If you’re a real estate investor you’ve had a ‘white-knuckle ride’ in the last two years. Covid struck the sector like a Comet, decimating valuations. Hotels, offices, retail – there seemed no place to hide.
Well, I just hope you’ve got a strong stomach. What’s coming could be even more disruptive, as tougher regulations for the ‘built environment’ start to bite and weary investors discover the “brown discount”.
According to an assessment made by the engineering faculty at the University of Cambridge, buildings account for “50% of all extracted materials, 42% of final energy consumption, 35% of greenhouse gases (GHGs) emissions, and 32% of waste flows” in the EU. Figures for the States are often higher. It is hardly surprising that they are attracting the notice of Governments and regulators.
For the first time there is a “Built Environment Day” on the formal COP agenda, and the EU recently unveiled its “Fit for 55” package of 13 policy proposals as part of efforts to achieve the European Green Deal. It includes plans to establish a new carbon market for buildings, a strengthening of the Energy Efficiency Directive (EED) and a promised revision to the Energy Performance of Buildings Directive (EPBD).
In the States, the Biden administration is undertaking similar initiatives to improve the efficiency of federal, commercial, and residential buildings. For the first time it has established Building Performance Standards (BPS) which will “establish metrics, targets, and tracking methods to reach federal carbon emissions goals”.
The city of New York recently introduced Local Law 97 which requires buildings to meet carbon emission intensity standards set by the local government. Buildings that have carbon emissions above the threshold will pay $268 per metric ton of CO2. That could run into millions of dollars for large buildings.
Industry groups are responding to the new mood music emerging from national and local governments. Last week, the World Green Building Council updated its Net Zero Carbon Buildings Commitment to include new requirements for addressing “embodied emissions”. Apparently 10% of carbon emissions comes from the materials and construction processes required to build and renovate buildings, also known as “embodied carbon”. It is estimated that between 2020 and 2050, more than half of total carbon emissions from all new global construction will be due to embodied carbon.
There are good reasons to focus on embodied carbon. Rick Walters of GRESB (the Global ESG benchmark for real assets) tells me: “Improving operational efficiency was a big deal in the past, we’re largely there now. We know how to make buildings energy efficient.” For new buildings: “the operational design is increasingly so good that most of the carbon is actually in the materials.”
Robbie Epsom, EMEA head of ESG at real estate giant CBRE GI agrees. It is looking increasingly likely that a reduction in greenhouse gas emissions from the building sector will be targeted. He says, “Some suggest that a reduction of up to 96% in greenhouse gas emissions is possible.”
96%. Now that’s a revolution.
The race to Net Zero is well in hand for some investors (CBRE GI aims to achieve it by 2040 for directly managed, core investments), but not everyone. While GRESB data for the last three years shows a consistent 75% of respondents who are making some kind of climate related targets, the proportion making a specific Net Zero commitment is tiny, if rising: 3.7% in 2019, 7.9% in 2020 and 15.1% in 2021. This is way below the kind of net zero targets being set in the public equity space.
I pressed Rick Walters of GRESB on this point. He defends real estate investors, saying their Net Zero targets are “more meaningful” than in equities, but even he admits property “investors need to go five times as fast if they are to get anywhere close to meeting the Paris targets.”
Pause a moment. The implications of this are significant. A massive transformation of commercial property will have to take place on a scale we have never seen before.
CBRE GI talks of assets needing to be refurbished to remove all burning of fossil fuels on site, replacing gas and oil burn boilers with technologies such as heat pumps to take advantage of grids that have already been decarbonised. And “any major refurbishment going forwards will inevitably use circular economy materials.”
Paris’s biggest landlord, Meka Brunel, CEO of Gecina tells me she believes “we should follow the principles of the circular economy and renovate buildings using existing materials as much as possible.” Gecina says their recent redevelopment of the Pergolese building in Paris brought this “ground-breaking circular economy approach [to] the heart of Paris.” More than 81 tons of materials have been reused, making it possible to avoid 394 tons of CO2 emissions.
Imagine what this means for the building materials industries who will face additional disruption from the worldwide move towards carbon border taxes. Trade-offs between, say, structural timber and concrete, or structural timber and steel.
Disruption certainly came recently when a Swedish court revoked the operating license of Sweden’s largest cement plant due to concerns over the plant's environmental impact assessment. Construction industry body Byggföretagen warned: "Sweden is facing an extensive construction halt. By November, three out of four new homes will not be able to start construction.”
Also, consider the implications for property valuations. Investors are increasingly discovering a “brown discount.” Walters points to the dangers of a tipping point in. “If it's already starting to be in the minds of sellers and buyers before then you may start to see a ‘snowball effect.’ You don't want to be the last one trying to sell in 2030.” GRESB tells me they are launching a new service for members “by the end of the year to help them to understand their transition risk in their portfolios”.
But before you get too depressed, we should also note the upside for investors here: plenty of new investment opportunities. Technology can play a role in all this. It is likely we will see more and more use of industrial/logistics roofs for solar panels and in due course there may be direct carbon capture from the air within urban areas. Two Germans, Christoph Gebald and Jan Wurzbacher, who run Swiss-based Climeworks, have developed CO2 collectors the size of SUVs that sit on the roof of buildings sucking carbon dioxide from the air.
And there is a flipside to the “brown discount” – a “green premium” for well-appointed properties. Savills points out: “There’s a clear link between properties that have got sustainability accreditation and the price per square foot that landlords are charging for those properties.”
Last year, JLL identified the green premium already existing in central London real estate. It compared BREEAM (Building Research Establishment Environmental Assessment Method) certified A-grade buildings to those buildings uncertified. It found that between 2017 and 2020 “the average premium of all rated buildings above non-rated buildings is approximately eight per cent.” Those holding those properties could see this get ever better for them.
Just ‘never buy “brown” in Town.’
Christopher Walker is a writer on business and politics. He sat for several years on the asset allocation committee of a major asset manager.