Beyond Bricks – Navigating Sustainability Risks in Commercial Real Estate for Maximum Value

Environmental, Social, and Governance (ESG) is taking a real battering right now. The Wall Street Journal even labelled it the “latest dirty word in corporate America.” Although this characterisation is debatable, it’s clear that the commercial real asset market is increasingly cautious about where and how to invest in sustainability outcomes.

During and shortly after the COVID-19 pandemic, we saw a notable increase in ESG inquiries. However, the recent politicisation of ESG, combined with a high-interest environment, has transformed our sustainability consultants’ previously smooth path into a bumpy uphill climb.

Proponents of real asset sustainability, including EVORA Global, now need to work harder and smarter to influence savvy sustainability investment decisions. This challenge, however, isn’t necessarily negative. It highlights the core principles we’ve long advocated: sustainability programmes drive long-term value by managing future risks.

 

Stay On Course: Fact-Based Risk Assessment

An essential element of working smarter is sticking to the facts and making rational decisions about potential risks to cash flow and shareholder value. As emphasised by Alex Edmans, the focus should be on “rational sustainability” rather than “ESG checklists.”

This approach is crucial because purposefully ignoring sustainability and ESG considerations goes against the grain of fiduciary duty. Evaluating risk is not only integral but imperative within this duty. Moreover, possessing comprehensive information to inform decisions is not just advisable but essential.

Maryland Comptroller Brooke Lierman aptly explains: “Think about trying to drive your car with one eye closed. Sure, you might be able to see out of your other eye, but you’re only getting half the picture.” State Street Chief Executive Ron O’Hanley supports this perspective, stating in the Financial Times that the backlash against climate-conscious investing has “left facts aside” and lost sight of the needs of long-term shareholders.

Having underscored the importance of informed, fact-based decisions, let’s examine three critical factors directly influencing real asset value:

1. Rising insurance premiums
2. Rising energy costs
3. Implementing Building Performance Standards

These key elements highlight the necessity of incorporating sustainability and ESG considerations into investment strategies, aligning with fiduciary responsibilities, and maximising long-term shareholder value.

 

Rising Insurance Premiums: The Impact of Climate-Related Catastrophes

It’s well-documented that the frequency and severity of major climate-related catastrophes are significantly impacting both the value of real estate and the costs of insurance. From flooding and wildfires to hurricanes and winter storms, these events contribute substantially to annual insured losses. As NOAA Climate.gov reports, the cumulative cost of weather and climate disasters since 1980 now exceeds $2.6 trillion, with nearly $100 billion in the US in 2023 alone.

In addition to more extreme weather events, a compounding factor driving up insurance premiums is the increased cost of capital, alongside escalated property replacement costs. The former is propelled by heightened interest rates, while the latter stems from increased costs of materials and labour due to supply and demand dynamics, inflation, and government policy shifts.

Similarly, industry data released by CBIZ reveals a surge in insurance premiums, with an average increase of 20.4% in Q1 2023 and 18.3% in Q2 2023. Experts anticipate further hikes ranging from 5% to 25% in commercial real estate in 2024. Locations more susceptible to climate-related natural disasters are expected to experience significantly higher increases. The resultant price rises will impact Net Operating Income and ultimately value, particularly if rents fail to adjust in tandem.

The impact of higher premiums and climate risk is directly impacting residential real estate value. According to BizJournals, property insurance in Florida costs nearly five times the national average, prompting twice as many homeowners in the state to plan to leave compared to the national average, as highlighted by Newsweek. This outward migration will bring more inventory to the market, likely reducing prices due to the increased supply.

This trend extends beyond southern US states. A recent CBC News broadcast reported that a beachfront home on the island of Nantucket in Massachusetts recently sold for $600,000, down from a previous high listing of $3.2m in 2017, with climate change cited as the main cause.

From the documented rise in insurance costs to the tangible effects on property values, it’s clear that climate risks are reshaping the landscape of real estate investment. Moving forward, proactive measures to address these challenges are essential to safeguard property values, ensure market stability, and mitigate the long-term financial risks associated with climate change.

 

Rising Energy Costs: The Impact on Property Performance and Valuation

Energy prices have steadily climbed since the early 2000s, with an average annual increase in commercial energy costs. Over the past decade alone, prices have surged by 23%, reaching a peak of 52% for the Pacific Grid, which serves the western coast of the US.

Looking ahead, if this trend continues for a further five years, certain areas could see energy prices soaring to as high as 30 cents per kWh, with an average of 16 cents. These escalating costs are anticipated to significantly impact operating expenses, potentially reducing the Net Operating Income (NOI) for landlords and leading to higher total occupancy costs for tenants.

This transition risk will deepen the divide between high-performing (mostly newer) energy-efficient assets and the less efficient (typically older) stock. For example, despite valuable improvements, older multifamily buildings in New York City still consume significantly more energy per square foot than those constructed in recent decades. However, case studies do exist on how older assets can embrace sustainability measures and significantly reduce their environmental footprint. Take, for example, the Empire State Building. Following its energy efficiency retrofitting project, the building succeeded in slashing its energy expenditure to $8.5 million in 2019.

Conversely, if a building didn’t address energy efficiency, the 23% rise in energy costs could translate to a notable drop in value. For example, if a large office building (500k sq ft) is spending $2.50 on energy per square foot, a 23% increase in costs adds around $290k in energy spend.  If that building was achieving $60/sq ft, the additional spend accounts for around 1% of an estimated $30m rental income, potentially leading to a decrease in NOI and the possibility of a cap rate expansion. Cap rate expansion typically correlates with decreased property values, as market consensus perceives properties with higher operational costs as carrying greater risk.

 

Implementing Building Performance Standards: The Impact on Energy and Carbon Efficiency

The introduction of Building Performance Standards (BPS) marks a significant stride towards reducing carbon emissions in buildings by enhancing energy performance. With around 45 state and city planning to implement BPS, these standards are set to reshape the landscape of building sustainability regulations.

One particularly ambitious initiative is Energize Denver in Colorado. This programme targets commercial buildings exceeding 25,000 square feet, mandating a reduction in energy use intensity (EUI) of around 30% by 2030, relative to a 2019 baseline. To ensure compliance, interim targets have been established for 2024 and 2027, with penalties ranging from $0.30 to $0.50 for every kBTU surpassing the designated thresholds.

This proactive approach not only drives energy efficiency improvements but also underscores the growing urgency to address environmental concerns within the built environment.

For one of Denver’s largest assets – 555 17th Street, a 40-storey office measuring 800,000 square feet – the Energize Denver Building Performance Forecasting Calculator projects potential fines of $1.3m in 2025, $2.2m in 2027, and $3m in 2030 if EUI targets are not met. This is despite the building consistently holding a high ENERGY STARÔ score (currently 90).

An alternative avenue for compliance is to electrify at least 80% of the building, a path some assets are considering. However, the transition costs are anticipated to be comparable to potential penalties. It’s believed that penalty levels have been strategically set slightly above intervention costs. Nonetheless, several tax breaks and credits are available to alleviate this financial burden.

Regardless of the chosen route, compliance will inevitably entail significant CapEx and/or penalties, both of which will influence an asset’s exit value.

 

Next Steps: Strategic Sustainability for Shareholder Value Protection

Sustainability risks present a significant threat to the value of real estate assets. Thoroughly understanding and measuring these risks is crucial. Shareholder value hinges on the present value of all future cash flows, and each of the aforementioned examples has the potential to erode these cash flows. Therefore, understanding and quantifying sustainability risks are essential steps to safeguarding shareholder value.

At EVORA, we specialise in sustainability consultancy services and data capabilities designed to streamline your best route forward. With a sharp focus on value aligned with your real asset investment strategy, we’re dedicated to optimising your sustainability journey. Our solutions include:

• Conducting climate risk analysis to evaluate your real asset exposure, vulnerability, and adaptive capacity.
• Assessing your compliance with Building Performance Standards and benchmarking against industry norms.

Developing your energy and carbon reduction strategies, including due diligence assessments and CRREM (Carbon Risk Real Estate Monitor) analysis.