Real estate faces energy efficiency 'cliff edge'

To the long list of things that real estate investment trusts (Reits) have on their plate right now, we can add one more. As well as trying to manage plunging share prices and the soaring cost of debt, a series of energy efficiency deadlines loom in the short and medium term. With energy prices surging and concerns over the climate crisis growing, these targets are sorely needed and a long time coming, yet commercial landlords who own hundreds of millions of square feet (sq ft) of real estate are nowhere near ready.

By April next year, every commercial property that is leased needs to have an energy performance certificate (EPC) of E or above. The government plans to increase that threshold to C by 2027 and B by 2030. Commercial developers cannot let buildings that don’t meet those targets. So they are spending billions of pounds on retrofitting and redeveloping their properties to avoid being lumped with scores of empty, useless assets.

Many are struggling. In September, Savills warned that UK retail faced an EPC “cliff edge” with 185mn square feet of space at risk of being unlettable by next year for failing to meet the E-or-above target. The agency said most of this space belongs to small-time players, but it added that a still sizeable 35mn sq ft can be attributed to retail parks, shopping centres and supermarkets which tend to be owned by larger players such as Reits.

That 35mn figure – which amounts to just over a square mile of space – is just for retail. When you add in the obsolete office and industrial space that could be on that market next year as well as the amount of space that will need to be retrofitted to hit the 2027 and 2030 targets, the sheer scale of the challenge becomes apparent.

So, how are the Reits getting on? In order to answer that question, Investors’ Chronicle asked all of the commercial property Reits in the FTSE 350 what percentage of their portfolios met those three targets and how much they estimate they will need to spend to hit those targets. Their responses reveal a lot about the difficulties of making real estate a more sustainable investment.

Long way to go

Only nine of the 22 commercial property Reits in the FTSE 350 confirmed they have met the 2023 target and none have met the 2027 or 2030 targets yet. The market leader is warehouse developer Tritax Big Box (BBOX). It says all of its portfolio meets the 2023 standard and 95 per cent of its portfolio by size meets the 2027 standard. At the other end of the spectrum is Workspace (WKP). Only 77 per cent of its portfolio meets next year’s standard while just 61 per cent meets the 2027 standard, although its figures are from a slightly earlier point in time than peers.

Tritax ESG (environmental, social and governance) director Alan Somerville says that part of the reason for the company’s green credentials is that it works with single-tenanted buildings which makes it easier to have discussions about improving energy efficiency – stressing that “collaboration and dialogue” are key. Christopher Turner, property director of rival warehouse developer Urban Logistics Reit (SHED), which has also met the 2023 deadline and is 76 per cent of the way to the 2027 deadline, agrees that working with single-tenanted buildings is easier than working with multi-tenanted estates.

“Broadly, if you’re running a multi-let office or a multi-let industrial estate, your energy consumption is just divided by floor area,” he says. “Therefore, if you spend £100,000 a year on electric and divide it by floor area, the smaller tenants will say ‘well, there’s no saving for me because I can’t influence what the other 90 per cent of tenants do.’”

This in turn could explain why landlords with multi-tenanted assets – such as Workspace, Derwent (DLN), Hammerson (HMSO), Shaftesbury (SHB), and Segro (SGRO) which has a large multi-let industrial estate as part of its portfolio – are further behind on their EPC targets than landlords with large single tenanted assets such as Tritax, LXi Reit (LXI), Primary Healthcare Properties (PHP) and Supermarket Income (SUPR). Tenants that take larger, single-let buildings are also more likely to be international, blue-chip businesses or governmental organisations with their own sustainability targets as well, making them more susceptible to covering at least some of the cost of EPC retrofitting.

Sirius Real Estate (SRE) – whose UK portfolio comprises a swathe of multi-tenanted small business parks that it acquired from BizSpace – declined to comment on its progress in meeting the EPC targets. Its own filings reveal that it does not yet know how far it has left to go.

In its report for the year to 31 March, the company said: “To date, we have completed an EPC review on 20 per cent of the BizSpace portfolio. We will then be in a position to start to build a detailed model that will show any potential improvements to be made to each building.” In a recent update, the company confirmed that the EPC review of the BizSpace portfolio was still ongoing.

As Sirius’s experience shows, getting a handle on EPC improvements can be tricky. It can be costly, too. Landsec (LAND) says it has put aside £135mn to fund its portfolio’s transition to meeting the EPC targets and becoming ‘net zero’ while Derwent, Segro and CLS Holdings (CLI) say that they anticipate spending £97mn, £72mn and £64mn, respectively, by 2030 to hit their targets. Assura (AGR) believes it can get where it wants to faster and for less money, estimating a spend of up to £30mn by 2026. Assuming other Reits are spending similar amounts on their retrofitting, they will have collectively spent billions on their assets in order to meet higher EPC standards.

However, it might not cost that much as landlords can avoid footing the whole bill themselves. British Land (BLND) says it expects the total cost for retrofitting the portfolio to be in the region of £100mn, but that two-thirds of this will be funded through the service charge or by customers directly.

Turner from Urban Logistics adds that a lot of the money needed for upgrading assets can be captured through dilapidation payments – which is when tenants agree to pay to cover any wear and tear of the asset during their tenancy. In theory, dilapidation payments are a complex and lengthy process that can involve the courts. In practice, landlords say that many tenants, particularly international companies with large balance sheets, will simply write a cheque to cover dilapidation at the end of the tenancy rather than spending time arguing over the issue. 

Sometimes, the tenant will simply choose to pay for the upgrades outright. Urban Logistics says that 25 per cent of the buildings which will need improving “will have been improved by the tenants’ own sustainability goals and targets by 2027, without cost to the Reit or with insignificant impact on cash flow”.

All of this might explain why some Reits are confident they won’t need to spend much or anything at all. Safestore (SAFE) calculates that retrofitting its remaining assets up to the 2027 standard will cost a mere £200,000, while Londonmetric (LMP) expects most of its occupiers will pay for EPC improvements themselves, and adds "where [we] do take a warehouse back to improve and re-let generally the cost of improvements are more than met by a commensurate increase in rent".

Green premium

Whatever it costs and however the money is found, there are benefits to the spending beyond adhering to government regulation. Somerville from Tritax says it is hard to put a figure on how much value a better EPC can add to an asset, but says that it can often be the difference between a tenant leasing your asset or leasing someone else’s. “If you’re in a competitive market, it can be the difference between making the transaction or not – but it’s hard to put any numbers on it,” he says.

JLL (US:JLL) has tried. In a report from the start of this year, it calculated that ‘green’ buildings – those with a higher sustainability rating through EPCs or other certifications – generated a 7.6 per cent sales premium and a 6 per cent rental premium. And with the rising cost of energy prices, landlords say that the appeal of a more energy-efficient building has only increased.

“It has only been in the last year that people looked at EPCs in terms of valuations,” says Turner, adding that part of the reason for this change of heart is that tenants can now feel the 'payback' of a more energy-efficient building much quicker than before because of the soaring cost of energy. The forthcoming EPC deadlines and awareness of the climate crisis will no doubt have helped, too.

Yet, despite the many carrots for achieving a better EPC, landlords argue not every building can be retrofitted. Marks & Spencer locked horns with Westminster City Council over its plans to knock down and replace an existing building in order to build a more energy efficient office. The retailer’s central argument was that the current building was unsalvageable from an energy efficiency perspective and that the resulting building would be greener than anything it could have done to the current asset, but the council disagreed over concerns that the construction of a new building would in itself create tonnes of emissions.

The story shows the bind many real estate companies will be in as these deadlines approach. While improving the sustainability of a portfolio has innumerable benefits from both a business and environmental perspective, the difficulties of doing so extend far beyond just cost. In the end, it will be a price worth paying – but that does not mean it will be easy.