Real estate – ESG risks and stranded assets

There has not yet been a widespread move in the real estate sector with respect to ESG and decarbonisation in the same way it is apparent in other asset classes. Neither in terms of action by property owners nor capital values of properties.

Why? Well, there’s a historic misalignment between tenants and landlords, which persists. Tenants have not seen it as a priority, so asset managers haven’t been able to do much without their tenant’s engagement. And for properties that are vacant, attempting to enhance ESG credentials will likely 1) be costly and 2) lengthen the vacancy time, both of which will negatively impact returns. Moreover, enhanced ESG credentials have not led to any observable valuation improvements or increased the ability to rent at higher prices (not yet anyways!). It’s a double whammy, so you can’t blame asset managers for not focusing so intently on ESG in real estate up to now!

This is now beginning to change. Everyone, and especially governments and corporates, are focusing more on net zero initiatives. The “built environment” accounts for nearly 40% of global carbon emissions, so it is natural to think about decarbonisation in real estate as more and more investors set net zero targets. This should bring about changes in government regulations and demand dynamics (increased demand for more greener properties and currently very limited supply). Ultimately, at some point, properties that are unable to demonstrate strong ESG and climate credentials, will be considered disadvantageous, and may very well see valuations suffer due to an unsustainability discount.

What’s pushing ESG up the agenda?

Corporates are increasingly thinking about the climate and putting into action their own pathways to becoming net zero. In the UK, this is primarily driven by the UK government’s 2050 target, but each corporate can take a different approach. The properties they reside in play a large part in this. As a result, when their leases are up for renewal, they will expect, and look at properties with better climate metrics that will aid them in their commitments to being net zero. More importantly, they will pay a higher rent for these properties compared to unsustainable ones, which will feed into asset valuations.

Alongside this, investors want to put more capital in assets that contribute to positive externalities. This is from a personal standpoint and a regulatory/reputational perspective, particularly in the case of pension schemes and local authorities. Real estate asset managers will need to take note. If they want to continue to successfully raise capital, they will have to adhere to their investors’ ESG beliefs, and this would mean a greater effort to engage with tenants and push for sustainability within their investment framework.

On the regulatory side, all buildings need to start complying with the minimum Energy Performance Certificates (EPC) standards. EPCs measure the energy efficiency of buildings and each building is rated between A (very efficient) to G (inefficient). One of the policies implemented by the UK Government in their drive for net zero by 2050 is that it will be unlawful to let a commercial property with an EPC rating below an E from 1 April 2023. The regulations get stricter with all commercial properties needing a minimum EPC rating of a C from 1^st April 2027, rising to a B from 1^st April 2030 to be let.

Because of these reasons, properties that aren’t sustainable now may not be able to attract tenants (and the associated rental income) and/or suffer valuations falls in the coming years. Asset managers will need to purchase, develop or refurbish assets to make them more sustainable. Some asset managers have taken note and incorporated this into their strategies. Some go further. In fact, we are already seeing asset “develop to green” strategies being launched by a number of asset managers. Whilst this may not result in higher investment returns, it will definitely help to avoid any sustainability-related risks and preserve asset valuations.

Avoiding stranded assets

The first thing investors should be thinking about is to scrutinise the sustainability characteristics of their incumbent asset manager and their real estate portfolio more closely. They should look at whether new builds are being built more efficiently i.e. with more green materials and sustainable technologies. For standing assets, they should look at whether the manager is presently attempting to enhance ESG characteristics such as increasing energy efficiency/EPC ratings through the addition of insulation, smart metres and other technologies.

If this is not being done, investors could be left with stranded assets. As an example, if an asset manager has high exposure to D-rated EPC properties or below and the manager isn’t attempting to improve this (for whatever reason i.e. existing tenants aren’t engaging), they simply won’t be able to lease them post-2027. They will also likely struggle to attract new tenants or re-lease properties in the meantime. In this scenario, the asset manager will either have to sell it at an unfavourable price, taking into account an unsustainability discount, or inject capital to meet these minimum standards whilst the property is vacant, both of which could leak value for end investors.