Article by Ioannis Orfanos, Arbitrage RE
Most investors today would not develop a new commercial building in a major city without attaching some green credentials to it. Τhis proves an underlying value differential in green labeled and more energy efficient properties. However, this value differential is not evident at present as it has not appropriately quantified due to lack (so far) of reliable data.
Likewise, defining and quantifying the impact of sustainable initiatives in existing commercial real estate matters if we are to overcome the slow progress of green retrofits in current building stock. It is undeniable according also to a recent analysis report in UK that the economic factor of value creation is simultaneously one of the most significant drivers and barriers to advance the pace of retrofits.
So how do we calculate their value impact?
I will share first a real case example from a recent project. A large office building, 80% occupied with an up to 30% energy saving potential. Based on a £800k retrofit budget, in 6 months post retrofit completion there was about £4 million verified asset value uplift. This was a result of existing tenants’ retention, rental growth in certain lease renewals (part of a pre-retrofit agreement to share operating costs savings) as well as new lease signings on higher than (previously) average rental terms. And in addition thanks to a yield adjustment, which was confirmed by an acquisition bid.
Additionally, sustainability’s intangible benefits in commercial real estate investments lead to tangible paybacks. Tangible paybacks that originate from the reduced exposure to risks associated to climate change mitigation and future carbon regulation changes. Risks affecting directly insurance costs. The intangible benefits linked to enhanced worldwide reputation and sustainability credentials also lead to actual returns. As an example in Carbon Disclosure Project (CDP), well-known real estate investors are disclosing and getting scored on their carbon performance. And based on CDP, 2013 Climate Disclosure Leader outperformed more than 30% over the last 7 years the returns of the overall Global 500 corporates.
Therefore, in attempting to answer the value impact question, we will need to focus on three areas that can generate better returns:
- Revenue; due to higher rental income than in an ordinary building as a result of lower service charges, decreased void periods and reduced tenant churn.
- Profits; from improved capital values due to higher revenues and lower exit yields as a result of enhanced attractiveness to good covenant corporate and public sector occupiers conscious about long-term sustainable business models and thus occupation of sustainable buildings.
- Intangible benefits; such as boosting investor’s brand value and reputation due to enhanced sustainability credentials and reduced exposure to associated environmental and climate change risks, which could lead to greater competiveness in future fund raising.
Based on which of these categories a sustainable retrofit initiate fits into, the industry owes to measure its value impact. And to quantify the value generated at an asset or portfolio level, the industry may well use and better integrate existing tools, data and techniques that are used to measure commercial real estate performance.
The integration in sustainability measurement data would need to materialise across three levels. Portfolio, asset and building unit levels to increase transparency and interaction. On a building level, there are plenty of green rating and labeling standards. The same applies in portfolio level, where quite a few credible and well-established annual reporting and benchmarking tools exist. The goal should be to work across all current tools, standards and benchmarks to integrate and consolidate results.
Hence, appropriate data exist, it is all about communicating them in such a way that we are in a position to demonstrate the additional value impact. To showcase reliably what industry leaders achieve when they address sustainability in their property portfolios. This will lead to a quantifiable and much broader definition of the added value impact that will help fund managers to better monitor performance, manage progress, benchmark results and demonstrate sustainability credentials to investors. It will also help fund managers to report and compare apples for apples, given the huge inconsistency in how buildings have been constructed, which is making benchmarking on an asset level a big challenge.
To conclude, we need to better use the present metrics and standards to quantify at a property and/or portfolio level how much added value in revenues, profits and intangible benefits a sustainable investment initiative generates. We might have to develop supplementary specific KPIs, however without measuring and communicating performance, it would be difficult to strategically influence investors’ decision making when buying, developing or actively managing commercial real estate.
Undeniably, substantial opportunities exist to increase transparency and collect better and more reliable sustainability performance data. And a major challenge will be to integrate accountability and reporting delivery across levels and job roles as it cannot be left just to the sustainability function.
And please allow me a final remark. The property industry is facing a similar challenge the car industry has handled multiple times in the past due to technology innovation and regulation changes. As an example when the Airbag and/or ABS breaking system were introduced, measurable tests helped the market to understand the value these technologies were bringing. And thus very early, any car without these systems became obsolete, because they became indispensable. The same I argue it will happen with sustainable and non-sustainable buildings.