Paul McNamara explains how measuring environmental depreciation must, for the time being, rely on qualitative analysis
I have been arguing for some years that environmental issues need to be seen as an emerging new dimension to property investment performance and, because of the likely implications for property values and investment performance, it is as much a fiduciary as a social responsibility of property fund managers to understand their implications on portfolios.
The argument goes that, in a property market where tenants prefer to occupy ‘green' rather than ‘brown' properties, green ones will experience higher rents for longer and lesser voids at the end of leases. Similarly, if investors are seen to prefer green rather than brown properties, green properties will be more liquid. Furthermore, in a world of higher energy costs, green properties will probably prove less expensive to run and should thus achieve higher rents. Additionally, green properties are also less exposed to changes in government environmental policy.
This suggests that green assets will experience higher net rental growth and attract lower risk premia, which, in turn, means they should have lower capitalisation rates and higher values than comparable brown assets. Finally, given that this is only now beginning to have an impact on the market pricing of assets, as we move to a time when differential pricing is observable in the market, green assets should maintain their value better and outperform brown assets.
So far, so good. But what can property fund managers do to measure and account for such processes in their asset appraisals? The preference would clearly be for some form of method by which to account quantitatively for these burgeoning new influences. But for a number of reasons, this is a very difficult thing for fund managers to do.
First, and this is a mistake sustainability enthusiasts often make, we need to recognise that property is a multi-faceted investment asset, the performance of which is determined by multiple factors. Property professionals are long used to location quality, tenant covenant strength, and remaining time to lease expiry being major determinants of performance with their precise relevance waxing and waning with market cycles.
In this regard, the level of sustainability of an asset is merely an emerging new addition to this established set of potential performance drivers. However, for researchers to separate out and distil the impact of ‘sustainability' on investment performance requires complex econometric work to neutralise or blank out the effects of all variables other than sustainability. Such work requires large amounts of data on the environmental and investment performance of lots of properties, preferably over a long period of time, and there are very few markets where such data exists today.
Second, even if it was possible to identify a difference in existing rental or capital value between properties attributable to differential sustainability credentials, it will not prove easy to then take this differential and convert it into an adjusted risk premium or depreciation rate to be applied to existing properties, not least because this new factor in valuation is still evolving.
Even if we could simplify reality and have a world of only green and brown assets, the ultimate magnitude of the impact of sustainability on the value of an asset will depend on how important sustainability is to the tenant, investment and the wider community. The more it matters, the greater the impact; the sooner it matters, the sooner the impacts on valuation and performance will be felt. So, what we might be able to measure now is not necessarily what we should be putting into asset appraisals.
Third, the impact of sustainability issues on individual assets is not always easy to quantify. To give a simple but typical example, in a world where petrol prices run ahead of wider inflation, shoppers getting in their cars and travelling to a retail warehouse on the edge of their urban area to buy goods will now have less to spend. Consequently, they buy fewer goods. The retailer receives less sales revenue and can therefore only afford to pay a lower rent. At a similar or higher capitalisation rate, this means the asset is worth less. Such logic is simple enough to describe but how easy would an investor find attaching a discount factor to an asset today to account for something like that in the future?
At PRUPIM, we have reluctantly accepted that at the moment we are not going to be able to specify clear appraisal parameters for these important sustainability-related issues. But we have developed a more qualitative approach to help us focus on the likely implications of an asset's sustainability credentials on its future value and prospective performance, and have begun to generate the necessary data to support subsequent empirical analysis.
We identified a set of 11 key sustainability variables that we believe are likely to affect the future value of properties in five to 10 years time. The presence or absence of such features in a property, which relate predictably to building resource usage, building labelling credentials, on-site energy and resource generation and management, dependency on carbon-based vehicular movement of goods and people, are then used to assess how ‘future-proofed' the property is.
For each asset, a question is asked about each of these 11 variables and, through predetermined weightings attached to the questions and the different potential responses to each question, a ‘future-proofing' score is recorded. Through this process, every asset held or considered can be given a sustainability score. The resultant score is then compared against an internally estimated scoring scale for properties of different environmental standards, and by comparing each property against this benchmark, each property can be classified as ‘very well', ‘well', ‘averagely', ‘poorly' or ‘very poorly' future-proofed.
Finally, in order to tie this outcome into the investment decision-making process, this final descriptor of the asset's level of future-proofing is presented as an integral part of the financial outputs from our in-house worth appraisal model. This ensures that whenever fund managers and the relevant hierarchy of investment committees are reviewing assets, they are simultaneously and visibly informed about both the quantitatively-generated prospective returns and risks of the asset and the qualitative view of the how well placed or otherwise the property is for the environmentally-conscious market of the future.