Levelling up commercial real estate in the ESG era

Not only is ESG expected by an organisation’s stakeholders – from its customers and employees to shareholders – its elements are also becoming a legal requirement, posing a whole array of new challenges to commercial property owners, occupiers and investors. Given the government’s drive to raise minimum energy efficiency standards (MEES) on commercial buildings, which will need to be EPC ‘B’ by 2030, upgrading obsolete buildings is no longer optional.

Few would argue against the benefits of more environmentally friendly buildings. They are cheaper to maintain (better insulation results in lower heating bills, for example), are often more visually attractive and some are even designed as mini-power stations. However, the cost of renovation to hit ESG targets will be a determining factor for the property investor, particularly in secondary and tertiary locations. So can these ambitious targets be achieved by all in the real estate sector, or will it just be confined to the big and well capitalised players?

Offices

The most energy efficient offices are achieving rental growth as corporate real estate trends demand the highest standards. There is a drive for this kind of product across primary locations in the UK as many ESG-aware businesses are looking to occupy sustainable buildings, but there are pressures on the landlords of older buildings especially in secondary and tertiary locations as upgrading will come at a price. If you take the average office rent in somewhere like Leamington Spa, which is around £20- £25 per sq ft, and compare it to the cost of improving the space (which may be around £100 per sq ft minimum), it’s clear there will be trouble ahead. For smaller property owners with a limited improvements budget, justifying the capital expenditure would prove challenging. While doing nothing isn’t an option, some will find that doing something isn’t either.

Retail

Due to the MEES target, 83% of retail stock will need to be upgraded by 2030 according to Savills. While the institutional landlords with deep pockets that own the larger shopping centres and retail parks will find this achievable, albeit at a big expense, it’s the smaller units on the high street, more likely to be owned by private investors, that will struggle. One thing that will help is the updating of the ‘carbon factor’ in EPC ratings. As electricity is less reliant on fossil fuels due to a large increase in renewable power, carbon emissions are significantly lower relative to gas than they used to be – a small ‘win’ in difficult times.

Logistics

On the other hand, the logistics sector offers some of the most opportunistic asset management potential with rooftop solar panels and even rainwater harvesting allowing carbon neutral buildings and other clean energy use opportunities including electric vehicle charging units. The challenging aspect with offering the above will be working on the existing stock as there may be restrictions relating to the older units in terms of their weight bearing capability.

What next?

The question investors are asking is whether it is feasible to upgrade these buildings at a large cost in the hope that occupiers will pay increased rents Regulated investors are under pressure to increase their proportion of sustainable assets but with costs for development so high, the upgrades demanded will push the boundaries of affordability. Fortunately, there are many funds that are raising capital for these types of carbon neutral or ESG portfolios. Therefore, with a future influx of demand from funds there will be a predictable increase in value for these properties if supply does not follow suit.

Eventually investors will be required to use capital to improve the efficiency of buildings whether they are buying the assets, or the assets are already within their portfolios. It will be difficult for the private investor to advance in this space as they will have to deal with a level of risk that could be hard to justify, especially in the still-struggling retail sector. Given this problem particularly affects regional towns and cities, and the government’s much heralded levelling up agenda, political intervention or policy changes such as tax incentives will likely be necessary to support these buildings and the high streets that rely on them.

While ESG reigns supreme in investment decisions, work to improve the UK’s commercial real estate stock is not as straightforward as it may appear to be.