Reflecting ESG in property valuations

COMMENT Over the past few years, the concept of environmental, social and governance has been one of the biggest talking points in property. There is good reason for that – the built environment can have a huge impact on the fight against climate change, and that is something that is beginning to be reflected in the values of individual buildings, with occupiers and investors increasingly opting for properties that meet exacting criteria. We are already beginning to see that play out, with a swathe of refurbishment projects being undertaken across the UK. There are many buildings that need to have their energy performance certificate ratings improved significantly if they are to avoid falling foul of impending legislation that could make some of them untradeable and unlettable. Pressure to upgrade The pressure to go green is coming from multiple fronts. Banks and other lenders are having conversations with their customers about their commercial property holdings to find out what steps they are taking to improve the ESG attributes of their portfolios to avoid financial penalties under the terms of their loans. Market forces are another important influence – the limited evidence available suggests a correlation between the ESG characteristics of a property and the price or rent it can command. Research from Knight Frank’s Active Capital report found indications of a green premium in London – average premiums of around 12% on rent for BREEAM New Construction Outstanding-rated offices and 10-11% on the sale prices of BREEAM New Construction Very Good and Excellent ratings. It is a double-edged sword, though. As top ESG credentials become the norm, the premium attached to green buildings could 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. In Edinburgh, sales of older grade-A offices during Q1 2023, including 7 Castle Street and Caledonian Exchange, achieved yields of 7.3-7.5% – reflective of a discount in part for market perception of the anticipated cost of upgrades. In contrast, Capital Square achieved a yield of 5.7-6%, the main differences being high-quality environmental credentials – EPC A, BREEAM Excellent – and stronger tenant cashflow. Complexity and change Although sustainability is now a top priority for everyone with an interest in property, it is still relatively new ground in some sectors and geographies in terms of influence on value. From a valuation perspective, we have the tools to factor in the steps that will be required to bring a property up to the right standard, and to reflect the value the market is attributing to various ESG features. The challenge is knowing what that value is, given a shortage of transparent transactional evidence. From a legislative perspective, we know that in England, as of April this year, properties with an EPC rating of F or G are considered “sub-standard” and cannot be let to occupiers, unless exempt. Hence, upgrade costs should be factored in. However, in Scotland we are yet to have full clarity on what requirements buildings must meet. Then there is the fact that the way EPC ratings are calculated is not the same in both countries. One building rated C in Scotland may actually be a B in England, which can cause confusion for cross-border buyers and sellers. The ratings themselves also change over time and buildings deteriorate. What was a BREEAM New Construction Excellent or EPC A building a decade ago is unlikely to meet the current requirements. What role for valuers? So the question is: what then should the realistic expectations of the valuers be? The guidance from the Royal Institution of Chartered Surveyors is that valuers consider influences on value, which include building obsolescence, capital expenditure requirements and carbon emissions, when valuing a property. But even with that steer, accurate assessment is no easy task. For example, there is no consistency in measuring, or availability of data on, carbon emissions. Also, the scope of EPC upgrade works is extremely variable between individual buildings and there may be several potential upgrade solutions. Depending on the starting point of a building, works may be relatively inexpensive or very costly – at the extreme end, there are examples of properties requiring works budgeted at more than 20% of previous assessments of market value. Meanwhile, construction cost inflation and energy costs remain at elevated levels and are unpredictable. While at Knight Frank we have guidance on build costs, which incorporate ESG upgrade features as business as usual, the building-specific nature of assessments means that any valuations where capex is needed can only be provided within a margin for error. The best way to provide robust valuations is for the landlord to undertake an accurate costing exercise, which can be shared with the valuer. A pragmatic approach It is important for valuers to learn to factor in changing circumstances to provide robust valuations that truly reflect the market. At Knight Frank we have an extensive ESG guidance framework to help valuers with the process. We engage with clients and have an ongoing research programme to ensure we fully understand the drivers of value and impacts on pricing. But it is important that valuers don’t exceed their expertise in areas around construction and ESG upgrade costs where specialist input is required. For now, valuations will continue to be based on transactional evidence, both in instances where robust information can be provided for ESG upgrade costs and other factors, and in instances when not. Valuers are embracing the new considerations that have come into play – as they have done in the past. The skill of the valuer continues be in the analysis of the comparable sales evidence and how that relates to the property being valued. Michael Lindgren is valuations partner at Knight Frank Scotland Photo © Knight Frank