Climate-related stranded assets in real estate part 1: Driving change and de-risking real estate

You’ve all spoken about regulatory change as a driver of climate-related stranded assets. Are there other factors at play?

Paul Greenhalgh: People are very aware of physical obsolescence, where the physical fabric of the building is degraded. There’s also functional obsolescence and economic obsolescence. It’s not just regulation that’s compelling landlords to improve the performance of their premises, it’s also occupiers.

MH: Legislative change is driving the agenda. There’s also increased levels of corporate governance: with top tier blue chip or listed companies under massive pressure from the boardroom and shareholders to drive better performance around environmental and climate factors. There’s increasing pressure from shareholders and investors. Then there’s uptake – if you are tenant or prospective occupier, do you want to be located in a building that’s got high carbon emissions? As a corporate entity this might mean you are not adhering to your ESG credentials.

KMS: While the built environment is taking steps to improve its sustainability, it is still fundamentally reliant on fossil fuels to support most of its functions. There is a lot of emphasis at the moment on the fossil fuel world and those who have investments in fossil fuels. There’s less attention on those assets that are reliant on fossil fuels downstream, where the built environment exists and a variety of other assets. If international governments really do take seriously the environmental concerns around reducing global warming, that reliance will be magnified quite starkly. The largest asset owners, managers, portfolio investors and institutions know that there’s an issue. They are just not too sure how they will fix it, because taking action has a variety of different implications. For those occupying or reliant on properties, there is also the sheer cost of energy to consider, which has also been further exacerbated by the geo-political situation between Russia and Ukraine. This just adds further impetus to making the built environment more efficient.

PG: There’s something about time horizons as well here. When you buy an asset, you’re buying the future, you’re not buying its history. Asset owners, managers and occupiers today are having to look into the future: when the legislation around emissions will start to bite, and whether it will be in the long, medium, or short term.

KMS: Because the risk of stranded assets is in the future, it’s not priced into most valuation models, it’s not priced into the book value of investment portfolios. As soon as the major institutions start altering their behaviour and focusing on this issue, it will bring into question the techniques of the market and the value of properties. I think that’s where a lot of the concern is in the market, especially among the big fund managers and big institutions. They want to act, they know it is an issue, but they know if they do change, it will have implications in the short term for the value of the assets in their portfolios. That connects into how they’re financed through debt.

Do we know what the scale of the issue is, or what the level of exposure is to stranding risk?

KMS: Organisations are starting to think about stress testing their portfolios or assets, but I don’t think we’re really there yet. Our initial research[2] tried to get to grips with this in the international market. We used minimum energy performance standards (EPCs) to estimate stranded exposure in terms of value. We used a very low baseline: EPCs in the UK, and we tracked everything below the minimum threshold of E. In theory virtually all commercial and residential stock is at risk because it is reliant on fossil fuels for basic functions. If environmental legislation is enforced around energy and emissions, it will be very difficult to heat and cool buildings in a basic sense. There’s still a great deal more work to be done to understand the quantity of the space involved, the type of space, the location of exposure.

PG: Someone might have a pretty good grasp on the state of Grade A offices, which you hope would be hitting the higher EPC certifications. But there’s a lot of grey space out there, a variety of asset classes and grades of assets.

A lot of data has been published recently because of COP26, so things can only get better in terms of understanding the issue. Last year Saville’s looked at the energy performance of buildings using EPCs and quoted 87% of UK offices at EPC rating C[3] or below, which gives you an idea of the scale.

MH: What’s less known is the extent of the impact in terms of costs. How much it will cost to retrofit the stock, what extent of the stock is impacted. From the perspective of asset managers, their stock is constantly changing and evolving. We’re seeing a lot of turnover of buildings now as owners become more proactive in managing and mitigating exposures, so the scale of the problem is difficult to quantify.

KMS: Sometimes we retreat into the conventional way of understanding a problem: we look at the numbers. It’s not just about the value of the property, but about how you alter people’s behaviour, how you change institutions and governance. My feeling is that most in the sector know that their assets need to evolve – the challenge is catalysing related change.

[2] Suspect foundations: Developing an understanding of climate-related stranded assets in the global real estate sector - ScienceDirect

[3] how-sustainable-is-the-office-stock-in-the-uk.pdf (savills.co.uk)