Key themes from COP26 for commercial real estate investment
COP26 has highlighted an increasing desire amongst the real estate investment community to generate environmental and social returns alongside purely financial ones and an acknowledgement by many investment managers that it constitutes both their fiduciary and also broader moral duty to do so as powerful influencers of our built environment. As noted by Neil Slater, Global Head of Real Assets for abrdn plc in the COP26 Green Zone seminar, while the real estate industry has always been focused on asset performance, generating value while assuming appropriate levels of risk, the concept of performance is evolving to take into consideration creating assets that perform for occupiers and which also perform for wider society.
So, is there any clear consensus emerging in the industry as to the key challenges to address and key steps that need to be taken in order to make meaningful progress on the climate challenge?
A varied picture across sectors
See our diagram of the climate transition challenge across the sectors.
The scale of the challenge varies significantly between real estate sectors, with the logistics sector offering some of the best opportunities for achieving energy neutrality through the use of rooftop solar panels. A recent report by Savills states that on average around 40% of a warehouse roof may be suitable for the installation of solar panels and working on that basis, the additional 250,000,000 sq ft of warehousing due to be delivered in the next decade could deliver sufficient energy to service 97% of the energy requirements of the new development. However, work to retrofit existing stock with rooftop solar may prove to be more challenging due to the weight bearing capacity of older units. Rainwater harvesting and electric vehicle charging offer further opportunities to green logistics assets.
Change in the office sector has been driven by investors’ desire to protect their assets against obsolescence and keep them appealing to prospective tenants, who in turn have also been demanding greener buildings, with 45% of all central London office lettings since 2018 occurring in relation to space rated BREEAM Excellent or better. The present challenge is considered to be an undersupply of green office space, driving rents for green spaces and further illustrating the existence of a “green premium”.
The residential investment landscape is a complex picture: with “beds, meds and sheds” a key focus for real estate investors due to the consistent outperformance of alternative real estate sectors in recent years and structural tailwinds, the numerous new build to rent developments currently underway offer real estate investors the opportunity to develop green buildings, which are also increasingly being demanded by residential tenants. The broader UK residential sector however is likely to pose a much tougher challenge, with Savills noting that the Government’s target of upgrading all homes where “cost efficient, affordable and practical” to EPC C by 2035 is looking highly unlikely to be achieved without more policy intervention, particularly in respect of owner occupiers.
The retail market presents a similar challenge, with a divergence of prospects between the larger scale and usually institutionally owned shopping centres, retail parks and larger units and the typical smaller, British high street store. The latter account for the vast majority of retail space in the UK and are likely to prove far more challenging to retrofit (and in many instances, not economically viable to do so).
The unifying theme across the various markets is the need for owners and investors to successfully navigate the threat of assets being stranded as a result of failing to meet the climate challenge.
Moving beyond operational carbon
As investors become more adept at reducing operational carbon emissions and even operating buildings on a carbon neutral basis, the role of embodied carbon (carbon attributable to the extraction of raw materials and construction process) is likely to become an increasing focus for the real estate market. The UK Green Building Council (UK GBC) has predicted that by 2035, embodied carbon will account for over half of all built environment emissions. The UK GBC has also recently launched a "Net-Zero Whole Life Carbon Roadmap" which aims to build a common vision and agreed actions for achieving net zero in the construction, operation, demolition and reuse of buildings and infrastructure in the UK. It does this through establishing a carbon budget and trajectory for the UK built environment sector, as well as setting out the key policies and actions for central Government, local authorities, and relevant stakeholders. Amongst the UK GBC’s recommendations are:
- mandatory embodied carbon measurement, followed by the phased introduction of embodied carbon limits for new buildings to reduce demand;
- removal of VAT on refurbishment works (i.e. 0% VAT) which retain the building structural frame and achieve energy performance targets to incentivise re-use over demolition;
- development of a freely available national embodied carbon assessment tool;
- utilisation of existing industry resources to establish a national asset and product embodied carbon database, such as the Built Environment Carbon Database;
- publication of embodied carbon benchmarks and voluntary best practice standards by 2023;
- updating National Planning Policy Frameworks to require evaluation of embodied carbon impacts of a new build before permitting demolition; and
- enabling local planning authorities to set more ambitious limits on upfront carbon for new development than those introduced via building regulations.
It is abundantly clear that measurement and management of embodied carbon will be a significant feature of real estate investment and development processes over the coming decades.
If you can’t measure it, you can’t improve it
Real estate investment management increasingly entails the collection, processing and reporting of ESG data in multiple areas, including:
- disclosure driven by legislation, such as the Task Force on Climate-related Financial Disclosures (TCFD) and in Europe, the Sustainable Financial Disclosure Regulation (SFDR) and the Taxonomy Regulations (with UK versions of such initiatives also to be implemented);
- reporting against voluntary benchmarks and ratings at portfolio or corporate level, such as the Global Real Estate Benchmark (GRESB);
- reporting against global frameworks and guidelines, such as the UN Sustainable Development Goals (SDGs) and the Global Reporting Initiative; and
- data gathered and reported upon by a real estate manager itself in order to make investment and asset management decisions, at business, portfolio and individual asset level and for reporting to investors.
Reliable data is therefore becoming a critical tool to enable real estate investors to monitor and increase their asset’s contribution to social and environmental goals. Innovations such as smart metering, automated data collection and Wi-Fi enabled building sensors along with the IoT (Internet of Things) devices are all becoming useful tools for embedding the capture of and transmitting data on various aspects of the ESG performance of a building.
High levels of visibility and data sharing around climate related KPIs (for example, tenant energy consumption) are likely to be demanded and underpinned by green lease provisions. With some commentators predicting that green financing products will become mainstream, there is a need to ensure that the KPIs around which such products are centred have integrity and are properly structured in order to both drive value and achieve sustainability targets. Stakeholders are also grappling with how to reflect climate related risks in valuations, with owners and valuers often reaching different conclusions as to how this should be reflected, with some owners carrying out “net zero audits” at the time of acquisition and adjusting the price based on their own views of the ESG risks.
It is clear that a digital transformation of real estate is well underway and investment managers are going to have to devote an increasing amount of time and resource to ESG data analytics.
Real estate is a highly idiosyncratic, negotiated asset class, with a vast network of different stakeholders involved in the typical lifecycle of an asset, from architects, development teams and agents to asset managers, occupiers and investors, to name but a few. The highly varied, interactive and collaborative nature of the sector is what draws many people to work within it, but in the context of climate change this poses additional challenges. In the COP26 Green Zone seminar, the challenge of bringing all stakeholders along throughout that value chain led Shuen Chan, Head of ESG Real Assets at LGIM, to call for “radical collaboration” within the real estate industry. This will involve working with all stakeholders to ensure they understand their role in the process and the interventions that need to take place, which in many instances will entail educating such parties at the same time.
COP26 has highlighted that there is a great desire within the real estate investment industry to address the climate challenge and an increasing understanding of the steps that need to be taken in order to achieve net zero carbon in the built environment. Real estate investors are likely however to have to adapt their mindset to consider the whole life carbon impact of their real estate assets and become increasingly sophisticated consumers of data. Perhaps the most resounding message is the need for radical collaboration across all stakeholders in the lifecycle of an asset in pursuit of a greener real estate market.