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Deriving value from property investments and ownership is a long-term game. It requires significant capital investment and a willingness to embrace a degree of risk, but it also comes with a reasonable expectation of solid and stable financial returns. Across the economic cycle, little had changed within this sector of the economy for nearly half a century. But the past few years have been marked by major changes and a recognition that not only will this continue; the pace of change is accelerating.
The impacts of climate change (and regulatory action to address them) are a big part of what’s driving all this change. The result is that the property investment sector is facing a massive challenge on the horizon: the likely increase in stranded assets or assets that have become functionally obsolete. As a result of this looming reality, all eyes have moved to ESG as the solution.
But is this singular focus on ESG adequate to ensure that the long-term value of property portfolios is maintained? Or could it be that ESG is not the panacea that people are expecting.
Why ESG may not get the job done
There is a lot of hype around corporate Environmental, Social and Governance (ESG) impacts, and there has been a proliferation of new ‘ESG’ positions emerging across businesses. This absolutely makes good sense. Property investors recognize the need to collectively address the pertinent issues of decarbonization, climate change, and to contribute to fairer and more equitable societies.
The term ‘ESG’ is simultaneously used to refer to ‘sustainability’ as well as a slew of broader non-financial and social impacts. But, so far, ESG has not delivered on the promise that it could be used to safeguard property investment value and, also arm decision-makers within companies to take decisive action to address climate change.
The collective challenge is that the concept of ESG suffers from ambiguity and a lack of consistent application. This leads to misunderstandings and a general confusion about what data we need to consider and whether certain data are reliable and decision worthy. The ESG-landscape is also dynamic and rapidly changing, particularly when it comes to the positioning and value of existing properties
On top of this, there’s a plethora of other forces altering the playing field for property investors and owners. New regulations are either already on the books or coming down the pike. The EU’s Sustainable Finance Disclosure Regulation and the UK’s Sustainability Disclosure Requirements are both prominent examples.
Additionally, tenants and other stakeholders are demanding more sustainable occupancies and advances in technology and materials are disrupting the ways we build and maintain assets. And all of this is happening within an economy with high interest rates, high construction costs, and tender inflation.
Perhaps it’s no wonder that for some, determining how to convert corporate pledges into tangible actions has devolved into a tick box exercise. But this approach is also risky given that regulators are increasingly focused on calling out greenwashing. At first glance, some property investors may think the best option is to do nothing and see what happens down the line. But this approach exposes investors to significant legal, regulatory, and reputational risks, as well as climate-related, physical risks to their asset portfolios.
The unavoidable challenge confronting the sector
With the bow wave of change happening, property investors need to make immediate ‘no regrets’ investment decisions that will enhance the sustainability performance of their properties, particularly while high energy prices persist. And they must do this while also developing and implementing individual strategies to position their portfolios to deliver value in the emerging green economy.
It's estimated that the construction and operation of buildings account for 39% of energy-related carbon emissions, which means that this sector has a crucial role to play in helping the world address the climate crisis. When it comes to new build, it’s relatively easy to deliver highly sustainable assets with a good ESG rating. The question is, how will investors and owners collectively decarbonize their existing properties, which account for around 27% of those energy-related carbon emissions? To quantify the challenge, indications are that around 80% of existing commercial offices in London do not currently comply with the 2030 Energy Performance Certificate requirements.
Creating real change across the whole sector, especially against the current market backdrop, will take time, significant investments, and conviction from property investors and owners. But the reality is that inaction is no longer a viable means of maintaining property values and ensuring long-term returns.
We can already see that properties that are on the journey to net zero are attracting a “green premium”. At some point in the future, this will become the new baseline and properties that are less sustainable will be subject to a “brown discount”. And there are a few good reasons for investors and owners to act now. First, even under the current market conditions, it will be cheaper to start the journey now. Second, earlier action will allow a longer time for secure returns. And third, this the right thing to do for the planet. Ultimately, money and stakeholder demands will flow to more sustainable properties.
The elephant in the room is that those properties which are most at risk of becoming stranded are likely to be divested by investors and owners, who are looking to mitigate their risk and enhance their credentials and returns. But these are the properties most in need. The risk is that we end up with a split property market – those that can and will invest in a sustainable future, and in turn achieve desired financial and social returns over the longer term, and those that cannot, even with prevailing regulations. Unless this second tier of property, which may equate to a significant portion of existing stock, can be adequately addressed, then the collective industry effort to decarbonize the future will not be successful.
A more resilient approach
From an Arcadis perspective, we see ESG as an important piece of the jigsaw puzzle that we must assemble in order to ensure long-term property value and more resilient returns. But focusing on ESG alone misses the full picture of things property investors should be considering. ESG is focused on how an individual property impacts its wider environment and community. To really drive long-term value, the investors need to also focus on how their individual assets are affected by the context in which they are situated.
For example, let’s imagine I own an office building in a city. I might then be very focused on the building’s ESG performance and invest in retrofitting the building with solar panels, all LED lighting, and install state-of-the art digital systems to regulate power use efficiently. In addition to this, I might also take steps to harden the building against the impacts of climate change by putting in flood protections and moving back-up power systems from the basement to a higher level of the building.
But what happens when a storm hits, the city is inundated, and while my building is indeed essentially unaffected, the public transportation system in the city is wrecked and none of the workers who use my building can get to it? Or what if utilities like electricity, water, and internet service are knocked out?
The answer is that despite my best ESG-efforts, my building may still become a stranded asset. And this hypothetical is why at Arcadis we take a holistic approach to helping our clients protect their property investment portfolios.
A key part of this is recognizing that the impacts of climate change are myriad and wide-reaching. They can’t be boiled down to a simple ESG check list. While ESG-evaluation does touch upon some aspects of the climate challenge, we believe it misses the full scope of impacts that sit across two buckets: physical risks (flooding, urban heat stress, drought, storms, associated repair costs, business disruptions) and transition risks (shifts in government policies, regulations, technology, markets, as well as legal exposure and potential reputational damage). Adopting this broader view of the landscape creates better conditions to make better-informed decisions and no-regrets investments that can protect long-term value.
Working from the bottom up and the top down
At Arcadis, we’re strong advocates for a more comprehensive approach to protecting property investment value because, in our work with clients, we’re helping to address the climate crisis from both the asset level and the city level. Our work in New York’s Lower Manhattan, in the aftermath of Superstorm Sandy, exemplifies this method.
Hurricane Sandy devastated the city back in 2012. The flooding of the Verizon office, at 140 West Street, crippled Wall Street telecommunications and, actually shut down the stock exchange for two days. After the storm we worked with Verizon to harden that office against future flooding, so it’s protected in the event of another superstorm. But also, at the city level, we’re engaged in the East Side Coastal Resiliency (ESCR) project. The ESCR will establish a 2.4-mile system of floodgates and floodwalls that will be seamlessly integrated into the local streets.
By working from both the bottom up and the top down, we’re helping to safeguard investment value in Lower Manhattan, but more importantly, we’re contributing to the climate resilience of the area, thereby protecting people from the impacts of climate change. The ESCR will also enhance the insurability of properties in Lower Manhattan. The project received a federal grant of $388 million dollars (USD), because of the potential it has, to protect this section of the city from climate-related flooding. This highlights that the transition to climate-adapted cities also presents opportunities to tap into new sources of funding for investors and owners, such as pre-disaster grants, green energy, and infrastructure subsidies and tax incentives.
Protecting your bottom line, while combatting climate change.
In short, when it comes to protecting property values and financial returns on investments, we believe this can only be done by taking a view that’s much broader than just ESG. Only when property investors grasp this bigger picture, can they develop compelling business cases and make no-regrets investment decisions, today, that will yield benefits tomorrow. At Arcadis, we help our clients do this through our experience working from both the asset level as well as the city level, leveraging predictive data and state-of-the-art engineering skills so our clients can make profits while also making demonstrable, positive impacts on climate change. Together, we can do both.
For more on this topic please check out the International Construction Costs 2023: New Horizons