European Green Deal: Towards a Zero-carbon Urban Environment

European Green Deal: Towards a Zero-carbon Urban Environment

Part 2: Real Estate Owners: Moral Obligation versus Economic Benefit

CHRISTOS ANGELIS, CAIA – Director at Masterdam

This is the second article in this series. For Part 1, please click here.

EUROPEAN RENOVATION WAVE

The European Green Deal (EGD)[i] is paving the way for stricter regulations and more applied measures at the EU level to move towards a zero-carbon economy. The real estate sector is an integral part of the EGD by prioritizing on existing buildings, which generate circa 40% of total energy consumption and 36% of total greenhouse gas emissions in the EU. The current policy named Energy Performance of Buildings Directive (EPBD)[ii] has yielded results in reducing emissions by more than 20% compared to 1990 levels in line with EU’s 2020 targets. Yet, the implemented measures have not been sufficient to meet the energy consumption reduction target of 20%. Although new real estate development projects in the EU are obligated to follow high energy efficiency standards (NZEB)[iii], restrictions on existing buildings are relatively low, reaching energy label C on paper with countless exceptions. As a result, only 1% of the European building stock is being renovated every year whereas 75% of the buildings have low energy efficiency levels.

EU policy makers have proclaimed that the EGD will initiate a major Renovation Wave[iv] across Europe focusing on improving the energy efficiency of buildings in line with the principles of circular economy. The target is to at least double the current renovation rate per annum for public and private buildings prioritizing social infrastructure primarily owned by national governments. The EU stands ready to provide technical and financial support to promote this ambitious initiative. Co-operation between local authorities, real estate owners, developers, service providers and financiers will be encouraged to stimulate energy efficiency investments, to pool renovation efforts into large urban blocks for economies of scale, and to explore ways to develop innovative financing solutions.

PUBLIC REAL ESTATE OWNERS

Government-backed real estate owners are in theory less profit-driven compared to private real estate owners. The majority of public real estate assets serve concrete purposes and their use is typically long-term. Social infrastructure properties such as schools, universities, hospitals, elderly homes, prisons, sport centers, pools, libraries, museums and military camps are prime examples of operating assets owned by national governments or government-backed entities. The government can also be an owner-occupier of administrative offices, logistics and warehouses. However, in the past 15 years, such properties are increasingly being sold to investors, while government tenants are simply renting commercial space.

By default, public real estate owners have an obligation towards the society as well as a long-term perspective to invest heavily in energy efficiency improvement projects. Improving the sustainability of public buildings will lead to substantial cost-savings at a national level and will attractive positive media attention for political reasons.

The quality of property management and capital expenditure (CAPEX) programs for public real estate in a significant part of the EU is sub-optimal. National governments and local authorities are in most cases lacking the knowledge and the resources to effectively monitor energy consumption and to make targeted investments to improve the sustainability level of their properties. EGD can provide significant technical and financial support following its slogan: “making sure that no one is left behind”. Especially in less developed EU member states, the quality of public buildings is low and they are in need of major renovation or redevelopment. EU’s intervention can be a catalyst for backlog CAPEX investments or redevelopment projects to follow high standards of sustainability since they will be directly or indirectly subsidized.

A problem is that each EU member state has differing levels of knowledge, organizational structures, and financial budgets for their real estate holdings. This makes planning, decision-making, and executing a nightmare straight from a book written by Franz Kafka. An idea would be for the EU to create a taskforce to provide support and to monitor the green initiatives at member state level. Since the EGD will eventually become European law and the EU’s financial support will be substantial, national governments should be more motivated to co-operate.

PRIVATE REAL ESTATE OWNERS

Private real estate owners are often in the center of criticism when it comes to environmental policies. In the eyes of policy makers, private property owners do not prioritize investments in energy efficiency improvement projects. As always, generalizations can be highly misleading. It is convenient for the EU, national governments and media representatives to present real estate owners as scapegoats for a dysfunctional system that simply does not generate the desired level of real estate sustainability investments. To make things more complicated, real estate owners are not a homogeneous group. They have diametrically different perspectives and economic interests, all of which need to be well understood. The following characteristics typically influence the real estate owner’s approach towards sustainability:

  • Investor Base
  • Holding Period
  • Underlying Tenants
  • Sustainability Reporting

In my interactions with real estate professionals across function and seniority, I have discovered that they have a high degree of awareness regarding the urban environment and its impact on the wider environment and society. Furthermore, professional private real estate owners have, on average, substantial technical expertise through their project teams and co-operation with installation companies in order to execute energy efficiency improvement projects. Good intentions and know-how are present to a certain extent. What is missing is economic incentive. Sustainability investments need to make sense both in marketing campaigns and in spreadsheets.

The details of the EGD’s plan still need to be solidified by policy makers, hopefully in consultation with real estate industry representatives. In my opinion, EGD should introduce well-thought measures that stimulate real estate sustainability investments based on real economic benefit and fair sharing of the burden between stakeholders. One thing is certain, without the inclusion of the private real estate sector in the EU’s renovation scheme, the ambitious sustainability targets will not be met.

OWNER CHARACTERISTICS & APPORACH TO GREEN INITIATIVES 

  1. INVESTOR BASE

Institutional investors worldwide have embraced environmental, social and governance (ESG) responsibility as an essential part of their direct investments or fund manager selection. As a result, the investment policies of the selected real estate vehicles need to comply with high sustainability standards. This is evident in the investment policies of core real estate funds whose investor bases are primarily institutional.

Family offices and entrepreneurial real estate investors are also gradually following the bright example set by institutional investors. The market has witnessed a major shift towards real estate sustainability by atypical investors. A quick market scan through real estate company websites, press releases and investment policies (private or publicly available) would show that green initiatives are gaining momentum.

  1. HOLDING PERIOD

Energy retrofit projects are by nature long-term investments, which entail high upfront costs and small annual returns from energy savings. Therefore, these initiatives are more suitable for long-term real estate investors. Core investors with 10 years plus holding periods have strict asset requirements, which include high levels of energy efficiency. The problem is that they cannot create such buildings through major retrofits since heavy (re-)development activities are typically outside their investment policy. As a result, core investors tend to focus on newly built or newly refurbished prime assets, which do meet the sustainability requirements.

Energy inefficient properties are typically acquired by value-add or opportunistic investors with investment horizons of up to 5 years. If the buildings have the potential to become prime assets in order to be sold to core investors at a premium, the extra investment in sustainability measures is justified since it could lead to a higher expected sale price. This is also called the “green premium.” On the other hand, if the buildings are situated in secondary locations with no prospect of becoming prime assets, entrepreneurial investors tend to prioritize CAPEX on aesthetic improvements and active leasing efforts. Only the bare minimum sustainability improvements are executed to simply comply with current regulations. As discussed above, the mentality is gradually changing but there is still a long way to go.

An interesting group of real estate investors, which is well-positioned to acquire assets in need of energy retrofit projects and maintain them for the long-term, is real estate investment trusts (REITs). As evergreen real estate investment vehicles allowed to engage in refurbishment projects, REITs are able to include the long-term benefits of creating and owning highly sustainable assets in their underwriting.

III. UNDERLYING TENANTS

Energy efficient buildings should, in theory, charge lower like-for-like service charges to tenants due to lower utility bills. As a result, total occupier cost should decrease, making the buildings more attractive for current and future tenants. The higher attractiveness of sustainable buildings to tenants is by itself an economic incentive for landlords to invest in energy efficiency measures. However, in most cases, it is not enough to justify the investment without rent increases. There are also wide differences between buildings in terms of services provided, making a like-for-like comparison of service costs attributed to energy efficiency confusing.

Owners of buildings occupied by short-term tenants (average occupancy: 3 to 5 years) are less incentivized to invest in sustainability measures because short-term tenants cannot fully capture the long-term economic benefit of paying higher rents in exchange for lower like-for-like service charges. On the other hand, real estate owners with long-term tenants (average occupancy: 7 to 15 years) are more likely to convince tenants that a higher rent is justified.

Tenants who are operating businesses such as flex-offices / co-working, hotels, care homes and student housing typically have a strong economic incentive to reduce utility bills since they are very interested in the effects of total occupier costs on their bottom line. Therefore, building sustainability is a standard topic in lease negotiations, which could affect the level of rent that tenants are willing to pay.

Lastly, owner-occupiers such as government agencies, major corporations and operating businesses owning their real estate have much to gain by improving the energy efficiency performance of their properties. There is also a marketing benefit to own and use space in a highly sustainable building, which could enhance the company’s brand.

  1. SUSTAINABILITY REPORTING

Over the past 10 years, real estate industry bodies such as GRESB[v] and EPRA[vi] have developed elaborate systems of measuring and reporting the levels of sustainability of real estate vehicles. A plethora of market participants have voluntarily chosen to participate in the assessments and to provide relevant reporting to their shareholders. It is logical that most of these vehicles cater to institutional investors since ESG is an important part of their due diligence and fund selection processes. Real estate vehicles subject to sustainability reporting typically adhere to higher standards of sustainability since their performance is regularly evaluated and reported. This is reflected in their investment policies, asset selection criteria and efforts in monitoring as well as in reducing energy consumption.

WHAT CAN THE EUROPEAN GREEN DEAL DO DIFFERENTLY?

RESTRICTIONS ON LEASING

EGD can impose stricter energy efficiency requirements for leasing space or even selling assets. Such restrictions are already in place for government tenants and could eventually be extended to all tenants. These measures will effectively make energy inefficient buildings commercially obsolete unless they are renovated by their owners. Although this may increase the renovation rate for existing buildings, the burden will be borne solely by real estate owners. In my opinion, the higher restrictions should serve as the stick coupled by concrete economic incentives.

TECHNICAL SUPPORT

As discussed earlier, professional private owners have, on average, the know-how when it comes to energy efficiency projects through their development teams or interaction with installation companies. On the other hand, public real estate owners and smaller entrepreneurial outfits would welcome the opportunity to understand more about the technical aspects, investment costs and potential benefits of such projects. EGD’s commitment to increasing awareness and bringing closer all stakeholders to create open platforms of co-operation is very positive.

TAX INCENTIVES

The EU in consultation with national governments could consider the introduction of tax incentives regarding energy efficiency project costs. These incentives could range from full tax deductibility to VAT exemption and everything in between. Hence, sharing the burden with the government.

RENT INCREASE

Another measure could be to allow real estate owners to increase rents during the current lease terms upon the completion of sustainability works. Hence, sharing the burden with the tenants. This will result in higher property valuations from day one since the quality of the asset will improve and rental income will increase. Tenants will have to pay a higher rent but at the same time will enjoy lower service charges due to the decreased utility bills.

CO-INVESTMENTS

EGD has also announced its intention to co-invest in energy efficiency projects. The lion’s share of the announced package of €100 to 150 billion will be allocated to social infrastructure. However, well-thought renovation projects by private investors with wider impact on the urban environment may receive subsidies or co-investments by the EU.

GREEN FINANCING

Another area where EGD can play a big role is to provide guarantees or to co-invest alongside traditional or alternative lenders and offer inexpensive financing to real estate owners for green initiatives. Low financing costs for retrofit projects with flexible terms would make sustainability investments more attractive since no high upfront commitment will be required.

ENERGY SERVICE COMPANIES (ESCOs)

Innovative financing structures are also part of EGD’s agenda. One that stands out is the ESCO[vii] model where ESCOs are formed by installation companies and/or financial investors in order to provide financing for energy efficiency improvement projects in exchange for payments from energy savings. This financial lease structure called Energy Performance Contract[viii] (EPC) is highly beneficial for real estate owners since it reduces upfront costs and future payments are fully or partially contingent on the actual economic results of the retrofit works. In most cases, ESCOs guarantee a certain level of energy savings and the payments are tax deductible. EGD is planning to support the creation of ESCOs by providing guarantees or co-investments.

PPPs AND SALE & LEASEBACKS

In the aftermath of Covid-19, the financial position of EU member states will be substantially weaker. Even before the pandemic, certain members particularly in the southern and eastern parts of Europe were already facing challenges with their public finances. Embarking on ambitious renovation plans for social infrastructure without substantial financial support would be unrealistic at this point. However, EU’s funds are not unlimited and most importantly the buffer of €100 to 150 billion[ix] from the Just Transition Mechanism is contingent on stimulating public and private investments of circa €279 billion. Close co-operation between public real estate owners and private investors is essential in the form of Private-Public Partnerships (PPPs) and Sale & Leasebacks (S&LB) with high retrofit requirements for the new private owners. Apart from capital, private investors can contribute knowledge and create synergies. In my opinion, PPPs and S&LBs should definitely be part of EGD’s marketing and information campaign.

CONCLUDING REMARKS

EGD is a beacon of hope for European real estate. Passive market observers might mistakenly consider glossy press releases of highly sustainable newly built assets as a “wind change”. The truth is that the problem lies with the current building stock, which based on the latest EU statistics, is 75% energy inefficient. The acknowledgement by the EU that in order to meet our environmental targets we need a renovation wave is a great step forward.

Starting with social infrastructure, there is a plethora of underinvested building stock ready for sustainable renovation across the EU. However, national governments lack the financial means and expertise to plan and execute such projects. EGD could make the difference by providing technical and financial support for energy efficiency projects. The challenge would be how to coordinate such initiatives and surpass the obstacles set by red-tape. Making major installation companies through the ESCO model and private investors through PPPs or S&LBs part of the solution would be beneficial for all stakeholders, and would align their interests towards a common goal.

It is still unclear how EGD will approach private real estate owners in terms of regulatory restrictions and economic incentives. An extreme scenario would be to pass the renovation bill to the real estate owners by simply increasing the regulatory requirements. In my opinion, a balanced approach is required on behalf of the EU with targeted measures depending on the type of real estate owner. As discussed, long-term core investors have a different perspective compared to value-add / opportunistic investors. It is important to have a fair sharing of the renovation cost between different stakeholders namely owners, tenants, financiers and the government. A combination of tax reliefs, rent increases and lower financing costs for green initiatives could stimulate a wave of energy efficiency investments by the private sector.

In the next article, we will discuss the European Green Deal from the perspective of the tenants.

CHRISTOS ANGELIS, CAIA, Director at Masterdam

Chris is a real estate corporate finance advisor at Masterdam and the Head of CAIA Netherlands. As an investment professional, he is committed to a better urban environment by supporting real estate innovators. He has more than 12 years of experience as a portfolio manager and investment advisor in European real estate markets. Chris holds a MSc in Finance & Investments from Rotterdam School of Management (cum laude) and has attended executive education courses at INSEAD Business School. He has been a Chartered Alternative Investment Analyst (CAIA) Charterholder since 2012 and a member of CAIA Netherlands executive committee since 2015.

 

[i] https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal

[ii] https://ec.europa.eu/energy/topics/energy-efficiency/energy-efficient-buildings/energy-performance-buildings-directive

[iii] https://ec.europa.eu/energy/topics/energy-efficiency/energy-efficient-buildings/nearly-zero-energy-buildings_en

[iv] https://ec.europa.eu/commission/presscorner/detail/en/fs_19_6725

[v] https://gresb.com

[vi] https://www.epra.com/sustainability/sustainability-reporting

[vii] https://ec.europa.eu/esco/portal/home

[viii] https://e3p.jrc.ec.europa.eu/articles/energy-performance-contracting

[ix] https://ec.europa.eu/commission/presscorner/detail/en/qanda_20_24

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