The Great Stranded Asset Gold Rush: There's Profit In Making Old Offices More Sustainable
Some of the biggest names in the real estate world on both sides of the Atlantic are gearing up for a very particular challenge: taking old office buildings that are big emitters of carbon, making them more energy efficient, and turning a profit in doing so.
Fund managers like Tishman Speyer and Patrizia have raised money for brown to green strategies. Brookfield is taking private a listed German company at the forefront of making offices more sustainable. And UK REIT Great Portland Estates sees buying and improving stranded assets as a key pillar of its strategy going forward.
“I’ve been doing this for 30 years, and it’s one of the most interesting moments of my career,” GPE chief executive Toby Courtauld said ahead of an appearance at Bisnow’s London Future of Office event on Thursday.
It is a strategy that can be profitable for both property and the planet. To tap into a cliche, it is a huge challenge, but a huge opportunity, too, if it is done right.
For real estate owners in cities like London or New York, making assets energy efficient isn’t really a choice any more.
In New York, Local Law 97 will levy fines on the owners of buildings where carbon emissions are above a certain level. And in London and the UK, the Energy Performance Certificate system will make it illegal to lease offices that don’t reach a grade B standard or higher by 2030. Just 4% of London offices currently meet this requirement, data from Cushman & Wakefield showed, highlighting the scale of the problem for current asset owners as well as the size of the opportunity for those with capital ready to deploy.
The nature of that opportunity involves taking noncompliant buildings and making them compliant in a regulatory sense, as well as meeting the requirements of occupiers that have their own ESG goals and brand issues in mind.
“The EPC regime is the most important, because it is the only one that carries a regulatory burden,” Courtauld said. “But corporates are looking at their brands as well. I look at my kids, they want the company they work for to reflect their values, and that is a big change from a generation ago. And your building is now a big part of your company brand value.”
But how to identify the right buildings and buy them at a price that still leaves room for making money? Office buildings don’t have a big sticker on the front saying they are energy inefficient. Potentially stranded assets come in all shapes and sizes, from big prominent City of London offices to small midcentury assets in the West End.
Courtauld said that a few years ago, the company went to a large brokerage firm and asked for a list of buildings with particular qualities: a low EPC rating and an upcoming lease event. With that information, the company could start to determine which buildings it would be possible to refurbish and re-let at improved rental levels.
Yet there is one crucial element that needs to be borne in mind if the strategy is to be undertaken profitably: the current owners.
“There are a lot of owners who may not have even started thinking about these regulations yet,” he said, citing private investors and family offices that don’t have external stakeholders. Those entities might not have felt pressure before now to address ESG performance, but will be increasingly forced to going forward.
“There are a lot of people out there who might prefer to sell rather than put more money in to bring things up to standard, or who might want to joint venture with someone who has the expertise to undertake the refurbishment necessary,” Courtauld said.
Office assets are now starting to be priced with the cost of refurbishing them to meet sustainability regulations factored in, he said — if it is going to cost x to bring a building up to code, then buyers want to pay y minus x. As the deadlines to meet regulatory requirements get closer, those discounts will steepen, he said.
The profit comes from being able to lease the refurbished building at a higher rent, although the uplift may come in a different form.
“I think you will see the difference in capital values before rents,” Trilogy Real Estate chief executive Robert Wolstenholme said. “All of the big funds, especially the Europeans and Canadians, are interested in this now, and where they go, everyone else follows. I have investment agents asking me, 'Wolfie, can you take this building and get it up to a NABERS 5-star rating, because the yield will be 100 basis points tighter.' For investment agents to be talking to you about that is unheard of.”
Wolstenholme said that the cost of improving a building with an EPC G or F rating and getting it to a C rating was about £150 per SF. Getting to a B rating, which might involve replacing glazing, was about £175 per SF, and getting to an A rating, with the replacement of glazing and heating and ventilation systems, was about £200 per SF.
There are other challenges facing those looking to undertake this strategy.
“It is much more difficult for smaller buildings to be improved,” Wolstenholme said. “For something like replacing the glazing or insulation, you don’t get the economies of scale.”
Materials costs might well be the factor inhibiting the ability of owners new or old to undertake refurbishment right now.
“The recent spike in inflation makes it more expensive to try and undertake these kind of repositionings right now,” CBRE Investment Management associate Maria Wiklund said. “I wouldn’t be surprised if a lot of these projects have been rendered too expensive at the moment. But of course everyone is hoping that high inflation won't be here forever.”
On a more systemic level, there is another issue that might hinder such refurbishments. Wolstenholme pointed out that many green labels applied to buildings base their scores on the energy emitted while buildings are in operation, but do not factor in the embodied carbon used to build them. So a brand-new building might look incredibly energy efficient and receive a top rating, but use a lot of carbon in its construction.
“To give you an example, at Republic [Trilogy’s refurbished office campus in east London], we got a consultant to run a calculation on the extra carbon that would have been created by the previous owner’s plans, to knock it down and build 1M SF of resi," Wolstenholme said. "It was 100,000 tonnes of extra carbon. But the current system doesn’t give us any credit for the fact that we’ve saved that carbon.”
Ultimately, Wiklund said, owners will need to embrace the strategy of refurbishing assets. Otherwise, the losses could be sharp and severe.
“At the start of the pandemic, everyone thought that working from home would have the biggest impact on offices, but in fact it has turned out to be ESG,” she said. “There is a lot said about green premiums, but right now that is only coming through for the very best buildings. The bigger risk for the overall market is of brown discounts.”