_How does ESG impact commercial property valuations?

Most sectors agree on the urgency of decarbonising. As the regulatory landscape tightens and the requirements to measure and report sustainability impacts of businesses increase, investors continue to focus their agenda on the efficiency or resilience of existing assets and new acquisitions.

2024 marks 5 years since the UK government announced its intentions to achieve net zero. 2024 is also the year when we anticipate the release of the UK Net Zero Building Standard. This is designed to provide one point of reference for all stakeholders wanting to demonstrate their assets are net zero aligned with an industry-agreed standard.

So now seems like an opportune time to look at what role the valuation profession may play as the industry moves towards net zero, as well as look at some of the challenges we face in drawing representative, empirical answers as to the value impact of this move.

Journey to net zero for commercial real estate

The way the market has reacted to the net zero agenda was highlighted in the ESG Property Investor Survey we produced in Q3 2023. Of those investors surveyed, 41% stated their goal for net zero was 2030. Additionally, many large corporate occupiers are setting clear targets for net zero and engaging with their landlords to work collaboratively towards this goal.

According to our research from Active Capital, there is a green premium for buildings. We found an 8-18% sales price premium for green-rated buildings compared to equivalent buildings without a BREEAM or NABERS rating across these markets, depending on the level of green rating.

As top ESG credentials become the norm, the premium attached to green buildings will tip towards a ‘brown discount’, where buildings that fail to reach a certain sustainability standard are rented out or traded at a lower-than-expected rate, with the risk of them becoming ultimately obsolete.

And so, whilst there is consensus for action and the need to accelerate that action, many stakeholders still don’t know exactly what form that change should take when it comes to their assets, and therein lies the challenge.

The challenge for valuations

No two buildings are the same, and as such, no two decarbonisation pathways will be the same. For owners to formulate a net zero strategy and understand which levers they have at their disposal, they must first understand the unique performance and life cycle of their building or assets. To do that, they need access to reliable data and the expertise to confidently interpret it and use it to guide their strategic decision-making.

Even then, if they have been able to collate and analyse the data and are in a position to make strategic decisions, they still need access to suitable decarbonisation solutions, and a number of those solutions cannot yet be implemented at any scale. As a result, their potential at the moment cannot be truly realised.

The role of the valuer in ESG considerations

The guidance from the RICS is that valuers consider influences on value, which include building obsolescence, capital expenditure (capex) requirements, and carbon emissions when valuing a property. Yet, even with that steer, accurate assessment is no easy task. For example, the variability of decarbonisation pathways, case-by-case cost requirements and lack of benchmarking highlight our challenges when making asset pricing comparisons.

Additionally, the scope of EPC upgrade works varies between individual buildings, and there may be several potential upgrade solutions. Meanwhile, construction cost inflation and energy costs remain at elevated levels and are unpredictable.

Valuations have always been and will continue to be based on transactional evidence, both when robust information can and can’t be provided. Valuers are embracing the new considerations that have come into play - as they have always done.

We have the tools to factor in the steps required to bring a property up to the suitable ESG standard and to reflect the value the market is attributing to that standard, but how do we go about quantifying that “empirical” value?

In some pioneering markets, we’ve seen indicators and transaction metrics which can guide those discussions. Still, as these standards become the norm, investors will not pay a premium for something they perceive to be, by definition, standard. Instead, they expect a price reduction to account for the missing features.

Input from valuers is key

As already mentioned, the first step is consistent data. Whilst acknowledging the current challenge around multiple data points, this should not be a barrier to net zero considerations being a part of discussions around value.

At Knight Frank, ESG is incorporated into our data collection, analysis and due diligence processes for valuations. The next step is to move towards standardised processes and a common framework for measuring and reflecting performance.

To truly understand pricing, the openness of rationale and input is imperative. This includes disclosure of specialist information such as legal advice on landlord and tenant questions, information on specification and environmental issues, upgrade options, and plans and costings for upgrade works. Owners, lenders, interdisciplinary teams and valuers must communicate effectively and collaborate to build our understanding of market behaviours.

We may follow behaviour, but it’s important for us to be part of the discussion that decides those behaviours so that we can add value. While the moral argument for net zero is evident and easy to justify, the economic stance is more complex and, therefore, arguably a more significant barrier to progress, and that is where valuers come to the table.

One of the biggest drivers for behavioural change across the sector is likely to come when asset pricing and liquidity reinforce the moral incentive and effectively force action or prohibit inaction. Considering how much ultimately comes down to value, valuers need to be involved in the conversation now so that we can reflect on what is being discussed and understand what’s driving decisions.

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To learn more about how we can support valuations and ESG please get in touch.