Proactive developers adapt their due diligence procedures, manage change, and deploy green features to protect their bottom line.
In response to the global climate emergency—and cognizant of the significant responsibility of the built environment for greenhouse gas emissions—cities worldwide are instituting aggressive climate action plans and policies that directly affect real estate’s bottom line in terms of costs to comply and fees for noncompliance. Many of the required actions also result in energy savings, reduced operating expenses, and increased net operating income and asset value.
It is not easy to keep track of all the different city requirements, but these considerations are being incorporated into acquisition due diligence analyses for real estate firms globally. But how will these increasingly stringent regulations affect real estate’s bottom line?
With buildings contributing nearly 40 percent of carbon emissions globally and upward of 70 percent in urban areas, cities and countries around the world are looking to the buildings sector to make substantial cuts in energy use and emissions as part of their larger climate action plans.
These reductions cannot just come from better-designed new buildings: over 75 percent of existing buildings in the United States will still be in use in 15 years’ time. To achieve the Paris Agreement target of keeping the global temperature increase within 2 degrees Celsius, all buildings will need to become effectively net carbon neutral by 2050.
Leading cities are passing game-changing climate action plans with policies specifically addressing both new and existing buildings, and more cities are expected to follow.
Building owners are taking note of these new expectations, and the ULI Greenprint Center for Building Performance’s Greenprint Performance Report, Volume 10, in 2019 listed “Cities Get Serious on Climate: Regulations Set Performance Standards” as a trend pushing sustainability forward. For those cities with regulatory programs already in place, next-generation legislation is being crafted looking to set minimum energy and emissions performance standards that will become more stringent over time. These climate action policies directly affect real estate’s bottom line in terms of costs to comply and fees for noncompliance, so these considerations are being underwritten across the real estate value chain, from acquisition to management to disposition.
Focusing on Compliance
The real estate industry is beginning to think about how to comply with these new targets. To meet ambitious climate policies, compliance comes with a cost. Building owners will eventually need to make significant capital investments or risk being fined. Some in the real estate industry have started calculating the potential impact to their bottom line from compliance with the new legislation and capital planning to minimize costs.
But not all policies are the same: cities are passing a wide range of regulations, including mandatory energy benchmarking, building rating systems, stricter energy codes, and mandated compliance with energy and emissions performance caps. Cities have passed an array of policies as they move to reduce emissions from buildings, generally starting with energy benchmarking ordinances and follow-on actions, and increasing in complexity, sophistication, or both to energy performance requirements and net-zero energy building codes.
“The recently passed Climate Mobilization Act puts New York City at the forefront of climate regulation worldwide,” says Laura Vulaj, senior vice president and director of sustainability for SL Green Realty, New York City’s largest commercial landlord.
“The act will have a profound impact on New York City real estate, and as the largest commercial landlord, our job is twofold: we need to continue operating our buildings efficiently to minimize our carbon footprint while upholding our responsibilities to all stakeholders. Every single building that passes through SL Green’s hands, as either an existing asset or a potential acquisition, is evaluated under both a financial and environmental lens to ensure that building systems and operations are aligned with our overall goals and the Climate Mobilization Act.”
The avalanche of new regulations is already affecting fund strategies for building management and real estate transactions. In cities and states with climate policies for buildings already in place, decisions about acquisition, disposition, tenant selection, and holding periods are changing. Investors looking to acquire a building are asking more questions about energy and emissions performance before making an offer and are incorporating that information in the underwriting process for the deal.
In markets where periodic energy audits or commissioning is mandatory, buyers can now review those reports before purchase. Assessments of the condition of the property during the due diligence process are also becoming more thorough to identify the risks and potential investment needed to meet local sustainability requirements. A new concern is what the cost will be to bring a building into compliance as minimum sustainability standards increase, though timing such building improvements with standard capital repair and replacement cycles can mitigate those costs.
Traditionally desirable tenants that have higher energy-use intensity such as stock trading firms, which have high-density plug-load equipment, and tech firms, which have large on-site data servers, may be looked upon less favorably than tenants with lower energy use profiles because they increase the building’s overall energy consumption.
Bill Lashbrook, senior vice president of PNC Real Estate, notes that “political risk to real estate owners comes in many forms. Local climate and energy actions will influence exit strategies, regardless of intended hold periods. If you are looking to acquire a property in a locale with an aggressive climate agenda, lenders will increasingly expect a well-thought-out improvement plan to secure acquisition financing.”
The Business Case for Green
A strong business case exists for real estate doing its part to reduce its contributions to climate change by investing in high-performance green buildings. The required actions from these climate policies result in reduced operating expenses, increased net operating income, and ultimately increased overall asset value.
“The silver lining of these initiatives is that, long term, green building values should increase versus their competitors as tenants/users continue to differentiate in favor of sustainable buildings,” says Bob Lieber, executive managing director of New York City–based Island Capital Group. “Lower costs and increased relative rents by definition will generate higher net operating income and, long term for owners, a lower cap rate which reflects the increased value of necessary building enhancements.
“In the future, the marketplace will place a real premium on assets with meaningful sustainability improvements,” Lieber adds. “A reasonable metaphor would be centralized HVAC [heating, ventilation, air conditioniong] during the ’50s. Many thought the increased capital costs wouldn’t generate incremental returns, and obviously today such systems are base-level requirements.”
Cities with these policies often provide programs for building owners to receive financial and nonfinancial incentives to drive action and compliance in the new construction and existing building markets. These incentives may include a higher floor/area ratio, an increased height allowance, expedited permit review, reduced fees, tax abatements, or cash incentives.
Beyond incentives, getting ahead of these policies by investing in energy efficiency and emissions reductions early can help differentiate assets and better ensure long-term asset value protection as performance requirements inevitably increase. Doing so also has significant market appeal to major potential tenants, who increasingly face corporate climate change and emissions goals that influence their real estate decisions.
There are also value-add opportunities for savvy owners to acquire low-performing assets with a “brown discount.” The potential value at stake for embedding sustainability is significant and in some cases can represent a 50 percent–plus increase in asset value over the life of the investment. ULI’s recent Embedding Sustainability in Real Estate Transactions report shows how acquisitions and dispositions present an opportunity to create value through investments in energy efficiency by supporting better upfront assessments, underwriting sustainability investments to drive higher returns, marketing the value created by these investments to tenants, and communicating this value to buyers.
For all the potential benefits of incorporating decarbonization into new and existing buildings, these policies can cause uncertainties beyond fines and other compliance penalties. Each policy has different requirements, timelines, and consequences. This lack of standardization across cities and countries makes staying ahead of these policies particularly challenging for real estate organizations with a global portfolio.
There also is uncertainty as climate policies rapidly evolve, given that major development projects already well into planning and design will be faced with new emissions requirements. Anticipating and planning for existing and new building decarbonization measures will increasingly become the norm for successful developers and owners.
“As part of our long-term perspective, we are taking a thoughtful approach to addressing environmental issues across our portfolio,” says Caroline Johns, senior project manager at Pembroke, an international real estate developer and adviser.
“Competing environmental regulations can complicate the ability to deliver consistent, best-practice outcomes across international markets. It is vital we support every community that we are part of in its initiatives to be a good steward of the environment, while implementing our own sustainability initiatives that share a global perspective tailored for each place.”
Finally, responsibility for collecting benchmarking data and accomplishing required emissions reductions challenges existing tenant/landlord relationship dynamics. If the building’s tenant pays all the utility bills with a triple-net lease, owners may have difficulty getting access to utility bills for benchmarking or exercising control over improving the building’s energy use and carbon emissions. Yet, generally, it is the owner whom the city holds responsible for these actions, not the tenant.
Collaboration between building owners and policymakers will be key to overcoming these new uncertainties, and lease terms will need to evolve rapidly to incorporate whole-building decarbonization requirements in clear and cost-effective ways.
“The myriad recent environmental regulations can make it more complex to acquire, lease, and manage properties,” says Sophie Carruth, head of sustainability in Europe for LaSalle Investment Management. “However, legislation certainly has its place in galvanizing the real estate industry into action to mitigate climate change.”
One thing is clear: this type of legislation is here to stay, and building owners will need to adjust their business practices to incorporate the new requirements. This does not mean that public and private-sector goals cannot be aligned. ULI, with other partner organizations, has held multiple events over the past two years to bring public-sector policy-makers and private real estate owners together to discuss best practices in facilitating collaboration with the hope of achieving mutually beneficial climate action plans and policies.
ULI also is developing a Ten Principles of Public/Private Partnerships for Climate Mitigation report to be released in 2020. The report will be grounded in the context of localized best practices with a goal of serving as an ongoing tool for cities, real estate leaders, and other stakeholders to engage productively on climate action plans and policies.
If the planet is to avoid the worst consequences of climate change, it is imperative that the built environment achieve net carbon neutrality by midcentury. ULI and its forward-thinking members will play a critical role in ensuring that this massive effort to achieve building decarbonization is accomplished in the most economically efficient and equitable manner. UL
BRIAN SWETT is principal and director of cities and sustainable real estate at Arup, a global independent firm of designers, engineers, architects, planners, consultants, and technical specialists.