5 min read 21 Sep 22
Momentum is growing behind the case for decarbonising real estate as portfolios face potentially significant climate risks that could impact future returns. The industry itself is responsible for around 40% of global carbon emissions1, meaning it will play a vital role in the bid to achieve net zero by 2050.
As many investors strive to navigate the complexities of aligning their real estate holdings with decarbonisation goals, there is still some debate over the link between ‘greener’ buildings and generating better financial outcomes.
But over the past couple of years, evidence has been growing about how the green premium of buildings – such as those with a high-rated energy performance certificate (EPC) and green building certification – can outperform both in terms of rental income and valuation2.
“On the other side of that coin, especially where there is a regulatory driver, we are seeing the impacts that valuations are having from poorer rated energy performance certificates, particularly because the cost needed to improve those buildings is starting to be priced in by investors and the valuation market,” says Nina Reid, Head of Sustainability for Private and Alternative Assets at M&G Investments.
Decarbonising real estate comes with its challenges and nuances, however, especially regarding pricing climate risks – both on the transitional and physical side – into property valuations.
To generate the best possible risk-adjusted returns over the long-term, in our view, institutional investors need to take into account what impact climate risks may have on portfolios, considering how assets may be vulnerable to rising temperatures and changing weather patterns in the future.
Although these risks are still not feeding through into real estate valuations in a meaningful way, this looks set to change over the coming years. In the meantime, we believe investors need to build these considerations into their analysis now to avoid jeopardising future returns.
“In markets where there's a regulatory backstop, it makes it much easier for valuers and the market to start pricing in transitionary risk,” notes Reid.
Some European countries are already making it clear how minimum energy efficiency standards for buildings will become more stringent over the next decade. In the Netherlands, for example, office properties will require a minimum EPC rating of C by 20233, while the UK government has proposed legislation requiring the same for new residential tenancies by 2025, and for non-domestic properties to achieve EPC B – the second highest rating – by 20304.
As legislation in the industry develops, and tenants demand greener buildings to meet their own net zero targets, investors have to factor in the costs required to transition existing buildings as well.
With governments mapping out how EPC thresholds are set to change over the coming years, investors can gain some clarity on the amount of spend required to bring buildings up to suitable energy standards - one key aspect of transition risk.
“Essentially investors have to ask what capital expenditure (CapEx) it will take to get a building up to a satisfactory performance level, whether that cost is priced in, and whether there is allowance for it in future works” explains Reid.
Plotting portfolios against the Carbon Risk Real Estate Monitor (CRREM) can help investors estimate the CapEx required to align assets with net zero pathways beyond energy performance before they become stranded.
But retrofitting buildings to align them with decarbonisation goals is not always straightforward. It could impact short-term returns if carried out too soon, while incurring greater costs down the line if works are delayed. Nevertheless, making existing real estate more eco-friendly could help reduce future climate-related risks.
According to Reid, it may be necessary to put a CapEx for retrofitting against the valuation of a building to essentially penalise those who have not priced it in.
“This will become increasingly common in markets where there is a regulatory backstop,” she says. It is already evident in the UK, the Netherlands, and also in France where similar regulation is coming through.
Where it becomes more challenging to adjust valuations is over lack of consistency on the definition of net zero in real estate.
“People are using different methods to describe net zero in the sector,” says Reid. “It may just refer to operational usage, or the carbon emitted during construction of a building. It could also mean whole life carbon. Communication surrounding net zero in real estate is inconsistent. There are all these different definitions and this makes it much harder to price in that risk.”
It will take more time to understand the impact on valuations the transition to net zero will have, and more standardisation is needed beforehand.
“There are a lot of unknowns in the industry at the moment, but through experience we can still gain a sense of the direction, and how to approach the transition to net zero so progress can be made despite the uncertainty,” says Reid.
In the long-run – with temperatures hitting record levels across the northern hemisphere in the summer of 2022 – investors might want to consider how to safeguard their real estate portfolios from future climate-related risks sooner rather than later.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.