lack of green features poses a risk to occupiers and investors alike. This applies not only to UK offices and big industrial and logistics assets, but to emerging build-to-rent and residential properties.

“‘Brown discounts’ – guided by the upgrade costs required by investors to position the asset in line with [green] market expectations – are easier to understand and calculate,” Carson says.

In other words, the ‘green premium’ or ‘greenium’ – an expected higher return when a brown building is turned green – is becoming easier to quantify.

Beating the brown discount

Katerina Papavasileiou, associate director of real estate ESG and responsibility at fund manager Federated Hermes, says occupier preferences are shifting towards performance-based certifications focusing on actual energy reduction, rather than expressed commitments to sustainability. An example of this kind of certification is Nabers, the National Australian Built Environment Rating System.

“There is a growing demand for buildings with low upfront embodied or whole-life carbon for developing new assets,” she says. “The carbon agenda is being pushed aggressively by buildings being designed today compared to those undergoing construction.”

“‘Brown discounts’ – guided by the upgrade costs required by investors to position the asset in line with [green] market expectations – are easier to understand and calculate.”

Properties without sustainability credentials are experiencing lower rental values due to brown discounts – a valuation slashed by the capital expenditure needed to reach net zero. “Our Soho Square asset has, within the last nine years since the acquisition, managed to reduce energy use by 63% with new technology, smart optimisation and prioritising energy-efficiency upgrades during refurbishment,” says Papavasileiou, affirming that sustainability criteria are needed to minimise climate risk as well as maintain competitive rental and investment values.

Seeking ‘S’

Asset manager Federated Hermes manages its Fleets Corner Business Park in Poole, Dorset, in line with its responsible property investment programme. As well as meeting return targets, this seeks to generate positive socio-environmental impacts.

The firm has sought to reduce energy consumption and carbon emissions by promoting a more sustainable service, provided onsite with 100% renewable electricity.

The Building Research Establishment Environmental Assessment Method – a widely used technique known as Breeam – is used for rating existing office accommodation. In addition to the use of LED lighting, passive infrared sensors are used to turn lighting on and off in communal places.

Papavasileiou envisages a shift in the agenda beyond green premia to a wider ESG premia, achieved by linking an asset to its positive impact on the local community. “We have partnered with local businesses to support job creation and skills development through our mixed-use development, NOMA, in Manchester,” she says.

“Also, our asset at 26-28 Hammersmith Grove in London has offered a charity, the Centre for Policy on Ageing, space for their library at a peppercorn rent.”

From France to the UK’s big six

A recent Schroders Capital office refurbishment in Paris focused on increasing sustainability standards. The project, involving a new ten-year lease, was predicated on better sustainability credentials and is currently awaiting a Breeam ‘Excellent’ certification.

In January 2022, France adopted the RE2020 regulation, which puts a framework on energy consumption for new buildings. Charlie Jacques, Schroders Capital’s head of sustainability and impact investment, real estate, says: “Overall, this has led to an acceleration in brown discount in France.”

Research suggests that this could represent a greater premium of nearly 30% for centrally located office buildings compared to London. “Nearly 90% of new developments in the Paris region of greater than 5,000 square metres are at least certified Breeam and ‘Hauté Qualite Environnementale’,” adds Jacques.

“Our Soho Square asset has, within the last nine years since the acquisition, managed to reduce energy use by 63% with new technology, smart optimisation and prioritising energy-efficiency upgrades during refurbishment.”

Haute Qualité Environnementale, or the High Quality Environmental standard, is a green standard for French buildings. Its principles extend back to the 1992 Earth Summit.

Mark Callender, head of real estate research at Schroders Capital, says: “Our analyses suggest that offices in the big-six UK cities [Birmingham, Bristol, Edinburgh, Glasgow, Leeds and Manchester] with a Breeam ‘Excellent’ or ‘Outstanding’ rating currently command a premium of 5-10% in terms of capital value per square foot, after adjusting for other basic advantages such as fast broadband, cycle stores [and] roof terraces.”

The company expects the big-six office markets’ green premium to increase and converge towards the 15-20% premium seen in the London market.

Newly built, high-quality industrial units developed by the Schroders Capital Real Estate UK Fund have recently fetched more than the estimated rental value due to a high demand for space. Without standardised frameworks, it is hard to gauge whether this was driven by a lack of local supply for high-quality space or by tenants’ focus on sustainability. That said, the financial benefits of best-in-class assets are starting to reflect in better pricing and quicker leasing for top-quality tenants.

Robust

Sue Munden, senior analyst, European property, Bloomberg Intelligence, believes that new spaces – which typically have green credentials – fill up quicker than second-hand space, though no more so than historically.

Data disclosed by the British property development and investment company GPE in its November 2022 interim report, sourced from JLL, shows that the vacancy rate for new office space in London is at about the ten-year average of 1.22%. In the rest of the market, the figure is 8.4% – well above the ten-year average of 5.5%.

Similar figures for the West End show a 0.8% vacancy rate for new space, again at the ten-year average, and 6.4% in the overall market versus the ten-year average of 4.4%. “Despite this, landlords are saying that demand for net-carbon-zero property is greater than for second-hand property, and pre-lets for new developments are robust,” says Munden.

Sustainable buildings are in demand as occupiers become keener to curb their carbon footprints. “This has resulted in higher rents for these buildings depending on location, building type and demand/supply balance,” adds Munden.

While outcomes are not uniform across asset types, the growing salience of sustainability seems hard to deny when it comes to property prices.

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