How to avoid a widening gap.
Investors and occupiers are increasingly prioritising environmental, social and governance (ESG) credentials as part of their appraisal process for office space across the UK. As the demand for grade A office space rises alongside the volume of ESG-related legislation for property owners, a two-tier office market of prime space with strong ESG credentials and obsolete office buildings is emerging. Owners of properties in the secondary market may become trapped in a cycle of weakening rents and lower capital expenditure, culminating in company failure, as tenants and lenders shy away from sub-prime office space.
The flight to quality
In the wake of the pandemic, office occupiers are re-assessing their requirements and demanding high-spec office space with strong ESG credentials. Today’s workforce is drawn to flexible, collaborative spaces with wellness features and amenities. As a company’s office buildings are a tangible expression of its values and ethos, businesses have increasingly been utilising office space as a tool to attract and retain employees.
This flight to quality has been evidenced by a growing imbalance between occupier demand and available supply of high-quality office space across the UK. Knight Frank reported that during Q3 2021 16.7% of available office space across London was comprised of new buildings, while secondary stock accounted for 83.3%.
As a result of the flight to quality, the disparity between the high rentals commanded by prime office space and discounted rentals offered by sub-par stock is becoming more pronounced. While prime offices are expected to witness significant growth in the mid-term, older stock will see a decline in rental income and occupancy rates. According to CBRE over the next five years, the best 25% of office space will see rent growth of 7%, while the lowest 25% will fall. Grade A office buildings have been proven to generate better returns for investors owing to higher rentals, longer and faster lettings and lower voids. Consequently, investors are increasingly adopting ESG criteria as part of their investment strategies, to better determine the future financial performance of office stock and its ability to drive stronger returns.
Changing legislation
Coupled with occupiers’ demands for grade A office space, there is increasing government pressure to improve the energy efficiency of buildings. As the UK building stock is responsible for an estimated 31% of national greenhouse gas emissions, it’s not surprising that the Government is targeting commercial properties to help the UK achieve its net-zero emissions target by 2050.
Under current legislation, subject to exceptions, a landlord cannot grant a new or renewal lease for a building that does not comply with the minimum energy efficiency standards (MEES), originally set at EPC class E. From April 2023, this requirement will apply to both new and existing leases. In March 2021, the Government proposed lifting the MEES for non-domestic rental properties to an EPC rating of B by 2030. More than 85% of the UK’s commercial rental property currently has an EPC rating of C or lower. Investors are acting now to future proof their investments by assessing transition risk when appraising acquisitions and their existing portfolios.
For many investors this will involve identifying those lettable properties which are not capable of meeting the 2030 target of EPC B. The commercial real estate lending report published by Bayes Business School identified that 46% of lenders who participated in the survey already have a minimum EPC requirement.
Property owners can improve ESG performance with increased capital expenditure, but for a large proportion of owners of secondary office spaces, increased voids and weaker rents are likely to prohibit such capital expenditure. The implications are clear that without renovating, upgrading and repurposing old office stock, rental expectations will fall and the gulf between yields and capital value will widen. With a national recession looming, we should expect to see an increase in loan defaults and borrowers struggling to obtain financing in the secondary office market.
Sustainability-linked loans as a tool to create a more balanced market
As property owners and investors recalibrate their strategies in line with strengthening occupier demand and regulatory pressure for high-quality stock, there has been a rise in popularity of sustainability-linked loans (SLL). SLLs incentivise borrowers to make measurable improvements in a building’s ESG credentials by linking loan terms to performance against pre-determined KPIs.
At the end of 2020, Aviva Investors Real Assets launched a £1bn sustainable transition loan framework which aims to provide loans to borrowers with terms linked to improvements in ESG performance. Under the framework, borrowers can select 1 to 3 KPI(s), which include energy efficiency and wellbeing. Performance against each KPI will be monitored and borrowers rewarded with financial incentives for reaching agreed targets. The scheme provides owners of inefficient building stock with financing. whilst accelerating the transition of the buildings.
Crucially, the framework looks beyond the current ESG standards of a building to the appetite of borrowers to invest in ESG. If the roll-out of similar schemes becomes widespread, enabling a significant proportion of older stock to be converted to quality office space, it could result in the creation of a more balanced market.
There is a growing body of voluntary and mandatory sustainability-related reporting for all companies on both a national and global scale. Application of the relevant frameworks and standards to property companies will increase transparency in reporting ESG performance and allow investors to compare and benchmark assets in their existing portfolios and potential acquisitions. Enhanced reporting should also focus the attention of property owners to identify areas for improvements and encourage action in this regard.
As ESG will continue to be a main driver shaping the commercial real estate sector, it’s evident that property owners and investors need to act now to create long-term value for stakeholders. Owners of secondary space, who fail to properly prioritise ESG, will in the mid to long-term limit their access to lettings and more affordable finance options.
