Risk management has been at the centre of much debate but on the subject of sustainability significant risks are still being taken. Anne Sophie Blin and Julie Hirigoyen consider what action should be taken
Real estate investors have been making decisions based on market fundamentals
that do not explicitly incorporate long-term sustainability risks. As a consequence, a number of portfolios are likely to be exposed to significant risks which have so far been little quantified or understood.
Real estate investors and asset managers should consider the following sustainability risks in particular:
• Rising costs and financial liabilities. Reducing operational costs remains a focus for corporate occupiers and retailers in the current economic climate. Environmental taxation, such as the CRC Energy Efficiency Scheme or the Landfill tax in the UK, creates a financial liability for real estate investors that might affect their competitiveness.
By way of example, an office building consuming 3,500 MWh of annual electricity would incur a CRC cost of £22,000 (€24,700) in the first year, yet this could approach £47,000 per year if the carbon price were to increase to £25/tonne, as sources have suggested might occur before the end of the decade. Even more worrying will be the rising cost of energy: bills could increase rapidly within this timeframe, as a shortage of generation capacity is encountered, coupled with increased demand.
• Resource availability. Beyond taxation, the scarcity of oil and water resources is predicted to be the most significant driver for increased operational costs, likely to affect service charge and tenant retention. At a corporate level, resource constraints are starting to have an impact on share price. In February 2011, Britvic's share price collapsed by 12% when it publicly stated that its raw material inflation had risen to 10% because of the rising cost of oil.
• Changing market demand. Green certification is rapidly becoming the minimum standard for all new developments. As the push for green buildings continues to grow, the value of existing stock is likely to depreciate faster, unless it undergoes significant green refurbishment.
• Physical risks. Flooding, subsidence and overheating represent some of the more tangible physical risks to property value. The UK Environment Agency estimates that in England and Wales alone, there are nearly 4m properties at risk from surface water flooding. Regular updates to flood risk maps and increasingly sophisticated mapping techniques mean that assets that were supposedly risk-free at the time of acquisition can become high risk at a later point.
• Location disadvantaged by environmental trends. Asset location is already fundamental to property value for all asset classes. This will become more significant in light of increased fuel prices and public policies aimed at encouraging alternative modes of transportation to road use. A 2005 Royal Institution of Chartered Surveyors study showed that the London congestion charge, implemented partially for environmental reasons, had an adverse impact on the retail sector and resulted, initially, in a minor fall in rents and shorter leases.
• Lack of adaptability. The failure of individual assets to allow flexibility of use might also be an increasing risk to long-term income streams. The current trends in flexible working highlight the growing importance of productivity, which in itself is very rarely quantified by real estate investors. By contrast, the latest Jones Lang LaSalle/CoreNet Sustainability Survey of Corporate Real Estate Executives highlighted that employee health and productivity was ranked as the most important measure of success by 31% in 2010.
It is true that the significance of such risks to property value will vary depending on the asset class and the policies and economic contexts of different markets.
Despite some evidence from the US that Energy Star and LEED-labelled office buildings have achieved value resilience over non-labelled counterparts, there remain few comparative studies in Europe. This is perhaps unsurprising since traditional valuation methods do not explicitly take into account sustainability factors. At Jones Lang LaSalle, we are piloting an adaptation of valuation techniques to take account of such factors in discounted cashflow models.
There are, indeed, nascent positive signs from the investor community that sustainability risks need to be factored in sooner rather than later.
First, although it may be argued that the prevailing focus on carbon has sidetracked investors' attention from other sustainability issues, the progress that has been made in this area is substantial. The recently launched Carbon Action initiative by the Carbon Disclosure Project on behalf of a vanguard group of 35 investors with US$7.6trn (€5.25trn) assets urges large publicly listed companies to commit to carbon reductions, as they expect the cost of carbon to be internalised in companies' cash flows. Such pressure will inevitably raise the profile of sustainability, and result in real estate portfolios being targeted for improvement.
Second, it is encouraging that an increasing number of institutional investors are appointing heads of responsible property investment - Henderson and PRUPIM, for example. This should contribute to raising awareness of sustainability issues among fund and asset managers and drive more systematic implementation of sustainability policies.
Third, a number of specialist sustainability funds investing in real estate were launched in the past few years, with the expectation that these might, indeed, outperform mainstream funds. Tracking the performance of these funds will be critical to the establishment of a level playing field within a fragmented market. However, the scale of the challenge means that sustainability has to be incorporated into the strategies of all large investors, as boutique funds will never raise the capital required to induce the necessary changes.
So, what can real estate investors do to future-proof their portfolios against sustainability risks? An informed and sustainable investment strategy maight start by understanding the sustainability characteristics and associated risk exposure of portfolios. This should inform investment strategies and due diligence from acquisition to asset management and through to disposal. The array of options for mitigating sustainability risks is wide-ranging but should ultimately seek to maximise value. Investors that are proactive in this area will be in a good place to take advantage of new markets and arbitrage opportunities.
Julie Hirigoyen (left), lead director, and Anne Sophie Blin, sustainability consultant, Upstream Sustainability Services at Jones Lang LaSalle