ESG and the consequences: Flight into new buildings?

Text: Matti Schenk

ESG: not only on everyone’s lips but now in every portfolio
The EU sustainability taxonomy, better known under the abbreviation ESG (“Environmental, Social, and Corporate Governance”) is intended to contribute to the implementation of the European Green Deal. The objective of this Green Deal is to make the European Union climate-neutral by 2050. Against this background, ESG directives should result in capital flows in the financial markets being redirected into sustainable investments in order to provide sufficient capital for the pending transformation.

As an asset class, real estate is also affected by these regulations. The incremental implementation of the EU sustainability taxonomy is already creating shifts in the real estate investment markets. In March 2021, the Disclosure Regulation came into force, requiring investors affected by the taxonomy to disclose how they intend to respond to the sustainability objectives. Since then, the number of Article 8 funds has risen constantly and some Article 9 funds have already been launched. While Article 8 funds are aimed at taking sustainability objectives into account, Article 9 vehicles strive to make a direct contribution to greater sustainability with their investments. In October 2021, 32% of European fund assets were classified according to Article 8 or 9 and a further increase is foreseeable.

While an increasing number of funds and investors are making themselves ESG-compliant, the final structuring of ESG criteria is not even known yet. Indeed, this is not expected to be the case before July 2022. The ongoing absence of a binding regulatory framework for ESG criteria is ensuring that many market participants are drafting their own ESG property ratings and sustainability strategies. Consequently, how sustainability objectives are reflected in investment strategies and which points are emphasised can vary.

The most climate-friendly implementation of the E in ESG
In view of advancing climate change and the scientific consensus that the world must become climate-neutral within a few decades, the avoidance of greenhouse gas emissions should play a leading role on the issue of sustainability. Ecological sustainability objectives, the E in ESG, are likely to be a focal point for many investors. But what would their ideal implementation in the real estate market look like? Most researchers, the German Federal Environment Agency and the German Energy Agency are agreed that climate neutrality in the German built environment is only possible via extensive refurbishments of the existing building stock. This is attributable, on the one hand, to the relatively low new-build rate in Germany and, on the other hand, to the massive potential savings from energy-efficient refurbishments. Particularly when it comes to the least energy-efficient existing buildings the ratio of refurbishment costs to CO2 savings is especially advantageous. The refurbishment of existing buildings is almost without exception more sustainable than demolition and replacement with a new build. This is because the CO2 emissions produced during construction and the production of the building materials represent a significant proportion of all emissions across the life cycle of a property (see Graph below).

These emissions are described as grey energy, grey emissions or embodied carbon. According to calculations from the Federal Environment Agency, for instance, embodied carbon account for around 80% of all emissions across the entire life cycle of a new build completed to Effizienzhaus standards. In addition, embodied carbon is released practically all at once and therefore immediately impact the climate in their entirety. These are only offset by savings during the operation of the building after several decades. From a climate perspective, therefore, it would make the most sense if capital were directed into precisely such upgrades of existing property. An ideal implementation of the E in ESG should favour the acquisition and subsequent refurbishment of existing buildings over the acquisition of new builds.

The actual implementation of the E in ESG
In practice, however, ESG regulations are directing capital into new builds rather than refurbishments of existing buildings. The reasons for this are multi-faceted. Firstly, it is highly probable that grey emissions are not reflected in the taxonomy. Instead, the reduction of CO2 emissions is focused on the operational phase. We do not foresee embodied carbon being included in regulations over the coming years. This is also attributable to the highly complex calculation of these emissions, which is further complicated on existing buildings by a lack of data. Since new-build properties generally perform better than existing buildings during the operational phase, it is little wonder that new builds better fulfil regulatory requirements.

A further reason for the focus on new build is the fact that ESG criteria for new builds are significantly more straightforward owing to the better availability of data and are, therefore, easier to fulfil. This idea is supported by a study from the German Sustainable Building Council (DGNB). Furthermore, many new builds offer various amenities for occupiers that count towards the S in ESG. Finally, many major occupiers prefer new builds in order to fulfil their own sustainability and ESG objectives. The issue of embodied carbon is either overlooked by most occupiers or is completely unknown to them according to our observations. Hence, in view of how the EU sustainability taxonomy appears to be taking shape, institutional investors appear to be on the safe side by acquiring new builds. For owners of existing buildings, ESG regulations and their focus on the operational phase doubtlessly incentivise energy-efficient refurbishments. This could contribute to achieving refurbishment objectives. However, ESG compliance could also be achieved by owners by disposing of older existing properties or demolishing these and replacing them with new builds. This would counteract refurbishment objectives.

Potential consequences for the markets
As long as ESG compliance is predominantly achieved via new builds, capital in the investment market will be redirected into this segment. Since new-build availability is also limited, the shift in demand in the investment market is likely to result in an appreciable rise in sale prices on new builds. This, and no doubt also changing occupier requirements, is also likely to encourage development activity. It is already apparent that new-build activity remains buoyant. Developers were the third most active purchaser group in the commercial property market over the last twelve months, which is a novelty. The consequences of this trend for existing property would be significant. If institutional investors, in the first instance, predominantly acquire new builds and owners increasingly dispose of their non-ESG-compliant existing properties, this will result in a devaluation of existing stock. This, in turn, will create opportunities for value-add investors, who will be able to acquire existing buildings at a lower price and subsequently refurbish these properties to ESG-compliant standards.

Over time, ESG-compliant end investors will also have to turn their attention towards existing property. One explanation for this is that the supply of new builds will only be able to respond slowly to the further increase in demand in the investment market owing to the lead times involved. This is exacerbated by the fact that the construction industry is already largely working to its full capacity. A glance at new-build volumes in Germany illustrates that demand in the investment market cannot be satisfied by new property in any case. The new-build rate in the office markets in the 127 RIWIS cities over the last ten years stands at just 1% per year. On the other hand, the increasing price differential between new builds and existing properties will make taking on refurbishments of existing properties increasingly attractive. Building an ESG-compliant portfolio by acquiring and refurbishing existing buildings may well take longer than doing so by acquiring new builds. However, the cost of such a strategy will probably be significantly lower and the yields higher.

Hence, following a phase of intensive focus on new build and a withdrawal from existing property, we could witness a phase of differentiation in the acquisition profiles of ESG-compliant investors in the markets. In the long term, therefore, market mechanisms may contribute to a reorientation in the real estate investment markets towards the most climate-friendly implementation of the E in ESG. Should the road ahead include the introduction of a comprehensive CO2 tax, refurbishments of existing property would immediately become more attractive. Such a tax would price in the external costs of embodied carbon and make new builds significantly more expensive. This, too, would create an incentive for capital to be redirected back into existing properties and to refurbish these to ESG-compliant standards. The new German government has also announced in its coalition agreement that it wants to create the basis for being able to take a closer look at the use of embodied carbon. This is to be done, among other things, via a digital building resource passport. Should such an instrument be introduced, it could facilitate the recording and pricing of grey emissions and accelerate the redirection of capital into the existing building stock.