Climate-related stranded assets in real estate part 3: Attitudes, valuation and retrofit

Beyond the sector itself, are there wider societal knock-on effects?

Martin Haran: I found it very strange that the real estate sector didn’t have a carbon reduction roadmap towards the Paris treaty; a roadmap based on scientific targets i.e. the 1.5 and 2.0 degree heating scenarios. Many investors have a will and desire to align their portfolio with the targets agreed in the Paris Treaty. However, they do not have a clear understanding of their current portfolio intensity and the interventions needed to ensure conformity. As real estate is also an internationally diversified investment asset class, it is important to have science-based targets which depict the location specific climatic conditions. Climatic conditions are not uniform. Even within countries, it is important to understand climatic conditions as well as property type and usage to create robust science-based pathways.

With the CRREM [1] project, we had to create a roadmap. I found that dismaying. Particularly because the real estate sector is recognised as contributing over 40% of GHG emissions globally. The sector has a huge problem, but it also offers huge potential to reduce carbon emissions globally.

When it comes to decarbonisation, the key sectors of industry are so intertwined. For example, reductions from transport emissions and the decarbonisation of the power grid will have big impacts on the carbon intensity of construction, which requires both power and transportation. Equally, if you’re in another sector of industry and you occupy premises, then the carbon intensity of your assets will have impact upon your carbon footprint. Decarbonising real estate brings added benefits to businesses that sit outside the real estate sector as well. Understanding the value-chain and the interdependences within it is crucial to attaining impactful intervention strategies.

Kevin Muldoon-Smith: If we don’t tackle emissions from the built environment, environmental targets can’t be met. On the positive side, if you expose the stranded asset threat, so that people understand the magnitude of the issue, the outcome could be very positively disruptive, because it’s about future-proofing. It promotes the sustainable retrofit of our cities. Sometimes people see real estate assets as distinct from the economy and society, but fundamentally, its where people live, where they carry out their work, the infrastructure is how you travel around. So stranded assets in real estate are systemically related to everything we do.

Depending on your investment horizon, you expect to invest for typically about five, ten or perhaps 25 years. When you look at the time horizons for the ratcheting up of EPCs in the UK, it’s the very same time horizons: 2025, 2030, 2050. It’s been difficult to find an objective premium – how much extra value there is in a sustainable building. I think further exposing the stranded asset threat makes the case for retrofit and property adaptation. It’s about people paying more, it’s the recognition that if they don’t do it, their properties’ value reduces. So the next 20 years will see a lot of change.

You speak about the scale of properties affected, and the risk of stranding, how much has this risk been picked up in global real estate markets? And how are they responding?

KMS: Has it been priced into real estate markets? For me, this is the nub of the issue: I don’t think it has. Since we published our research [2] there’s been some recognition, but I think we’re almost at the moment before it’s been priced in. If you were going to see it priced in, you would see quite a systemic change going on.

MH: I don’t think it has. That’s not a criticism of valuers. It’s difficult for valuers because when you’re talking about the elite, the top quartile of property that is carbon neutral or carbon zero, it’s very difficult to disentangle what is the green premium and what is other value associated with the location and facilities of the building. More research needs to be undertaken to investigate the extent and constituents of green premiums and so-called ‘brown’ discounts.

KMS: We are in a really difficult moment: how do the techniques of valuation accommodate the stranded asset issue, and what happens to the valuation of properties when that happens? We value property based on what’s happened before-hand, the comparable basis of analysis, and previous transactions. Stranded asset exposure is in the future, so the very techniques that we use to value property don’t really account for climate related stranding. Ultimately, we don’t want to see widespread value reduction overnight. What we want to see is the adaptation of properties over time.

I think one of the wider problems we have at the moment is that some studies into stranded asset exposure are still using quite traditional number driven methods of analysis and valuation. Some organisations that have portfolios are retreating to traditional ways of understanding the issue. But if you’re looking at traditional models and methods, you’re probably going to find what you want to find – that you don’t have much exposure. I don’t think that’s really the answer. Those that move now, the early adopters, will have a strong foothold in 10 – 15 years’ time.

Paul Greenhalgh: I think price hikes like those we saw last year in electricity and gas will also contribute to changing demand in the market. Occupiers will pay more for rent on a green building because they’re saving on bills and the property is unlikely to get caught up by MEES legislation ratcheting up. There is only so much businesses can afford for rent and energy bills.

Coming down to valuation practice, what we do know as valuers and have known for decades is cash flow analysis and lifecycle costing. Whether its discounted cash flows or period by period compounding cashflows, you can do analysis into the future, but we don’t do enough of it, and we don’t factor in some of the costs. We need to look at the hard numbers projected forward over the next 15 years – that’s when it’ll work its way through into asset values. There’s got to be a step change in attitude. It’s a bit like BIM, where you have a virtual representation of a building. BIM can be used to build your property in the computer, and it will save you time and money because you make your mistakes in a virtual environment. Why haven’t we got a financial model of these assets?

KMS: Break clauses, income security, covenants, length of income, and average unexpired term are already monitored. Often the bit missing in the portfolio management is the physical nature of the building: its physical performance on things like fossil fuel exposure, and the likely cost of retrofit and adaptation.

PG: You can cash flow the energy consumption of the building in occupation, on the basis that the bills are only going to go up, and your income will be impacted by the cost of occupancy, because that’s the trade-off.

MH: Technology within the sector evolves quickly. The cost of retrofitting can diminish because the cost of technology is always coming down, while sophistication is going up. That creates a difficult balance to strike, because the logic would suggest that the longer you put off your retrofit, the less it will cost you. We need to look at it in terms of a wider debate and discussion, rather than just being purely cost driven. We need to ask: what is the societal uplift here? What is the environmental impact, and how does this contribute to change in the carbon intensity of the building? I see investors operating in the upper quartile of real estate assets choosing to liquidate rather than retrofit their stock. Its seemingly easier to go away and develop an entirely new carbon neutral building than to green retrofit an existing one.

This is why embodied carbon is so important: if you look at the demolition process, the construction process, there is a lot of embodied carbon wrapped up in that. It’s going to have to be a very special asset that can achieve net zero emissions with the amount of embodied carbon that has gone into demolition and construction. Such an asset will take a long period of time to balance itself out. If 50% of what we have currently will still be here in 2050, we’ve got to start thinking more holistically and more long term around the net zero challenge.

[1] https://www.crrem.eu/

[2] https://www.sciencedirect.com/science/article/pii/S2214629618309599