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What are green offices for?

A premium for green office space is encouraging. But that doesn't mean it will prompt the right kind of capital allocation
What are green offices for?

Two years after the pandemic first upended our daily lives, there is still limited consensus on how to use office space. In a bid to lure back reluctant staff, this magazine’s parent company first tried free cake, then a free canteen. Several strange, hermetically sealed pods have appeared in and around empty banks of desks. Fridays remain particularly quiet (or so I’m told).

If tepid city centre retail figures are a guide, weekday activity remains below the long-term trend. City centre offices were less than 25 per cent full in the UK last month, estimates one report, compared with a pre-pandemic average of 55 to 60 per cent. And yet, despite this, investor demand for one office market sub-sector has displayed remarkable strength: the energy efficient building.

Offices, as property investors are now well aware, are going green. The shift is welcome, given they account for a fifth of non-residential real estate energy use. Developers and landlords also have little choice, since the government mandated all non-domestic rented buildings achieve a minimum EPC energy efficiency rating of ‘B’ by 2030. It’s quite a job. According to the estate agent Savills, some 87 per cent of UK office stock – more than 1bn square feet – falls short of the required standard.

Getting there will likely be painful. And in keeping with most property and energy policy, we should anticipate big exceptions and a side order of fudge.

But don’t expect the market to lose sight of the opportunity here. Indeed, many expect sustainable offices to be one bright spot for capital returns over the next few years.

One reason for this is market fundamentals, given the dearth of top-rated space. In turn, this is leading to what analysts at Schroders see as a two-tier office market. “Previous doubts that occupiers were not prepared to contribute and pay a higher rent for special features have evaporated,” the firm’s real estate heads Sophie van Oosterom and Mark Callender now believe.

Even as yields have climbed across average grade office stock – thereby depressing capital values – the focus on prime, green space has sharpened. In Germany, green city centre offices made up just 9 per cent of total floorspace but almost a third of take-up in the year to June 2021. In the City, more than 70 per cent of new leases were deemed ‘green’.

To developers, these look like big incentives. According to Knight Frank, London office buildings with top energy ratings sell for a 10 per cent premium. This helps to explain why M&G (MNG) is keen to trump the ‘excellent’ BREEAM design standards of 40 Leadenhall, a 34-story office block set to complete in 2024 and into which the asset manager is ploughing £900m.

If this sounds like smart ESG principles at work, it’s worth noting that a major chunk of the emissions across a property’s life are incurred in construction. In heralding 40 Leadenhall’s “focus on sustainability”, its anchor tenant neglects to mention the sunk environmental costs of a shiny new building when so many remain less than half empty.

Savills, one of the building’s letting agents, elsewhere cites research from Germany’s environmental and energy agencies that carbon neutrality in the built environment is only possible via extensive refurbishments of existing stock. Helical (HLCL), which is now almost entirely focused on sustainable refits and upgrades, looks well positioned among its landlord peers to benefit from current trends.

As such, and upcycling aside, investors need to think carefully about who or what ‘green’ real estate is really for.