No More Automatic Increases in Real Estate Valuations as Climate Change Bites –Catella’s Xavier Jongen

Climate change mitigation measures such as CO2 reduction are going to lead to reduced economic growth, challenging traditional real estate investment strategies: “The investment perspective is going to change, waiting for value increases through economic cycles is no longer viable,” Xavier Jongen of Catella warns in this Vastgoed Journaal interview.

“The real estate world could do so much better,” sighs Xavier Jongen de Wargny . “The market makes a fuss about new regulations, the housing valuation system and ‘Box 3’ (the designation for savings and investments under the Dutch taxation system) but fails to realise that systemic change is going to take place in the next few years, resulting in social and economic upheaval that the market should already be factoring into the investment decisions it is making now. It would be much more constructive if the socio-political debate on real estate were about this instead of these side-show topics.”

About Catella

Catella is a real estate investment manager with €14 billion under management divided into several funds spread across all real estate segments. The majority of its invested assets are in residential property, some €8.0 billion in total. Catella operates in 12 European countries. The management organisation is listed on the Stockholm Stock Exchange.

Investment Horizon

Jongen is the managing director of Catella Residential Investment Management and deals with investment decisions for residential funds with some €8.0 billion in real estate across Europe.

“Systemic change has to do with climate change and, in that context, mainly with the choice of whether to reduce CO2 emissions or just let GDP continue to grow. Within 10 to 20 years - often the investment horizon of an institutional investor - that system change is definitely going to take place. The realisation that systemic transformation is going to have an impact on the returns we make in real estate, prompts us to already incorporate it in our decision making.”

Jongen believes the transformational change we are going to experience as a result of climate change may very well be accompanied by a contraction of the overall economy (GDP): “This is due to the fact that fossil fuels produce much more energy relative to their cost of production -- compared with solar panels for instance. Climate research shows that our current economic system needs an EROI (energy return on investment) of above 15 to 20 to keep it running, while a radical switch to sustainable alternatives, such as solar panels, yields an EROI of below 5.”

Catella calculates that it is, therefore, impossible to transform the energy mix from its dependence on fossil fuels to renewables like wind and solar in this century, while maintaining current levels of energy consumption and GDP growth.

"If we are aiming to hold to the commitments of the Paris climate agreement, then we really need to

get rid of fossil fuels, which will only be possible if the economy shrinks…and we think there are some question marks over the calculations used by the United Nations (on this subject)."

The debate that is already taking place about the Dutch government’s moves to cut the number of flights from Amsterdam’s Schiphol Airport and sharply reduce the livestock numbers of farmers, shows that economic contraction is a real option, Jongen said:

“The Netherlands is leading the way in the limits to growth debate, but at some point these discussions will be held all over the world… We think, for example, that the calculations used by the United Nations to achieve the goals of the Paris Agreement are questionable. The UN's standard IPCC (Intergovernmental Panel on Climate Change) model sees economic growth as an exogenous variable -- it therefore does not count in the model and is held constant. But biophysical research shows that with declining energy consumption, GDP also decreases with a correlation of almost one,” Jongen said.

“This shows that even the brightest minds have yet to model the interconnection of economic and ecological systems accurately, making it very difficult to take the right political decisions. The same applies to our investment decisions. Since we are at the beginning of this process, we call it: ’The Great Transformation,1’ after political economist Karl Polanyi's theories on systemic change during the rise of the market economy. In the Netherlands, the real estate sector together, in cooperation with the public sector, could play a pioneering role in the current debate.”

Waiting for the Right Sales Opportunity

For the real estate market, economic contraction will mean that previous straightforward investment strategies will no longer function:

“With real estate, you always have to deal with economic cycles and adjusting interest rates. Consequently, your total return is going to depend on the timing of acquisitions and disposals. If you mistimed deals and bought at the top of the market in the past it generally was not that big of a problem. Because of continuous economic growth, all you had to do was wait for the next top of the cycle which was always higher than the top of the previous peak.. By waiting, you could always make a positive return.

If economic growth comes to a halt, or contracts this century, you will continue to have cycles, but the next top of the cycle may be lower than the previous one, Jongen said.

"This changes the whole investment proposition for real estate. During the purchasing process, there is a calculation being made on the expected total return that is partly based on a disposal. So now we assume that the selling price will always be higher than the purchase price, but unfortunately we will have to let go of this assumption. Value increases in real estate are not going to be automatic anymore.”

Carbon Tax

The relatively good news, according to Catella, is that not all real estate and not all locations will be affected in the same way by losses in value.

“'Sustainable real estate - where the reduction of CO2 is paramount - will rise in value because this fits with the systemic change we are about to experience. Some locations are more resilient than others due to their bio-physical properties,” Jongen said.

Catella foresees three scenarios:

Purpose build green real estate that will increase in value; retrofitted green real estate that will moderately increase in value; and brown real estate that will only decline in value.

“'There are going to be many different factors that will affect property values. The tricky thing is that we don't know all of them yet. On the one hand, because we have to learn to think at the system level, namely that ecology and economy are intertwined. On the other hand, because some of the core parameters are dynamic, and thus change significantly over time. Take for instance the tax on CO2 emissions, which we believe is definitely coming for real estate. Emission rights on CO2 are already traded, and at some point those costs will increasingly be allocated directly to the polluter itself,” Jongen added.

“Real estate investors will have to pay carbon tax at some point, which would in turn affect their cash flow. While we don’t know how much they will need to be pay, we are convinced that a carbon tax will be levied within the present 20-year investment horizon and should be considered in your investment decisions now. After all, we all know that brown real estate emits more CO2 than green real estate.”

Jongen therefore finds it incomprehensible that this fundamental consideration is still not taken into account in valuations, particularly because the CO2 tax will be dynamic and prices will fluctuate, which will have a significant impact on investment returns:

"Just do a sensitivity analysis in your IRR (internal rate of return) on the current cost of emission rights from 80 euros per kiloton to 1,000 euros per kiloton,” he said.

“We have been working on a new strategy based on these ideas since 2019. This has led us to adopt the 'worst-first' strategy - meaning we have now sold our 'worst' or least energy efficient real estate, i.e. most brown properties. For us, the tipping point came when we saw the revised Tegova (European Group of Valuers’ Association) valuation manual as a draft. The manual stated for the first time that the appraiser should also consider the impact of future ESG regulations. The wording was not yet very concrete and in an appendix, but it was a clear signal that the 'tipping point' was now approaching. So in that respect, we have benefited from the real estate industry lagging behind, as ‘brown’ is thus not yet fully priced in.”

Silent Reserve

Catella’s strategy takes into account the predicted systemic transformation in the market in its investment acquisitions. The investment manager has partnered with French sustainable engineering company Elithis, which designs buildings that are ‘energy positive,’ or generate more green energy than they use in ‘grey’ energy including the tenant's total private consumption.

Catella has set up an impact fund to acquire these energy positive residential buildings aimed at the mid-level rental sector, with a targeted invested equity of €500 million for the French market, to be followed by a second tranche of €500 million across Europe. Tenants of the buildings will have hardly any energy costs.

'In our view, those buildings are not yet valued accurately, simply because they have several elements of a potential green premium that are currently overlooked. For example, these are midrental units, but because of the absence of energy costs for the tenant, we could increase rents to reflect these savings, meaning an increase in the property value. For now, we see it as a silent reserve we have,” Jongen said.

Catella is among the founding members of a group within the Urban Land Institute (ULI) industry think tank that is investigating how a new valuation standard, which takes into account the impact of decarbonisation, will affect property values. These shadow cash flow calculations lead to valuations that vary from +1 per cent to -20 percent compared with current market levels.

Dependent on Institutional Investors

Jongen is moderately optimistic about the chances for green real estate gaining a larger share of institutional investors' overall asset allocation: “(Regulatory) measures related to climate change and particularly CO2 reduction will significantly impact other parts of the economy and investment categories such as equities and bonds, will also face headwinds. But in a world where choices must be made, because we can no longer provide energy for everything and economic growth is at risk, basic needs like food, housing and security will be less severely affected than others. What remains to be seen is to what extent we can implement the anticipated systemic changes we foresee in our investment strategies and this will depend mainly on the institutional investors who invest in our funds. Thus it is vital to provide lucid explanations of what we are doing,” Jongen concluded.

1 The Epsilon Great Transformation of Real Estate Markets – Catella European Residential Vision 2023

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