According to the World Green Building Council, building and construction is responsible for 39% of all carbon emissions across the world. The largest share of this relates to operating emissions. As a result, the global spotlight has fallen heavily upon the real estate industry.
In Denmark, sustainability continues to be top of the agenda for government, business and everyday life. The country is fully committed to helping the UN achieve its 17 Sustainable Development Goals by 2030, and the Danish government has set ambitious targets.
There is a reason why Copenhagen is one of the world’s greenest cities, and innovation is abundant in the building and architectural industry. Three examples of buildings in Copenhagen that really characterise sustainable design and green features include the UN City in Nordhavn, Nordea’s Danish Headquarters in Ørestad, and the Green Light House in Nørrebro.
Drivers of sustainability
Occupiers, investors and lenders all have different catalysts causing them to drive forward sustainability.
The CBRE European Occupier Survey 2019 ranks the greatest challenges for occupiers. Sustainability may not be explicitly mentioned, but this does not diminish its importance. In fact, it directly influences an occupier’s fourth and fifth greatest challenge, which are Workforce and Talent Preferences and Cost Escalation.
Competition for the best talent remains high in many industries. The younger workforce, and future leaders, are placing greater weighting on a company’s sustainability credentials. A building’s sustainability features are intrinsically linked to workers well-being and, therefore, it can be argued that greener buildings improve staff turnover and productivity.
Climate change poses many risks for real estate investment and the question being asked is to what degree does age and obsolescence erode value and how much will inefficient buildings diminish the potential buyer pool?
Landlords are increasingly reacting to new environmental legislation, public opinion, occupier and investor requirements. Environmental, Social and Governance (ESG) policies are being used to measure a company’s sustainability practices and manage risks. In real estate, ESG’s encourage collaboration between interested parties over a building’s lifecycle. This is advantageous as occupiers are constrained by their legal possession as lessees and, therefore, might be reluctant to financially contribute to sustainability improvements. The adoption of ESG’s are assisting property funds in sourcing alternative financing options and attracting sustainability conscious investors. In addition, Green Leases can be utilised to instigate tenant green investment in existing buildings through incentive and penalty clauses.
Lenders are also subject to the same risks and challenges as investors. The availability of building sustainability credentials and ratings, and ESGs, which are benchmarked by the Global Real Estate Sustainability Benchmark (GRESB), allow lenders to offer bespoke products, such as Green Loans and Sustainability-linked Loans. These products are advantageous to lenders as they help demonstrate their own green credentials to stakeholders. A lender’s unique upstream position allows them to influence a building’s green credentials by nudging unwilling borrowers to invest in green features by linking the loan margin to ESG performance. GRESB provides an instrument to measure a borrower’s sustainable performance over the loan’s life. As a result, there is a pricing advantage for investors who can secure green or sustainability-linked loans.
Main International Rating Tools
There are approximately 30 voluntary rating tools worldwide, such as BREEAM and LEED, which are used to grade and rate building sustainability performance and environmental impact. The challenges are that they are not directly comparable across borders and geographical regions. EPCs, which measure energy ratings of existing buildings across the European Union, are often criticised for being too simplistic and inconsistent. From a valuation perspective, the ratings may well be outdated as at the date of valuation.
The valuation industry has recognised for some time that a building’s sustainability performance will increasingly filter into pricing. A few industry governing bodies have made attempts to direct the conversation and lay the foundations in capturing sustainability within valuations. As of today, consistent data sets have not emerged across the industry and the question remains as to how best to improve sustainable data transparency, standardisation and sharing.
Impact on valuation
Valuers track the behaviour of market participants very closely and sustainability considerations are driving behaviour. Occupier organisations with strong ESG policies can influence leasing decisions and rent levels; whilst investment funds with ESG aims can attract and deploy capital on sustainable investments, as well as tap into the availability of green loans with pricing advantages. Evidently, if the occupier demand is there, and reflected in market rents and absorption rates, such considerations will impact developers and the pricing of land. It is not difficult to understand that there is an impact on yield, the required return for the invested capital, when these sustainability considerations are influencing stock selection.
Over time the market should implicitly price in the effect of sustainability, in turn leading to the evolution and redefinition of prime or grade A space, to be an asset with characteristics and performance that can be defined against consistent sustainability criteria.
With the growth of sustainability over the last few years, it is natural to consider the quantification of a green premium for sustainable assets, and whether the presence of green features adds to value. However, if we are to argue that the market should automatically price in the green premium, redefining our view of prime, at this conjecture the valuer will be required to reverse engineer their thinking and consider whether the absence of green features detracts from value. In this instance, consideration would be required for the brown discount or value deduction required to account for the difference in secondary from prime.
Comparable evidence is the bedrock of reliable valuations and comparables with sustainability data need to be analysed and ranked. Yet this data is not always available, particularly for older buildings. To overcome these obstacles in the short term, valuers often rely upon OPEX budgets to review running costs and benchmark these against comparable evidence.
To conclude, valuation houses and institutional owners of real estate have previously worked together to move the needle forward on the issue of sustainability and value impacts. The opportunity now is for these same organisations to work together with all invested parties to build on this progress, to define and commit to a common set of agreed sustainability metrics.
With this in place, the valuation houses can improve and expand the data sets going forward to track and monitor the effects of sustainability components and the evolution of prime.
Only then will we be able to start to unpack the rent and yield proxy and be able to isolate and quantify value attributable to sustainability considerations.