Commentary

Who Will Provide the Capex for the Real Estate Transition?

Rupert Snuggs, Head of Capital Markets Group at IPSX, says new models are needed to deliver the capex required to future–proof buildings.

The pressure on the UK commercial real estate industry to ensure buildings meet ESG standards has never been greater, with a number of push and pull factors driving the need for change.  

The most significant driver is regulatory: earlier this year, and to meet its own national net zero targets, new UK government regulations on the Minimum Energy Efficiency Standards (MEES) for commercial buildings came into force, restricting a landlord’s ability to lease a building that has an Energy Performance Certificate (EPC) rating of F or lower.

According to BNP Paribas Real Estate, this has already left around 8% of all commercial stock obsolete. Under current government proposals, the MEES for let buildings is projected to increase to C by 2027 and to B by 2030, meaning that time is running out for landlords to get their portfolios in order if they wish to avoid their assets becoming stranded and obsolete.

Embracing EPC upgrades

Aside from complying with regulations, real estate owners must also embrace EPC upgrades to protect property values and maintain strong returns for their clients – with a clear ‘green premium’ emerging for energy-efficient buildings.

On the investment side, recent JLL data showed that offices with better sustainability credentials can achieve a 20% valuation premium. There was also a clear ‘green’ premium for buildings with better EPC ratings, with each step up in the rating adding just under 4% to a building’s value.

Research from Deepki last year revealed the green premium for industrial buildings was even higher. And, in the occupier market, tenants are willing to pay higher rents for best-in-class sustainable spaces, with offices with a BREEAM sustainability rating generating rents up to c. 12% higher than buildings without one. 

Finally, with institutional investors increasingly seeking out mission-aligned and sustainability focused investment opportunities, retrofitting or brown-to-green strategies are where this capital is focused. According to Aviva Investors, more than nine in ten global institutional investors actively consider ESG and sustainability in their real assets investment decision making, while Patrizia’s latest client survey revealed that 82% of international investors planned to track the energy consumption of their real estate investments over the next five years, with 70% expecting new investments to consider ESG objectives including Article 8 funds (as defined by the EU Sustainable Finance Disclosure Regulation) under which retrofitting strategies usually sit 

The benefits of upgrading the EPC credentials of an asset, alongside the dangers of delaying, are clear – for both real estate owners and the institutional investors they represent. The challenge, however, will be the capex needed to carry out these sizeable – and increasingly urgent – projects. This can be a significant number, with Savills estimating that the cost of bringing UK office buildings up to necessary standards will be £63 billion. Anecdotally, these projects can cost up to 50% of a building’s value for properties over 10 years old (and up to 100% of the buildings’ value for those older than that), meaning that the eventual true cost will likely be much higher.

Complexities and cost

These projects are so expensive because upgrading the energy efficiency (and therefore EPC rating) of a building can be extremely complicated: think about the intricacies of replacing ageing heating, plumbing and electrical systems while keeping as many original elements of the frame and façade of the building as possible to limit embodied carbon emissions.  

These EPC upgrades are also set against the most restrictive financing environment seen since 2008. Following 13 consecutive interest rate rises, many borrowers are being priced out of the market, at the same time as lenders take a risk-off approach.  

Access to capital is not just a real estate problem: BDO reports that nine in ten mid-sized businesses are having to halt their growth plans due to difficulty accessing capital. At the same time, macroeconomic trends such as rising inflation and energy bills are putting even more financial pressure on these businesses, with 33% of those surveyed saying that they would need to source new financing in the next 12 to 18 months 

Property owners can sell their buildings, however raising capital via asset recycling has become more challenging because of a lack of liquidity and the stubborn bid-ask spread. Finding a JV partner can take time. Private equity could be a solution in an era where cash is king, with many pinning their hopes on overseas institutional and private wealth investment from the US and Middle East. But the brown-to-green fundraising backdrop is highly competitive, with the rise of impact investing by established players proving a barrier to entry for newcomers, or those late to the party.  

Listed securities and REITs could theoretically raise capital via secondary offerings, but this is very difficult in practice when average share price discounts to net asset value (NAV) sit around 20%.

Alternative financing

Against this backdrop, the need for alternative financing solutions to fund these much-needed EPC upgrades is clear – especially those providing liquidity and flexibility. There are now financing models that enable real estate owners to raise capital from the public markets while retaining flexibility of ownership by listing part of a building or cluster of buildings to unlock capital for retrofits.

Under such approaches, issuers can phase their capex spend, rather than having to raise all the funding in one go and then sit on the cash until it is needed, while retaining the flexibility to buy the shares in the building/security back in the future.  

Both ESG regulations and institutional appetite for ‘impact’ strategies are only moving in one direction. With 80% of London office stock currently falling below the A or B EPC certification that is expected to be mandatory by 2030, the real estate industry is racing against the clock.

Property owners must take a long, hard look at their portfolios and consider all financing avenues available, so they can plan, protect values and maintain client returns – before it is too late.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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