Real Estate & ESG: Should I be paying extra for an ESG certification on my real estate project?
One of the most frequently asked questions we receive from our clients is: What are the costs and benefits associated with enhancing the sustainability of my real estate project? Is securing a high energy efficiency label sufficient, or is it necessary to pursue a recognized building certification or align with specific regulatory frameworks? Additionally, how can the substantial costs involved in achieving these standards be justified?
In this blog post, we will address these crucial and timely questions in detail, offering an illustrative example and referencing real-world case studies. We will also examine the comparative impact of new-build versus transformation projects and provide a preview of upcoming discussions on this topic.
Measuring Impact
There are a number of globally recognised certifications that can be used to measure the sustainability contribution of your real estate project. Some are more focused on environmental or social factors, whilst others combine the two. It’s also possible to align your real estate project with government-led initiatives or regulations. And sometimes, buildings may even have several different certifications or alignments. Below we will take a look at five different well-known options.
BREEAM (Building Research Establishment Environmental Assessment Method)
The BREEAM is one of the leading global sustainability assessment frameworks for buildings that originates from the UK. It evaluates the environmental, social and economic sustainability of buildings, measuring performance in areas such as energy efficiency, water usage, air quality, health & wellbeing, community engagement, and access to sustainable & public transport. There are a range of standards depending on your project – New Construction / Refurbishment & Fit-Out / In-Use – with different scores such as Pass, Good, Very Good, Excellent, and Outstanding.
CRREM (Carbon Risk Real Estate Monitor)
CRREM is a framework that evaluates the operational carbon performance of a building, focusing heavily on the energy efficiency of buildings. It provides science-based decarbonisation pathways for the Real Estate sector and tools to identify the risk of an asset becoming “stranded”. It is aligned with global climate targets, notably the goals of the Paris Agreement (to limit global warming to well below 2°C, and preferably 1.5°C, compared to pre-industrial levels).
EU Taxonomy
The EU Taxonomy is a way to assess whether a building is aligned with the criteria laid out in the EU Taxonomy Regulation, which defines sustainable economic activities that contribute to achieving the EU’s environmental objectives. For the Real Estate sector, the focus is mainly on two key objectives: climate change mitigation and climate change adaptation. As well as having “substantial contribution” to at least one of the six objectives, you must also demonstrate that the project does no significant harm to the other objectives and also complies with minimum social safeguards.
LEED (Leadership in Energy and Environmental Design)
The LEED is a globally recognised building standard developed by the US Green Building Council (USGBC) that focuses on factors such as energy & efficiency, material use & selection, air quality and human health. It is a points-based system with scores including Certified, Silver, Gold and Platinum.
WELL Building Standard
The WELL Building Standard is a framework that measures attributes of buildings that impact the occupant health. It looks at seven factors: air, water, nourishment, light, fitness, comfort and mind. Certification levels are Silver, Gold and Platinum.
But, what are the benefits?
Of course, it’s great to have a certification or prove alignment with regulations… but are the costs justified?* The most common “financial benefit” that many clients think of is cheaper financing. Take a development project as an example, it might be possible to unlock an interest margin deduction subject to achieving (for example) a certain BREEAM certification at completion (via a sustainability-linked loan). But what is (for example) 20 basis points cheaper financing in the grand scheme of things?
When deciding what sustainability measures to aim for in your real estate project, it’s crucial to think about long-term value and saleability. If you aim to comply with the minimum regulatory standards, that might not be sufficient in a few years if regulations become more stringent (which they are expected to) and that can impact value. That’s why it’s imperative to aim as high and make your building as future-proof as possible. Also consider alignment with sustainable finance regulations like the EU Taxonomy and SFDR, to make your building more investor-friendly from a reporting standpoint.
We speak to several investors on a daily basis, from family offices through to large institutional investors, all across Europe. Not only are these investors seeking longevity in returns, but they have a duty to invest responsibly. One thing that is becoming clear: there is a shortage of “best-in-class” buildings. For most parties (notably the likes of asset managers, pension funds and insurance companies), this is not just buildings with high energy labels (ie: A++), this means buildings with the highest available ESG building certifications. Furthermore, many such parties admitted they are paying significantly over the asking price to secure these assets given the scarcity in the market.
Now, if we consider a 20 basis points reduction in exit yield, we’re suddenly talking about significant value creation compared to the interest margin deduction. As you can see in the illustrative example below, we’re talking about c. €4m higher property value compared to c. €100k cheaper financing.
Some call it a “green premium” and others call it a “brown discount”, but either way there certainly exists a pricing differential. In some markets/sectors the difference is quite limited, however in others it can be exacerbated. Take the Office sector for example, which has undergone significant changes since the pandemic driven by shifts in work habits and occupier needs. Whilst overall demand has reduced, it remains extremely resilient for assets with the highest ESG credentials. MSCI compared the sales price of offices in London and Paris and found that those with BREEAM/LEED certifications commanded premiums of 25% and 35% respectively compared to those with no certifications.
Finally, whilst not tangible evidence, when discussing residential yields with one of the leading real estate valuers recently, they guided us to as much as a 50 basis point differential in gross yields when comparing new-build and transformation projects, given the ability to deliver higher energy labels, certifications and more future-proof products with new-build projects. Whilst we believe the amount is somewhat exaggerated, we agree that there is a price difference and can support this with insights from investor dialogue.
New-Build vs. Transformation
While the emphasis on high ESG standards is understandable, it raises an important question: should developers and investors focus more on new-build projects, or should they also consider transformation projects?
With new-build projects, achieving the highest possible ESG credentials is more straightforward. These projects can be designed from the ground up to meet or exceed the highest ESG building certifications. On the other hand, transformation projects, which involve retrofitting or repurposing existing buildings, often face more challenges. The energy label for such projects is typically capped at A+/ A++, whilst obtaining high ESG building certifications can be more difficult due to the limitations of the existing structure.
However, transformation projects should not be overlooked. They offer an opportunity to rejuvenate existing assets, including those with historic or cultural significance. Furthermore, the development phase is considered to be more sustainable since you are reusing embodied carbon and minimising waste. Whilst these projects may face more challenges in achieving top-tier ESG credentials, they can still play a significant role in a balanced and sustainable real estate portfolio. For example, they typically take less time to deliver compared to ground-up projects, allowing for quicker occupancy and returns on investment, as well as risk mitigation.
On the investor side, most are willing to consider both types of projects, however there are certain pools of capital dedicated to transformation projects, and vice versa. As mentioned earlier, many investors are seeking assets with the highest possible ESG certifications, which naturally takes them more towards new-build assets.
Conclusion
In conclusion, whilst the immediate financial incentives for obtaining an ESG building certification may seem modest, the long-term benefits are substantial. It’s important not only to focus on potentially cheaper financing, but to think about long-term value and creating as much demand for your asset as possible. As more and more funds prioritise sustainability and making their portfolios future-proof, demand for the “best-in-class” assets is likely to continue growing. Developers must carefully consider whether to focus on new-build or transformation projects, but in either case, aiming for the highest ESG standards possible is going to pay off in the long-run.
* Disclaimer: we’d like to point out that we are not guaranteeing a financial benefit from making your project more sustainable. However, we are confident that you will broaden your pool of available investors/financiers and create a more competitive process.
Any Questions?
At Sustainable Capital Group, we specialize in sustainable finance. If you’re curious about how sustainability certifications and aligning with frameworks like the EU Taxonomy or high ESG standards can help justify the costs and add long-term value to your real estate project, fill out our contact form and we’ll be in touch with you shortly!
