‘You Just Go, My God’. The Shocking Size Of London’s Green Office Overhaul
If you own an office property in London or are thinking about buying one, it is almost certain that you’ve got something on your mind: How do I make sure this building will meet coming government sustainability regulations?
It is almost certain because data from Cushman & Wakefield shared with Bisnow shows only 4% of London offices have an Energy Performance Certificate meeting the requirements on energy use that will be introduced in the UK in 2030.
This isn’t some technical requirement — it gets to the heart of an existential overhaul currently ongoing in the London office market, precipitated by the need to radically cut the carbon society produces.
“On most property-related stats, like rental levels or vacancy rates, if you asked me to guess, I’d normally get within about 10%,” Patrizia Head of Transactions for the UK and Ireland Phil Irons said. “When I was asked what percentage of London office stock would currently be obsolete by 2030, I said about 30-40%. When you find out that figure is 96% you just go, my God.”
The need to upgrade stock is vexing existing owners and causing potential buyers of assets like Irons to question what they are willing to pay for offices. Getting the sustainability aspect of office stock right is a huge opportunity for existing owners and investors, with data increasingly highlighting the financial benefits that accrue for sustainable offices. But those owners are only now waking up to the complexity of the issue at hand — a complexity only being exacerbated by the uncertainty around post-Covid-19 office use.
A quick explainer to the Cushman data and its implications: The UK currently has a rating system for buildings called an EPC, which grades the energy-efficiency of a property on a scale of A to G, A being good.
Under new Minimum Energy Efficiency Standard legislation currently being passed through Parliament, by 2025 all commercial buildings will need to have an EPC by law. By 2027, if your building doesn’t get a C rating, it will be against the law to lease it. By 2030, it will need to get a B grade in order to be leased.
Cushman’s data analyses all the buildings in London that currently have an EPC — not every building, but a decent representative sample, the company said. Only 4% had a B rating or higher, 22% had a C, 32% a D, and 22% an E. The other 21% had an F or G rating, meaning it is already illegal to lease them.
A separate analysis by JLL found that 90% of office buildings across the whole of the UK will need an upgrade to meet both government requirements and the sustainability requirements of tenants and institutional investors.
Irons said that offices were already front and centre of investors’ minds because of the uncertainty created by the coronavirus pandemic and because the cost of upgrading offices to ensure they don’t become obsolete is already higher than in some other assets classes.
The need to make offices ESG compliant is another cost to factor in. A fairly basic upgrade to the mechanical and engineering systems of a building can cost around £100 per SF, Irons said, with more serious upgrades costing more than £150 per SF. On a 100K SF building, that is a £15M upgrade.
Irons said the need for capital expenditure would soon start to impact capital values. “The question is, do secondary offices go the way of secondary shopping centres?” he said. “We’ve had painful experience of the value destruction that has happened in secondary shopping centres, where the decline from the peak is 80%. If you’d asked people that owned those centres five years would they see an 80% drop, they’d have said no.”
Irons said the difference in yields between prime and secondary offices was currently about 100-150 basis points in London, but that does not price in the risk of value declines in poorer assets if owners don’t spend significantly to improve the sustainability rating of buildings.
“That is a gap of about 20%, and when you take in the capex and the potential rent declines, the fall in value could be far greater than 20%,” he said.
This situation is not one office owners will be able to ignore for much longer, involving a triangulation of factors, with government regulation as well as the expectations of institutional investors and office tenants all pushing toward the need to improve the sustainability of buildings.
Getting it right is likely to pay off, however. Data from JLL produced in 2019 found the most sustainable office buildings in London have a rental premium of between 6% and 11%, a premium that is likely to have gone up as ESG has become even more important to tenants in a post-pandemic world.
That increase applies to the best new buildings. But the rental uplift created by refurbishing an existing building and making it more sustainable should more than pay for the cost of upgrading them. In that sense, a change in the way the real estate and financial world thinks about the carbon emissions created by buildings could actually help stay the demise of secondary offices — but only if they were built well in the first place.
“The greenest buildings are going to be the ones where you can reuse the embodied carbon,” Cushman Chairman for the UK and Ireland Digby Flower said. “Embodied carbon could be the saving grace of secondary offices.”
Embodied carbon is the carbon emitted during a building’s construction and demolition. Previously, Flower said, when looking at the carbon footprint of a building, investors and tenants might have just looked at emissions during its operation; now, they are looking at the emissions created by constructing it as well. Refurbishing a building creates far fewer emissions than building a new one because there is less need to produce new steel and cement.
“People will take good buildings from the '80s and early '90s, buildings that have good bones, that can incorporate modern amenities and sustainable technology, and refurbish them,” Flower said. “Those are going to be the most sustainable buildings, because they reuse the existing concrete, cement and steel. They are going to be the winners.”
What constitutes good bones in a building? According to Flower, it's things like the core being in the right place, good geometry of the columns on an average floor and floor-to-ceiling heights of 2.75 metres or more.
For those buildings that don’t have such bones, life will be tough. Conversion to other uses has been touted for such offices, but that is not an easy task. Other types of commercial buildings have the same rules as offices, and residential buildings also have minimum energy-efficiency standards under the EPC system, JLL Head of UK Offices Research Elaine Rossall said. An unsustainable office building can’t just be turned into an unsustainable resi asset.
“There will still be a need to provide energy-efficient homes as well as offices, and there is the added cost of conversion to residential,” Rossall said.
She also pointed to the fact commercial property is a "long tail" industry — one where even the biggest property company owns only a tiny fraction of all the offices in a country like the UK. Instead, the vast majority of offices are owned by small companies without the expertise or the capital to undertake the sustainability improvements required to bring buildings in line with regulation.
“The government need to think about ways it can bring smaller investors along,” she said. “There needs to be a carrot as well as a stick, which might be making green finance available to smaller owners. The policy needs to be thought out to bring everyone on the journey.”