How ESG requirements are disrupting the office investment market

Efforts to ramp up the office sector’s drive towards a more sustainable and carbon-neutral future are creating disruption across the market.

A race is emerging as larger corporate occupiers increasingly add strict environmental considerations to their list of requirements when searching for new office space – with BREEAM Excellent expected, and Outstanding ratings preferred, alongside an EPC A or B classification, PV panels, electric car charging points, heat pumps, Wired Score and Well Building certification.

Since these occupiers demonstrate a willingness to pay a premium for the most eco-friendly space that helps them deliver upon their own internal ESG goals, investors in turn need to keep pace and deliver buildings – both new-build and refurbishments – that can offer these gold-standard environmental credentials.

Add to this the government’s Minimum Energy Efficiency Standards (MEES) which mandate all commercial properties must be classified at least EPC B by 2030 to make them lettable, pressure is mounting across the industry to transform and reinvent the UK’s office proposition.

But whilst the vision for how the industry must adapt and evolve is becoming increasingly clear, the road to get there is anything but, and the impact on the market as a whole will be intense and far-reaching.

We are now seeing signs that indicate delivering these heightened ESG requirements could lead to a comprehensive reshaping of the office landscape as we currently know it, with increased value disparity between prime and secondary assets.

The current economic climate – with high inflation and rising interest rates – has dramatically inflated the costs of both materials and construction labour, pushing up the up-front investment needed for any refurbishment to improve existing buildings’ ESG credentials, and for new-build projects. This means limited development is in hand to meet the 2030 deadline.

For larger prime assets in the best locations, refurbishments or new builds still make economic sense despite these headwinds, where the rental tone allows it – for example in Zone 1 central London and the big six cities, alongside the obvious hot spots in the Golden Triangle and Thames Valley.

We are seeing for the best-of-the-best, the investment market remains robust. Take the Halo building in Bristol as a key regional example – a BREEAM Outstanding scheme which ticks all the ESG boxes and is currently under offer from the Tesco Pension Fund to CBRE Investment Management for a yield of c.5.60%.

Examples of schemes in the south-east under construction that will follow Halo’s lead are Tempo in Maidenhead, where Legal & General is currently undertaking a back-to-frame refurbishment and extension of the 25-year-old former HQ of Three, with the planned scheme targeting EPC A and BREEAM Outstanding; and Lincoln Property Co’s One Station Hill in Reading which is a new-build with similar targets. Once complete, these schemes are expected to become two of the best buildings in the Thames Valley and will potentially be highly sought-after both occupationally and as investments once they are let – watch this space!

We have also already seen early movers such as JP Morgan on their Foundation Park scheme in Maidenhead benefit from delivering very high-quality space where some of the largest leasing deals in the south-east have taken place in the last couple of years, with Ultra Electronics and Biogen moving to new EPC A-rated buildings.

But for more secondary assets, the picture is much less clear-cut and positive.

There will continue to be a significant market from smaller businesses across the country that are less focused on their real estate ESG and just want cost-efficient space, so a delicate balance is needed to deliver the right space for the occupier demand, whilst still meeting the government’s legislation. This is far from easy given the new EPC requirements.

High construction costs now render many refurbishment projects commercially unviable in locations where the rental tone is under c.￡35/sq ft, which is increasingly the case for numerous towns and cities across the UK.

As a result, huge numbers of large but older, shorter-income regional office buildings that require refurbishment are at risk of becoming stranded assets, with investors simply not able to make the numbers stack up to upgrade them to meet the new government-mandated standards.

Whilst there are exemptions from the government legislation – for example where it can be proven that the cost of purchasing and installing a recommended improvement does not meet a 7-year payback test – the question is then whether there is an investment market for such buildings?

Smaller buildings typically attract private property companies/trusts and may not be impacted so heavily as they are less focused on ESG and more on financial returns. However, if they are debt-backed they may have to consider banks lending “green loans”.

Larger regional buildings are likely to be the biggest losers since these owners are likely to be ESG focused. If viability will not allow it, they may be forced to sell, but the likely investor market for these assets may have a much higher cost of capital. This will likely result in values falling further to make a refurbishment viable for the investment market requirement of ESG compliance. There are some examples of this currently in the market and we wait to see if they find a level to trade at.

With only around 10% of the UK’s office property stock currently meeting the government-mandated EPC B classification, and with much of those that do located in central London, the scale of the problem is colossal.

But what does the future hold for these stranded assets, where refurbishment to meet the new ESG requirements does not stack up?

Conversion to alternative uses – such as residential, hotels, senior living/care and student accommodation – seem to be some of the obvious options, albeit construction costs remain an issue here as well.

To facilitate widespread change of use opportunities, a comprehensive review of existing permitted development rights will be necessary, to make these conversions easier to progress and to ensure the quality of new schemes delivered is adequate. In its current form the planning system is simply not fit for purpose to allow an efficient repurposing development programme to take place, despite demand for Build-To-Rent and cost-effective residential units for sale across the country.

Ultimately, we are currently in a period of stasis in the office investment market.

Occupier demand and government-led pressure for ESG-focused assets is rising, but the number being delivered or in the pipeline remains limited, with potential projects blocked by exorbitant building costs.

It seems highly likely that given the low levels of development currently underway, there will be a race for the best-quality space from both occupiers and investors as this decade progresses and secondary asset will become stranded unless there is a change in the planning system to allow more alternative uses.

Without these changes, there remains a real risk that the office sector will face the same blight currently impacting many of the UK’s more secondary high street and shopping centre assets, with redundant office buildings left to become vacant as they fail to meet legislative or investor needs.

Get in touch with the Hanover Green LLP investment and development team - Jonathan Webb , Simon Beckett and Simon Hall - today to talk further about how ESG requirements will impact your office assets and the opportunities available within the sector.