As we move to a more conscious world, with sustainability and Environmental, Social and Governance (ESG) at the forefront of our minds, the same can now also be said for the real estate sector. Property owners and lenders alike are now making conscious decisions to reduce their carbon footprint and focus on their ESG policies.
As part of this, we have seen an uptick in appetite for “green” buildings in the sector and earlier this year, Royal Institution of Chartered Surveyors (RICS) published their sustainability report which provided feedback on the impact of perceived sustainability real estate. In particular, their data has raised a thought-provoking question: how will the ESG agenda impact real estate asset value?
Considering the data collected by RICS, this article explores whether the ever-increasing appetite for green, sustainable buildings will give rise to a higher market and rental value for those buildings, also known as a “green premium“, or whether, conversely, it will be the case that buildings that do not conform to being “green” will suffer from a reduced value, a concept which is becoming popularly known as the “brown discount“.
The Green Premium vs The Brown Discount
As companies commit to reaching a net zero carbon footprint, commercial tenants are being encouraged to take a closer look at the real estate they occupy to ensure that it is in line with their sustainability and ESG policies. The knock-on effect is that occupiers are seeking sustainable and green certified buildings to capitalise on the cost savings and better energy efficiency across their management, services and utilities. Given that green buildings will benefit occupiers and their staff, prospective tenants may be willing to pay a premium to secure such buildings.
Putting this into perspective, the RICS report identified that, in Europe, around 52% of their contributors noted that occupier demand for green buildings has risen over the last 12 months. Interestingly, around 80% of the respondents also reported an increase in investor appetite for green buildings.
However, something to consider is whether, as the real estate market moves to be more ESG aware, the concept of a green premium may actually diminish in importance, as changes in attitude become embedded in market behaviour. Instead, it may be the case that energy in-efficient buildings will increasingly be viewed as substandard. For example, you would not pay a premium for something you perceive to be standard. Rather, you would expect a price reduction to account for the missing features. This prompts the question whether rather than there being a green premium, it is a brown discount that is more likely.
The brown discount
The idea of a brown discount is an emerging trend based on a shift in the market attitude that sustainable and energy efficient buildings are expected and, consequently, owners of buildings that do not offer such characteristics may face potentially a lower rental rate or sale price than the market average, or may even struggle to obtain investment from lenders.
What’s more, is that non-sustainably considered buildings could potentially suffer from higher occupancy voids, higher operational costs and could also be exposed to the risk of capital depreciation in the face of tightening of ESG-focused legislative and regulatory changes.
Quantifying this, RICS have reported that almost three-fifths of their European-based contributors accounted for a brown discount in rents and market value prices. Around a third suggested the discount is likely to be up to 10%, whilst near 25% of contributors suggest that it could be higher than this.
However, it must also be said that just under a third of contributors in Europe did not report a brown discount but they did report a rent and price premium for green buildings and around 12% reported no brown discount nor a green premium.
What does this mean for the real estate market?
It seems that the existence of both the green premium and the brown discount in the real estate market is still up for debate. With the trendline analysis of the data only being in its infancy, the data does not yet seem to suggest a quantifiable nor an instantaneous increase (or, indeed, a decrease) in property valuations.
Nevertheless, there is no doubt that ESG factors are becoming paramount for occupiers and investors and, as a result, the real estate market is expected to naturally adjust based on investor sentiment, further regulation and tenant demand. Investors and property owners will be rewarded for understanding their exposure and implementing an effective real-estate ESG strategy.
In the commercial market, we have already seen the introduction of two main products with lenders offering to borrowers based on sustainability through vehicles such as green loans and sustainably-linked loans. Furthermore, tighter regulation of the Minimum Energy Efficiency Standards (MEES) is expected to provide a trajectory for commercial property to be EPC band B by 2030. These can all be said to be influencing the market to be greener and more sustainable and it will be the introduction of more of these factors which will shape the market into what is deemed standard, and what is considered sub-standard.
Our Developing Connections panel event on 23 November 2022, chaired by Blake Morgan Partner Euan Mitchell, hosted key players from the industry who looked at the challenges and opportunities when it comes to ESG in real estate, practical solutions to implementing strategy and success stories.
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