UK SDR “Double-edged Sword” for Real Estate

Ongoing uncertainty is limiting decarbonisation progress, investors say, as the clock ticks down to new labelling and disclosure rules. 

UK investors have warned about teething issues for real estate fund managers looking to comply with the Financial Conduct Authority’s (FCA) Sustainability Disclosure Requirements (SDR) labelling regime. 

The FCA finalised the four new labels – focus, improvers, impact and mixed goals – for UK sustainability-focused funds last year as part of its work to limit greenwashing. Fund managers will be able to use them from 31 July, with disclosures required 12 months later. 

But industry sources have identified potential issues with fitting existing funds into the new regime. Jessica Pilz, Head of Sustainable Investing for Private Markets at independent asset management firm Fiera Capital, called it a “double-edged sword” for real estate funds. “It’s not easy to classify these strategies as either ‘impact’, ‘improver’ or ‘focus’ funds,” she told ESG Investor. “It’s always going to be a bit of all three in the case of ‘brown’ real estate.”  

Brown building stock refers to buildings with poor energy ratings and performance. 

Ongoing uncertainty around the measurement of real estate emissions reduction efforts will likely add up to challenges with label categorisations. 

“A lack of data means we don’t know the exact range of change,” said Pilz. “We also lack a common method for factoring climate risk into valuations, or a clear understanding of how technology will evolve and advance over time.” 

All these issues, Pilz explained, make it difficult to price the browning of stock (resulting in a discount) and adaptation or mitigation actions (attracting a premium) into new transactions. 

In the long term, managers expect SDR to introduce much-needed clarity on what sustainable investment products need to deliver, and how that can be measured. 

“The ‘improvers’ label will likely apply to most sustainability-focused real estate funds,” said Charlotte Jacques, Head of Sustainability and Impact Investment Real Estate at Schroders Capital.

To disclose under the improvers category, a fund must demonstrate an ambition to invest at least 70% in assets that have the potential to improve environmental, social or sustainability goals. 

“The main challenge will be the extent of improvement opportunity that will be needed for the label,” said Jacques. “Some buildings in a portfolio may reach a point where they can no longer be optimised significantly, in which case there is a question of whether they should sit under the ‘sustainability focus’ category instead.” 

The Schroder Real Estate Investment Trust recently tailored its investment policy to focus more on sustainability, with specific ambitions to align with the improver label.  

Wielding the stick 

Beyond the upcoming SDR labelling regime, other regulatory incentives are in place to encourage the decarbonisation of building stock in the UK.  

Most notably, in 2021 the government introduced minimum requirements for buildings’ energy performance certificates (EPCs), whereby all non-domestic lettings are required to achieve specific EPC ratings on the road between now and 2030.  

“The overwhelming majority of existing building stock will need substantial retrofitting to meet new performance measures and reduce the emissions profile of the built environment,” said Pilz. “New and existing commercial stock that does not meet increasing EPC standards by 2030, and potentially 2027, could suffer.” 

These requirements are also expected to ratchet up over time, Pilz explained, with incremental write-downs as previously compliant buildings get relegated. She also noted considerable intra-sector disparities in compliance with EPC standards. 

“Some investment managers are cutting sub-par assets adrift and focusing solely on new stock, while others see the pile-in across shinier assets and are retrofitting existing buildings to take advantage of early discounts,” she said. The former option offers security at the expense of superior returns, while the latter provides opportunities to transition brown assets, Pilz explained.  

With regards to factors such as age and construction style, the diversity of the UK’s built environment poses a further challenge, as this means there’s no one-size-fits-all approach to improving its climate resilience, she added.  

“One of the biggest issues with the EPC is that it is theoretical,” argued Schroders Capital’s Jacques. “The EPC is looking at a building and determining how energy efficient it should be, but not at its actual energy consumption on an annual basis. The associated carbon emissions of a building could be very different from theoretical expectations.” 

Jacques suggested the UK government should introduce an “in-practice certification” that would consider the actual annual emissions of a building. This could be modelled on the National Australian Built Environment Rating System (NABERS), which generates ratings on buildings’ efficiency across energy, water, waste and indoor environment.  

“We need this level of transparency in the UK, so that both occupiers and investors can really understand what they’re buying and how [the property] should be performing,” Jacques added. 

But given the global property sector accounts for nearly 40% of the world’s carbon emissions, investors shouldn’t wait for government intervention to accelerate the decarbonisation of building stock. 

“Though the greening of real estate assets requires high initial capital expenditure, which is admittedly challenging under current market conditions, those who shift their mindset towards future-proofing their portfolios are set to benefit in the long run as valuations diverge,” said Pilz.  

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