Do energy-efficient buildings have more pricing power, and what could that mean for those investing in the built environment? We bring together the views of leading capital markets researchers, a valuer and an asset manager for the second part of our deep dive into green premia, analysing the investment implications.
Read this article to understand:
- If empirical evidence exists to show greener assets have been more resilient in downturns
- How supply and demand have impacted recent sector performance
- Whether liquidity is stronger for investment in buildings with better energy-efficiency ratings
Anyone close to the world of commercial real estate investing will be familiar with the concept of a green premium – the idea that energy-efficient buildings might have more pricing power, which may translate into higher rental values and ultimately higher sales prices.
A wealth of research from many different practitioners suggests these premia exist, but not in every market. Figures 1 and 2 below give a snapshot of this work from 2000 to the present (read part one, “The view from the ground”, for more background).1
So, how is this data shaping the actions being taken by those financing, maintaining, repositioning and insuring the built environment? What empirical evidence guides what they do and underpins their forecasts? And how do they expect the pricing power of greener assets to evolve from here?
These are the questions we address in the second part of our investigation into green premia, led by David Hedalen of our real assets research team. Our survey group included Victoria Ormond, head of capital markets research at Knight Frank (VO); Sam Carson, head of valuations at CBRE (SC); and Imogen Ebbs, head of UK real estate funds at Aviva Investors (IE).
Figure 1: Evidence of rental premia in green buildings (per cent)
Source: F. Fuerst et al., 2009; W. Benefield et al., 2010; A. Reichardt et al., 2012; S. L. Heinzle et al., 2012; P. Das et al., 2013; A. Chegut et al., 2014; E.A. Hopkins, 2016; T.B. Oyedokun, 2017; M. Papinaeu, 2017; JLL, 2021; Knight Frank, 2021.
Figure 2: Evidence of sales price premia in green buildings (per cent)
Source: N. Miller et al., 2008; F. Fuerst et al., 2009; W. Benefield et al., 2010; A. Chegut et al., 2013; T.B. Oyedokun, 2017; M. Papinaeu, 2017; M. del Giudice et al., 2020; JLL, 2023; Knight Frank, 2021; MSCI 2022.
Introduction from David Hedalen, head of real assets research, Aviva Investors
Our last deep dive highlighted the scale of green premia available in different locations at different points in time, driven by a number of factors. This section looks at the investment takeaways, including whether it’s possible to draw conclusions on the relative resilience of greener assets or prospects of achieving timely sales.
We start the conversation with a frank look at how asset managers are pricing the investments needed to reposition brown assets, and how this is driving acquisitions and disposals in the institutional market.
To what extent are we seeing “green premia” as opposed to “brown discounts”?
SC: In terms of how the market is structurally addressing “green versus brown,” we are more inclined to focus on accelerated depreciation than green premia, because there is a growing risk to assets not aligned with the climate transition. Tenants, landlords, lenders and insurers all require a growing level of ESG compliance.
This is an important distinction. The phrase “green premia” suggests a way of positioning an asset to attract greater value and rent. But what is happening is much more complicated. It is probably easier to look at the question in reverse and determine a brown discount; we can then estimate the expected capital expenditure (capex) to reposition the asset.
Over time, fewer players will transact with assets that have not addressed climate transition risks or do not have a pragmatic plan to do so
I look at accelerated depreciation as a way of indicating the way the market is evolving. It is responding to growing pressures to price assets that do not align with the transition, in the measurable form of potential capex to address the risk.
Over time, fewer players will transact with assets that have not addressed those risks or do not have a pragmatic plan to do so. This could have a much more dynamic effect on the market than simply adding desirable features which bidders will pay more for.
Most institutional investors will look at the cost of upgrades and take a view on how to adjust pricing to acquire the asset. They could, of course, want the asset for reasons which are not sustainability-related, and forgo discounting to ensure they win the deal. But what has changed over the past five years is that most investors are assessing these risks and associated capex costs as a standard part of the due-diligence process. This is the basis of real-world pricing differences and is likely to be pressing down rather than up.
VO: We are describing these dynamics as green premia at the moment, because there are more brown buildings than green ones. In reality, the premium reflects the difference between the two. Over time, the narrative might turn into a “brown discount.” But what we can say is there is a statistically significant step-up in the average rental premium achieved by buildings of better environmental quality.
Is there evidence of different investment performance from commercial buildings with different EPC ratings?
SC: Yes. CBRE recently analysed over 1,000 regularly valued UK properties worth over £17 billion from the retail, industrial and office sectors to create an investment performance index based on their EPC ratings. The assets were categorised depending on efficiency, and the sample was shaped to reflect commercial stock across England and Wales.
Buildings with better energy-efficiency characteristics tended to be more resilient during the downturn. While capital values fell, more-efficient properties experienced smaller declines in total returns, but the impact varied by sector. It was pronounced in office (Figure 3) and retail properties, but not in industrials (Figure 4).2
We put this down to the fact demand is high for industrial space, but supply is constrained. In this environment, energy efficiency is not appreciated as much.
Figure 3: Energy efficient offices delivered higher total returns and more resilient performance, according to CBRE research
Note: Q1 2022-Q4 2023. Index: 100 = Q1 2021.
Source: Aviva Investors, CBRE, April 2024.
Figure 4: Energy efficient industrials delivered slightly weaker total returns
Note: Q1 2022-Q4 2023. Index: 100 = Q1 2021.
Source: Aviva Investors, CBRE, April 2024.
IE: The CBRE sustainability index reveals interesting nuances between sectors. ESG has been an important requirement in the prime office market as occupiers in the post-COVID era have sought best-in-class office space to attract talent back to the workplace. Outside of prime offices, ESG has been exacerbating capital declines where a green premium cannot be generated due to lack of occupier and investor demand. This has further widened polarisation between the prime and secondary office markets.
On the other hand, investor and occupier demand in the industrial market has been strong and the supply and demand imbalance has meant that access to stock has been prioritised and the importance of ESG appears to have been overlooked.
Of course, what has already occurred is not indicative of the future and today we are seeing building momentum around the importance of ESG across all asset classes in varying degrees. How these dynamics play out in the next five years is going to be vastly different to the past.
What about liquidity? Is there an obvious difference in the liquidity of assets with different EPC ratings?
IE: At a high level – yes, a poor rating can have implications for future income streams given EPCs are governed by the regulatory minimum energy efficiency standards (MEES) introduced in 2015. A non-compliant EPC therefore elevates regulatory risk, impacting on investor appetite and liquidity.
At the other end, a prime office building will need a high EPC rating to achieve the highest rent; without that value is unlikely to be maximised. So, while the EPC certification is not perfect, it provides a regulatory benchmark that offers insight into the energy efficiency of a building and does influence investor decision making, liquidity and pricing.
VO: 77 per cent of respondents in our recent ESG Property Investor Survey confirmed they have minimum environmental criteria in place, so this is likely to impact liquidity, given the size of the pool of potential investors looking for assets with good sustainability credentials.3
What are your most important takeaways for investors?
VO: This is potentially a moment of opportunity, because we are starting to see a shift in pricing adjustments between very green, well-located best-in-class buildings and others. This will aid in making it relatively more economical to retrofit or refurbish brown buildings with “good bones.” Turning brown assets green makes sense. Of course, there will be assets that cannot make the transition and might need to be repurposed into something else entirely.
Nevertheless, there is a lot of variation across markets and types of buildings. If you are looking at a building in a small, less-institutionally driven market involving non-institutional buyers, they may be less cognisant of how markets are moving at different speeds. Our message is: even if you're not seeing meaningful premia in your market, expect that to change.
IE: Sustainability is becoming a value factor in itself. Its complexity is an opportunity for alpha generation because of the scope for assets to be mispriced. But we also need to be mindful about stranded-asset risk. The volume of stranded assets outside core locations could be a problem because there will be commercial real estate where ESG capex is not justifiable. That’s a wider question we will all need to think about.
