Do Buildings That Are ESG Compliant Command More Value?

The pandemic has reshaped how we live, work, and interact in our communities.

As we navigate the 'next normal,' it’s clear that we must approach the world differently, with the climate crisis taking top priority.

The built environment is responsible for 40% of global carbon emissions, making it a critical issue that requires a unified international effort.

Change is already underway.

Evolving development regulations enforce stricter compliance, emphasising the need for sustainable building practices that meet legal and market demands for new and existing properties.

At the same time, proactive asset management is helping preserve value and enhance assets, creating significant opportunities for owners and investors.

With the rapid growth of Environmental Social Governance (ESG) investment criteria and ESG funds, inaction could negatively impact the value of your asset, regardless of its location or type, as sustainability challenges become more pressing.

Looking ahead to 2030, this is a key milestone year for many global corporations and ambitious governments striving to achieve Net Zero.

This means reducing emissions through energy efficiency, transitioning to renewable energy, and offsetting any remaining emissions.

In the commercial real estate sector, the vision for 2050 is for all new and existing buildings to achieve zero carbon throughout their lifecycle.

The goal is for all new buildings to operate with zero carbon emissions and reduce overall emissions by 40% by 2030.

As awareness grows, investors must understand whether a building can achieve Net Zero status, how to balance their portfolios, and the costs involved in reaching these goals.

A recent global survey by Bloomberg of 450 cross-industry businesses revealed that cost remains the top barrier to committing to climate action.

As workplace trends evolve and the future of work shifts, investors must also assess whether their buildings are equipped to adapt to changing market demands.

Valuation advisors guide clients through what is set to become a more intricate valuation landscape.

We anticipate building values deviating more from standard metrics this decade than ever.

However, these fluctuations will still be measured using standard, familiar methodologies.

This insights paper focuses on office real estate, outlining key factors impacting valuation methodology and the inputs influencing value.

Our hypothetical case study demonstrates how enhanced returns can be modelled for top-tier sustainable buildings in the short to medium term.

We also explore emerging global trends resulting from sustainability advancements, regulations, and policies and offer best practices for incorporating sustainability into valuations.

Value of Sustainable Strategies

We begin with basic principles, acknowledging that certainty and complexity will increase as more data becomes available, allowing for more sophisticated pattern recognition.

Valuers using the Discounted Cash Flow (DCF) method can adjust assumptions related to income, exit yields, capital expenditures, vacancies, financing, and discount rates across various building types.

DCF analysis enables scenario testing, helping demonstrate that investing in sustainable buildings makes both ethical and financial sense.

A DCF can determine a building’s current value or evaluate returns based on projected income over a relevant holding period.

To assess current value, the cash flow reflects net income throughout the holding period, accounts for necessary capital expenditures, and factors in leasing and rent-free periods, with the assumption of an exit at an appropriate yield.

The net present value (NPV) is calculated by discounting the cash flow at a suitable rate.

If the entry or purchase price is known, the same cash flow can be run to determine the internal rate of return (IRR), allowing for comparison with returns from other investments.

Premium Rental Incomes

Rental income will be shaped by the limited supply of buildings that meet the necessary specifications and growing demand from occupiers with ESG requirements.

We've already seen that new buildings with the most sustainable features are commanding premium rents.

On the other hand, older buildings face the risk of obsolescence as they may not comply with legislation or meet occupier expectations.

As a result, forecasts based on prime rent trends may not apply to underperforming buildings that fail to follow projected rent increases.

JLL's recent UK research paper, The Impact of Sustainability on Value in the Central London Office Market (June 2020), highlights that BREEAM-rated buildings and those with high EPC ratings command higher rents.

Similar trends are evident internationally, with rental premiums for LEED-certified buildings in the US and India and highly rated NABERS and Green Star buildings in Australia.

Capital Expenditure

When refurbishing or retrofitting older buildings, upgrading their specifications, plant, and machinery can be both financially beneficial and carbon-efficient, creating a more energy-efficient building.

Achieving the highest sustainability standards, especially meeting Net Zero Carbon specifications, typically comes with higher costs than standard refurbishments.

However, with rapidly evolving legislation and ESG requirements, there’s a real risk that, within the next decade, further capital investment will be needed if Net Zero-compliant choices are not made now.

Additionally, there’s a potential risk of future taxation targeting buildings with excessive carbon emissions or poor operational efficiency, highlighting the increasing obsolescence of less sustainable properties.

The key cash flow consideration is whether to invest more upfront in a retrofit to benefit from the current shortage of sustainable buildings or opt for lower initial costs.

The expectation is that further substantial refurbishment will be needed within the next 10 years to comply with future regulations and market demands.

Adopting circular Economy principles, with greater emphasis on material recycling, could mitigate costs in the future.

Demolition costs could be reduced as materials are resold, recouping some of the costs.

Additionally, building designs will increasingly focus on flexibility, allowing easier and more cost-effective adaptations for alternative uses.

However, how these savings balance against rising resource scarcity will need ongoing monitoring.

While cost variations and the pace of regulatory changes are uncertain, delaying action could mean missing out on current market advantages created by supply and demand dynamics.

Interesting decision to make

Voids

When leases end, tenants may either renew or re-market the space.

Research from JLL has shown that spaces designed to meet sustainability and wellness standards tend to lease out faster than standard office spaces.

This can be reflected in cash flow, with shorter leasing periods and potentially shorter rent-free periods due to higher demand for such spaces.

Finance

Leveraged returns can boost performance by using debt to acquire or fund a building retrofit.

The availability of green loans is increasing.

When sustainability KPIs are met, they offer lower financing costs, resulting in a lower cost of debt and thereby improving returns.

Discount Rate

The discount rate applied to the cash flow accounts for the risks associated with executing a business plan for a building over the holding period.

Less sustainable buildings will generally have higher discount rates due to the risks of increased future capital expenditure, potential taxation, longer vacancies, declining rents, and higher exit yields.

These risks contribute to a higher discount in pricing, indicating a greater chance of obsolescence.

In contrast, more sustainable buildings, which attract more equity and benefit from cheaper debt, are expected to have lower discount rates, reflecting their reduced risk.

Exit Yield

The exit yield in a DCF analysis represents the building's quality and the estimated average lease term remaining at the exit time.

It is typically tied to a business plan or standard assumption of a 5-—to 10-year hold period.

It also reflects the market’s outlook on long-term net income growth.

Buildings that fail to meet top market standards will have higher exit yields, leading to lower values at the end of the hold period.

Less well-specified buildings are likely to deviate from projected values, showcasing increased obsolescence and faster depreciation.

The following example illustrates how this analysis is applied in a DCF model.

Hypothetical Net Zero Valuation

Current "best-in-class" sustainable buildings typically have an energy use intensity (EUI) ranging from 120 kWh/m2 to 180 kWh/m2, whereas much of the existing building stock exceeds this, often at 250 kWh/m2.

An actual Net Zero building aims for a significantly lower energy consumption per square meter.

Carbon budgets aligned with the Paris Agreement's goal of limiting warming to 1.5-2°C vary by country, depending on how quickly the local energy grid decarbonises.

This leads to different "Paris-compliant" EUI targets globally.

Reaching Net Zero is a massive undertaking in any country, requiring extensive upgrades to both local energy infrastructure and the buildings themselves.

In our scenario, we assume a refurbishment with an EUI of 70 kWh/m2, which aligns with the building's local 2030 target.

Achieving this is projected to require a 9-17% cost increase for new developments (Source: UK GBC).

Scenario Outline

In our analysis, we consider purchasing and refurbishing a modern, vacant building in a major capital city with a 10-year holding period. Scenario 1 represents a standard market refurbishment, while Scenario 2 reflects a refurbishment compliant with 2030 Net Zero standards.

The property is a 10,000 sqm, ten-story office building.

We assume a fixed purchase price of $120 million and assess the impact on the rate of return and the increased competitiveness this may provide in terms of the purchase price.

The scenario suggests that a Net Zero-compliant building could increase the ungeared internal rate of return (IRR) by 106 basis points.

This analysis highlights that Net Zero compliance can lead to higher returns, more sustainable decision-making, and the ability to justify a higher purchase price based on a fixed hurdle rate.

It also shows how existing valuation methodologies can incorporate sustainability.

As the market begins recognising the returns from sustainable investments, we expect premium pricing for sustainable redevelopments and top-tier properties.

Conversely, as such standards become the norm and regulations tighten, non-compliant assets will likely face a price discount.

Further analysis applied to Scenario 2, which includes the addition of a ‘green loan,’ reveals an even greater difference in the geared IRR.

Factoring in a carbon tax would further widen this gap. Many developers are already accounting for an internal carbon tax.

This analysis does not consider the operational utility cost savings of the Net Zero building, as these benefits are typically passed on to tenants and partially reflected in higher rental rates.

Theoretically, a ‘gross’ lease structure, where landlords assume responsibility for energy costs—subject to lease agreements that limit tenants' energy usage—could solve the split incentive issue.

This arrangement would align landlord incentives and foster a more collaborative landlord-tenant relationship, reducing the performance gap often seen in sustainably designed buildings.

Emerging Trends

We can expect the next 24 months to bring several key trends based on these findings.

How Should Valuers Adapt?

• Supply and Demand Projections: Valuers need to develop a comprehensive understanding of leasing requirements as corporate decision-making trends evolve. Those who rely solely on outdated metrics related to the lettable area will likely need to catch up.
• Building Construction Insight: A thorough understanding of a building's construction is crucial for accurate value assessments. Utilizing digital twinning technology can aid valuers in conducting precise evaluations, but they must also be skilled in interpreting this data.
• Collaboration with Construction Experts: Collaborating with construction professionals to align compliance costs with property value is vital for accurately assessing value or investment performance.
• Monitoring Lending Market Trends: Valuers must stay updated on lending market trends and green debt pricing. Access to real-time data is necessary to form accurate evaluations.
• Bidding Data Analysis: Access to bidding data trends will help valuers gauge where demand is strong or weak, offering insights into how property demand is shifting. While the industry often focuses on comparisons, understanding the evolving bidding landscape for Net Zero buildings—particularly in terms of discount rates and yield fluctuations—will be critical for delivering accurate assessments.

What’s Next?

We anticipate that the ESG requirements of both investors and occupants will drive the development of new and refurbished buildings.

This shift may create imbalances in demand and supply, leading to green premiums for well-designed buildings. Conversely, with a significant portion of existing properties being older, there could be increased obsolescence.

These changes in demand, supply, costs, and regulations will likely emerge over the next 1-2 holding periods for investors.

Therefore, investors and valuers should start considering these factors, gathering relevant data, and reflecting them in their assessments as soon as possible.

Emerging trends, along with our hypothetical valuation analysis, suggest that short-term premiums could be associated with Net Zero buildings.

While the low-carbon premium in rents and capital values might diminish over time, Net Zero buildings will likely experience reduced obsolescence, helping them maintain their value longer than less sustainable properties.

Valuation methodologies can effectively analyze how these value changes arise from ESG factors and incorporate market shifts influenced by rising demand and sustainability risks that lead to fluctuations in value.

A forward-looking analysis of risks and returns conducted by valuers will highlight the substantial impact sustainability credentials can have on the investment performance of any property or portfolio.

JLL possesses the expertise to model anticipated market shifts, whether through scenario analyses for potential Net Zero opportunities or by adapting to a changing investment landscape as investors respond to market and legislative pressures.

*All information included in this article has been taken from JLL "Valuing Net Zero & ESG For Offices" Report 2021.