Do greener buildings have more pricing power, and if so, how much? We bring together the views of leading capital markets researchers, a valuer and an asset manager for a two-part deep dive on the latest market dynamics.
Read this article to understand:
- Evidence of rental and sales premia for buildings with certified sustainability credentials
- Why meeting minimum regulatory standards is not enough for comprehensive de-risking
- How brown assets are vulnerable to accelerated depreciation
How much extra rent can be generated from buildings that have strong sustainability credentials compared with those that don’t? And do these properties also achieve higher sale prices?
These questions have been the subject of much debate in recent years. Various studies have drawn on data from different locations, using different systems of certification, and broadly come to the same conclusion: a “green premium” exists (see Figures 1 and 2).
But how do we measure this premium accurately across assets, and how is it likely to change in the future? What does this mean for those investing in our built environment and those financing, insuring, building, refurbishing and maintaining it? Can investors in the UK and elsewhere use that knowledge to ensure they are positioned on the right side of change?
We confront those questions in this two-part investigation led by David Hedalen of our real assets research team. In part one, The view from the ground, we consult market practitioners directly about what they are seeing from transactions in the market and as they go about their work. In part two, Searching for value and resilience in green real estate, we will drill into the important investment themes, probing how energy-efficient assets have been performing and whether collective environmental, social and governance (ESG) considerations might become, or have already become, a value factor.
Introduction from David Hedalen, head of real assets research
We need to decarbonise the built environment to address climate warming, but now evidence of a green premium is well established, there is a financial imperative for us to understand the drivers so we can act in the best interests of our clients and stakeholders.
But this is a concept everyone sees in slightly different lights. My view is that the green premium – in a wide sense – has become material to decision-making and material to performance, but not yet in every market. There has been a lot of change: we have moved from struggling to define the concept and trying to evidence it anecdotally to where we are now, which involves a comprehensive responsible investment underwrite. We are bringing those conclusions directly into the business in terms of cashflow modelling and asset impact.
Our findings highlight the return potential in certain markets – for example, in super-prime offices – but they also have significant risk implications for large swathes of the built environment which could be vulnerable to asset stranding.
Given the complexity of the issue, we wanted to ensure our investigation covered a broad range of market perspectives. This is why we brought together a wide survey group of experts, including 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); to discuss green premia today and how the landscape might change in the future.
How compelling is the evidence for green premia?
VO: This is a question our ESG research team has spent a lot of time researching.1,2 We started looking at sustainability premia in London in 2021, focusing on the rental premium – that is, the extra rent achieved, on average, per square foot for prime central London office buildings with different Building Research Establishment Environmental Assessment Methodology (BREEAM) ratings, relative to equivalent, unrated ones. What we found from just under 6,500 Knight Frank transactions over an 11-year period was an average three-to-five per cent rental premium for buildings classed as “very good” and “excellent” for our sample, stepping up to 12.3 per cent for those considered “outstanding” (see Figure 1).
We used hedonic price modelling: this treats a variable as a sum of different attributes and takes a range of factors into account. That allowed us to control the variables statistically, to find out how much each factor contributed to the difference in rent. The age and size of the building, number of floors, sub-market, amount of green space nearby, proximity to public transport and the walk times to a National Rail station were some of the factors we controlled for.
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.
We replicated our study to cover sales price as well (see Figure 2). We also added the weighted average unexpired lease term (WALT) to control for the lease effects that also impact sales price.
There have not been enough “outstanding” BREEAM transactions in London yet to get a statistically significant number, but our results suggested that the average rental premium of three to five per cent for “very good” and “excellent” buildings stepped up an average sales premium of ten to 11 per cent, compared to the equivalent unrated building.
The findings suggest that on average, higher premiums may be enjoyed by investors who aim high for sustainability
We wanted to test if our results were specific to London and BREEAM or could be replicated more widely, so we extended our research to also capture the Sydney and Melbourne office markets, which use the National Australian Built Environment Rating System (NABERS). We found that the average sales price premium for the highest NABERS-rated office buildings in our sample reached an almost 18 per cent premium compared to the equivalent unrated building. This average premium is almost ten per cent higher than for lower-rated NABERS buildings.
The findings suggest that notwithstanding costs, on average higher premiums may be enjoyed by investors who aim high for sustainability, rather than just satisfying the requirements for BREEAM and NABERS. The findings also indicate that while part of the sales premia may be driven by higher rents, it is likely also driven by green buildings, which compared to their equivalent unrated counterparts may enjoy lower risk, including lower liquidity risk, from higher investor demand as well as reduced stranded-asset risk and obsolescence.
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.
SC: The green premium is likely a temporary additional value driven by the market’s appreciation for a green building feature that is common enough to be priced but rare enough to differentiate the asset from others. Historically, this has been associated with green certifications, but we see the market has matured to the point that green certifications like BREEAM are market expectations, particularly in the office sector.
We’re expecting to see the next green premium relate to demonstrable ‘net-zero’ assets
We’re expecting to see the next green premium relate to demonstrable “net-zero” assets, as climate risk is becoming increasingly important due to the speed at which conditions have been changing. Most standard risks are already implied within the rent and yield, and it is assumed the market will assess and price risks as appropriate. Valuers already assess social value, for example; we know buyers are likely to pay more to be somewhere with better amenities and fewer social issues.
Climate risks are different because they are complex to interpret and require substantial investment to mitigate. They are an anomaly; not everyone is well placed to evaluate the risk or address what needs to be done.
Ultimately, we expect greener assets to outperform less-green prime property based on features that are differentiated and rare but also evident enough to drive competition. This is worth contemplating at the moment. For example, assets that are demonstrably net zero are in short supply, and those developing such assets may want to continue to hold them to meet their own climate objectives. That means there is not a lot of market evidence of green premia in this part of the market, because there are few transactions happening to generate the comparators.
One high-profile example is Great Portland Estates’ sale of 50 Finsbury Square to a private German family office in September 2022. The price – £190 million – reflected a topped-up net initial yield of 3.85 per cent. That’s broadly in line with the March 2022 book value after adjusting for capital expenditure (capex), despite broader index values dropping sharply during that period.
ESG is evolving quickly, so the drivers may not be fully understood by bidders who lack specialist expertise to drive competition
To understand the market, it is important to consider whether the features are understood well enough to create competitive bidding. ESG is evolving quickly, so the drivers may not be fully understood by bidders who lack specialist expertise to drive competition. As a result, a more common influence on pricing greener assets is the level of capex required to maintain the positioning of the asset; for example, the expected cost of achieving a specific Energy Performance Certificate (EPC) rating or removing reliance on fossil fuels.
Ultimately, we expect assets with stronger ESG credentials to retain value for longer as markets cool, whereas those with poor ESG positioning will experience accelerated depreciation. But market dynamics vary a lot. In some markets, notably industrials and logistics, high demand and lack of supply means tenants and buyers are market takers and their requirements (ESG and otherwise) are secondary to availability.
IE: The “green premium” reflects a complex matrix of adjustments to rents, yields and capex expectations, which differ by asset, sector, investor base and occupier. The pace of change in our market means that nothing is static – not rents, yields or obsolescence risk. And neither are ESG factors or green premia.
Nevertheless, we can still develop insights into the unique factors that underpin and affect the premia (i.e., added value) and/or discounts at a specific point in time. They include macro and micro factors such as the regulatory landscape, supply-and-demand dynamics and specific micro features like location, age and design of the building (see Figure 3).
This complexity, however, can be seen as a significant opportunity for alpha generation for active managers. Those who deeply understand how ESG factors impact different assets in different ways can identify areas of mispricing. This understanding drives our hold, buy and sell decisions to ensure we enhance performance and mitigate downside risk.
With all that taken into account, having a fixed “green premium” is arbitrary given the heterogenous nature of real estate. This is why we don’t believe it is meaningful to say: “the green premium is x or y per cent”. Instead, we take individual assets, each with their own characteristics and local market dynamics, identify ESG capex requirements through net-zero audits and make considered judgements about the risk-return metrics in capital pricing models. Working asset by asset throws up different dynamics in every case.
Which factors are contributing to green premia?
VO: Environmental standard setting has moved beyond regulation alone. Think about the way buildings insurance is being impacted by climate risk. Environmental considerations are not ‘nice to have’: they are imperative and impacting the bottom line.
Another important element is financing. Many banks are starting to report on their own carbon emissions and are increasingly party to reporting requirements, which is also driving interest in greener buildings.
Environmental considerations are not “nice to have”: they are imperative and impacting the bottom line
When investors look at buildings, meeting the regulatory minimum is no longer their objective. UK real estate is a major global investment destination, and international investors are looking to the UK because we have established green-building credentials and they want their investments to contribute towards meeting their own targets. We believe if asset owners intend to de-risk properly, they need to understand the direction of travel, and make decisions based on that.
Additionally, investors need occupiers; the labour market is tight and there is a significant war for talent. The younger generation wants to work in places that reflect their values. As they reach decision-making positions, environmental and social considerations are only going to become more important. Asset owners know they must meet public expectations and stakeholder expectations, not just regulatory minimums.
Figure 3: Factors influencing green premia
Energy cost savings
Building quality
Lower energy consumption is associated with an increase in rent and sales value in a relationship established well before the recent energy crisis.3
Certified buildings of a high standard are generally more modern and can be better equipped to attract a premium beyond the strict environmental impact.
Branding impact
Carbon price/
offset impact
Positive branding impact for the owner and tenant of owning/occupying a building with better environmental performance.
As more investors commit to net-zero targets and disclose portfolio alignment, the carbon impact of their real estate investments will become more visible. For assets that are hard to decarbonise, buying carbon offsets may be necessary. Offset costs, whether actual expenses or used in internal decision making, could increasingly feature in asset valuations.
Source: Aviva Investors, May 2024.
Where premia exist now, do you expect them to diminish as regulation forces improvements everywhere and the baseline lifts?
VO: If we slice our data by year, the statistical significance isn't as strong. But what is surprising for some is that the average premium in London is relatively fixed over our sample.
In the run up to the Global Financial Crisis (GFC), there was more thinking about sustainability and that created demand for better buildings. Then the GFC happened, and although there was still demand, few green buildings were available. More recently, as supply has grown, so has demand, and many countries have legislated for net zero. We've also had the introduction of climate-related financial disclosures, and there has been more thinking everywhere about energy costs. So as the demand for green buildings has grown so has supply, although there is still a significant shortfall of green versus brown buildings in the market.
As the demand for green buildings has grown so has supply, although there is still a significant shortfall
We use the term green premia in our research because there are more brown buildings than green i.e., we are comparing a smaller pool of green assets to the typical non-green majority. Over time the weighting between green and brown assets in existence will likely shift, so the typical asset is “green”, meaning it will likely be more relevant to consider a brown discount.
We are already seeing a polarisation in pricing between those green, well-located, good-quality assets and the rest. As the stranded-asset risk of some brown assets becomes more acute, and as investor demand for green buildings extends, the brown discount is likely to persist. Just as, currently, the pool of BREEAM “outstanding” assets, which our research found commands a high average premium, is relatively small, in the future the pool of brown assets may diminish. But the discount for these is unlikely to.
To learn more about how professional investors are approaching the green premium, look out for part two of our deep dive: Searching for value and resilience in green real estate.
