Office refurbishments: The race against obsolescence

The fear of missing out, or FOMO, was a concept discussed at this year’s IPE Real Estate Global Conference & Awards in Milan – in relation to the potential dangers of investors trying to time the bottom of the market and rush back in at the same time as others.

In the London office market, where there has been notable correction in values, there is a rush of sorts taking place. According to Deloitte’s recently published London Office Crane Survey (see figure), which tracks office development trends, 37 new refurbishment constructions are under way in the UK capital, covering 3.2m sqft – the highest number and volume since records began in 2005.

But why? Rather than FOMO, this rush to refurbish seems to be motivated by what could be an alternative acronym – FOO, or fear of obsolescence.

“Perhaps the most prominent factor driving London development, which we first heralded in 2020, is the threat of obsolescence, or ‘stranding’ of assets,” writes Siobhan Godley, partner and UK Real Estate Leader at Deloitte, in the introduction to the London Office Crane Survey.

Last year, the survey found that 80% of London office stock fell below the Energy Performance Certificate (EPC) grade A or grade B that is expected to be mandatory by 2030. Deloitte therefore attributed the record refurbishment starts to these incoming Minimum Energy Efficiency Standard (MEES) regulations.

Through tools such as the Carbon Risk Real Estate Monitor (CRREM), which can be used to plot net-zero trajectories, investors are increasingly becoming aware of the timings of obsolescence risk for their individual assets.

Lora Brill, head of responsibility and ESG at Orchard Street Investment Management, says: “CRREM stranding dates are increasingly being included or discussed during transactions and this is beginning to play a larger role in the repositioning of office assets as investment managers look at who they can sell to and what the exit price will look like.”

Oliver Light, director of real estate at Accenture, works with real estate owners to assess their portfolios and understand what needs to be done to bring them in line with net-zero targets. He agrees that investors are increasingly having to look at refurbishments when “looking to dispose of an asset”.

He says: “Given the level of due diligence that’s going on in the real estate space, potential purchasers are looking at assets and avoiding them if they don’t have an EPC with an A rating or CRREM certification. All this helps contribute to making sure you don’t face any sort of discount when looking to dispose of the asset.”

The situation will only be compounded by a range of other regulations that are also “playing a big part here”, says Brill. In addition to MEES, she points to the new requirements relating to the Taskforce on Climate-Related Financial Disclosures (TCFD) reporting for pensions, “which are driving increasing investor awareness of climate transition risk and the carbon emissions of buildings”.

UK investors are still waiting for clarity on the incoming Sustainable Disclosure Requirements (SDR) – the country’s equivalent to the EU’s Sustainable Finance Disclosure Regulation (SFDR) – along with the industry-led net-zero carbon building standard definition, expected this summer. Meanwhile, “the EU Taxonomy and SFDR rules are starting to influence buying decisions for funds with a pan-European strategy”, says Brill.

In addition to imminent regulations, office tenants are also demanding modern and sustainable space in the new post-pandemic economic and working environment. “While the debate on stranded assets reflects the EPC legislation and is essentially about energy efficiency, many other factors are rendering swathes of office space unappealing,” Godley writes in the London Office Crane Survey report. “Occupiers now demand attractive interiors.”

Brill agrees: “We have definitely seen a shift in occupier demand to buildings that are ESG-aligned, not only because tenants are under pressure to achieve their own net-zero pathways, but to minimise their energy costs.” 

Last year, Orchard Street launched its Social and Environmental Impact Partnership (SEIP), with backing from the Brunel Pension Partnership, which will focus on decarbonising existing buildings and making them healthier for people working in them.

Toke Clausen, partner and head of office investments at NREP, has also noticed that more real estate companies are upgrading brown properties to green, grade-A space in the Nordics and northern European markets. “It is the right thing to do from an environmental perspective and from a profit perspective, under the right circumstances and in the right locations,” he says.

Clausen says office owners are under pressure to act and that this is coming from all sides. “Improved access to finance is a factor with banks starting to offer better terms for green-profile assets over brown ones,” he says. “Investor expectations, reporting requirements and tightening regulation also have a role in this. “Similarly, landlords and developers are reacting to increased demand from more socially conscious occupiers looking for sustainable offices, with research finding that a ‘green premium’ can result.”

However, while ESG retrofits are on the rise, the practice is still restricted to a small part of the market. There are great swathes of offices that will be in need of refurbishment, but are yet to be addressed. 

According to Light, not all owners of office assets feel the need to do what is necessary to upgrade their buildings – at least for the time being. Some “are playing the longer game, because of the state of the market right now”, he says.

“They’re not putting the same amount of money into these sorts of deep retrofits on their assets. What they’re looking to do is deliver short-term wins in those buildings. So they’re just thinking about anything they can do that’s low capex and service-charge recoverable that they can do to improve the asset. 

“Then they’ll wait for the lifecycle of key plant to end, or tenants to move out and then at that stage – and that might be five to six years away – I can see them going in and putting in the investment to bring that asset up to speed.”

But Light warns that owners could find themselves stuck with unsaleable, stranded assets unless they act fast.

We can’t build our way out of climate change

Some buildings are likely to prove too expensive to retrofit. Equally, investors cannot focus simply on demolishing and developing brand new state-of-the-art green buildings.

A somewhat symbolic example of this reality is the City of London’s recent rejection of what would have been the capital’s tallest new skyscraper, The Tulip. Proposed by the late Brazilian billionaire Joseph Safra and designed by Foster + Partners, it was to have a bulbous viewing gallery at the top of a tall concrete stem. Although billed as a sustainable building, The Tulip was rejected in part because of the use of “vast quantities of reinforced concrete for the foundations and lift shaft being highly unsustainable”.

“We cannot build ourselves out of climate change,” says Aleksandra Njagulj, managing director and global head of ESG real estate at DWS. “We need to fix what we have and transform buildings. After all, 80% of buildings that will be around in 2050 already exist. This renovation wave is trying to stimulate exactly this need to improve existing real estate,” she says.

Njagulj adds that the embodied carbon contained within the mass of existing real estate is one of the main reasons not to demolish and rebuild. “We know that the EU is looking to, as part of this renovation wave, institute a new directive that will require landowners or asset owners to refurbish the buildings with the poorest energy efficiency EPC ratings. We know this is coming, in one shape or form.” 

Njagulj points to another reason for the refurbishment of existing office assets – that of the fiduciary duty to pension fund members and other beneficiaries of institutional investors. “This may have less direct impact, but it will be extremely powerful,” she says. “It is our fiduciary duty to manage buildings in the right way in order that they perform financially. Any asset manager that is responsible, I would say, is doing a very detailed due diligence and risk assessment. We don’t want to have assets at risk, so from the risk management perspective it’s a responsible thing to do.”

Refurbishing Europe’s older and heritage office buildings will likely prove to be one of the biggest challenges, with so much of the standing stock decades, if not hundreds of years old, or even listed.

Clausen says the focus has to be on both lowering embodied carbon during the refurbishment phase and operational carbon once the building is in use. “Balancing capex against actual and validated impact often requires a high level of discussion and analysis. One example is when considering whether to replace existing windows with those with a higher insulation effect,” he says.

“It seems like an obvious step from an operational perspective, but first you must consider that the newer windows have a carbon footprint” associated with their construction and the disposal of the old windows. “On balance, you might find that in fact it is the existing solution that is closer to carbon neutral, and the capex can be used to implement other initiatives with a higher impact.”

Light agrees. He says that in the EU the issue has been delegated to member states. This means there is no single, coherent approach. “People don’t like to move away from their old, single-glazed windows. It’s going to require a real behaviour change for a lot of heritage building owners to adopt core fabric improvements that might be deemed intrusive.”

Show me the money

The key question to the great refurbishment challenge is: can adequate amounts of capital be allocated – and can value-add decarbonisation strategies satisfy the return requirements of that capital? 

IPSX, the London-based stock exchange set up to specialise in the list of individual property assets and portfolios, is positioning itself as a facilitator to the challenge.

Rupert Snuggs, head of capital markets at IPSX, says: “The current nervousness from traditional lenders towards some real estate sectors means that capital will continue to be constrained, with a need for alternative sources of capital to be unlocked. And it will be important for real estate owners to move early. As EPC and net-zero carbon deadlines approach, capital will become even more constrained and labour and material costs will increase as asset owners rush to complete their remedial work while competing for the same scarce resources.”

IPSX is looking to help investors find flexible financing solutions by raising capital through the listing of a single building or cluster of assets – to provide capex for the necessary greening improvements. 

IPSX recently admitted Bridgewater Place REIT to its platform, enabling the office-led, mixed-use property in Leeds to raise £35m (€41m) with the objective of carrying out a wholesale repositioning and to create an up-to-date, energy-efficient building. 

“This highlights how, at a time when corporate debt is increasingly hard to come by, real estate owners are beginning to consider alternative routes to raise the equity needed to fund their capex programmes,” Snuggs says.

Some real estate fund managers appear to be looking at the great decarbonisation challenge as an opportunity rather than a necessary cost. Only time will tell how their approaches and strategies play out and perform.

Alex Knapp, European CIO at Hines, told the IPE Real Estate Global Conference & Awards in May that the net-zero challenge was not just a risk but “the avenue to [achieving] outperforming assets”.

Knapp told delegates in Milan that, if “we invest in this” – the decarbonisation of real estate – “we get the outperformance”. He said: “This is the alpha we’re going to create and this is how we’re going to have better assets than the rest of the market. So we’re leaning in. We’ll see in a few years if we’re right or wrong but, for now, that’s the bet.”