‘The future is not some place we are going, but one we are creating.’
John Schaar, Legitimacy in the Modern State (1981).
The last year has been a challenge for the property world and, understandably, all eyes have been on the impact of Covid-19 and resultant acceleration of structural change in real estate markets. Indeed, no one would argue with the severity of that problem and the resulting hardship suffered by many property owners when the value of their assets fell substantially as market uncertainty prevailed, especially in the retail and hospitality sectors and, to a lesser extent, offices, with continued evidence of structural shifts in occupational demand.
But, while the pandemic will have ongoing impact, it falls into minor significance when pitted against the long-term greater global issue challenge: climate change. To many it might have become ‘out of sight, out of mind’, but for the major investment market players and for governments this has definitely not been the case. Indeed, 2020 proved to be a year when governments around the world really started to propose more major steps ahead of this year’s COP 26 climate change summit, due to take place in Glasgow in November. Physical climate change risk and the policy or ‘transition’ risks associated will have a much larger impact on property values than anything that has happened during the pandemic.
Two major announcements by the UK Government are pointing the way to why there is an impending impact on the real estate sector. First, at the end of 2020, the Government published its Department for Business, Energy & Industrial Strategy (2020) Powering our Net Zero Future: Energy White Paper. And, second, its announcement to enhanced climate change commitments by aiming for a cut in carbon emissions of 78% before 2035 – years earlier than had been anticipated.
Property and energy eficiency – uncertain target dates
The UK Government estimates that offices, retail space, hospitality and industrial buildings account for around 80% of private sector buildings energy demand; further buildings are the second largest carbon emitting sector. It follows that property energy efficiency is in the front line. Existing building retrofitting will be required, as it has long been acknowledged that we cannot meet targets based on new build alone. But, while demand for low and zero-carbon buildings grows apace, legislation in the form of Minimum Energy Efficiency Standards (MEES) for all investment buildings already exist, but these standards (minimum Energy Performance Certificate (EPC) E rating on new lets and by 2023 all lettings for existing buildimgs) were set when the Government was targeting zero carbon 2050 target of carbon neutrality.
The White Paper has stated that, for let commercial buildings, the intention is to raise the standard to B, ‘where cost-effective’, though this needs to be ratified by regulatory approval. The ambition for residential lets appears to remain at C by 2035. But, until the Department for Business, Energy & Industrial Strategy (BEIS) formally confirms this schedule and regulations are issued, we are all working in a relative limbo and many market players are simply ignoring the potential problem.
Is it the calm before a storm? And a storm it will certainly be. For example, it is estimated that only 6% of the current office stock is A or B rated. That means that within nine years, 94% of existing offices will not be legally lettable without mitigating action. And while upgrading to E could often be achieved by changing the lightbulbs or similar small actions, achieving a B grade is a whole new issue and expense leading to a real potential for the asset to become ‘value stranded’: a bad result for the investor and society alike. That will have such a momentous negative impact upon property values that it will make the impact of Covid seem like a walk in the park.
In our view, it cannot be ignored by valuers as something in an uncertain future. The current Royal Institution of Chartered Surveyors (RICS) guidance, while written long before the upgraded targets were even mooted, makes that clear.
The impact on valuation today
Even though changes to MEES regulation are not yet finalised, they are an issue that does, or should, impact on values today. After all, a valuation of a freehold commercial investment property is the value of all its expected future incomes and, come 2030, it might not have a cash flow unless significant expenditure takes place. With residential stock the issue may be slightly further away and the percentage of investment stock lower, but the challenge is also there.
So what do valuers do? Is it an option for a valuer simply to value the property based on an assumption that it will continue to be lettable when its existing EPC is below a B? The argument could be that the market is not yet factoring in the change, so the valuer should not; but can that really be a ‘reasonable and relevant’ assumption under the RICS Valuation Standards? We would argue that such a disregard of MEES risk would not be justified given the requirement in the RICS standards on valuers to ‘consider whether any sustainability factors that affect the valuation are likely to have altered’.
An alternative approach would be to deduct the cost of retrofitting to achieve compliance, but to do this may be beyond the knowledge and skillset of the valuer and the client may not wish to or be able to finance additional fees to employ additional advice.
Much may depend on the purpose of the valuation: sale, strategic advisory or loan security. Certainly the line between valuation and advisory is blurring, putting extra pressure on valuers. Additionally, as many top investors are seeking to make their portfolios carbon neutral ahead of compliance requirements, will it lead to major retrofit programmes or to disposals of non-resilient (A-) B stock, leading to lower-grade asset values spiralling quickly down? This becomes increasingly likely as lenders become far more aware of the risks of lending on non A-B grade stock, meaning that purchasers may find their ability to buy compromised.
In conclusion, energy compliance will demand increased consideration as part of due diligence, but as our understanding and knowledge of climate change risks grow, so MEES may prove to be just the tip of the resilience (melting) iceberg.
