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OPINION:
Sustainability and Real Estate

Landlords will find it harder to raise rents in energy -inefficient properties

07/2007

By P.F. McNamara

Two paradoxes are at the heart of integrating sustainability and real estate. The first is that 98 percent of the effort relates to 2 percent of the problem. While there are great achievements in construction, additions to stock are typically 2 percent per year. As such, greening new development is the “slow lane” to solving carbon-related issues in the built environment. The second paradox is that those with the knowledge have no power, and those with the power have no knowledge. Architects and engineers are far ahead of the real estate industry on sustainability. However, the investment managers who hold the purse strings, conscious of their fiduciary responsibilities, remain skeptical of the financial benefits of taking action. Therefore, I have sought to demonstrate to investment managers how the responsible management of their existing properties can benefit their clients in the (financial) language they understand best.

Sustainability and Real Estate
Photo courtesy of James Steinberg
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Through regulatory and policy developments, sustainability is changing the context for real estate investment decision-making. In the U.K. in the last two years, over 20 sustainability-related policy and finance initiatives have affected real estate investment in some way. Investors, tenants, suppliers, and others are increasingly reviewing each others’ sustainability credentials. These changes will affect the way properties are priced in the future, and, financial theory tells us, they should be influencing prices today, albeit at a discounted level.

How do investors assess what properties are “worth,” and how might sustainability-related issues affect this assessment? First, an investor sets a baseline for investment returns, usually those returns that are available from a risk-free government bond. This baseline is common to all investment decisions. The second consideration is how risky the expected returns from a property might be: The higher the perceived risk, the lower the price. This is called the “risk premium.” A final consideration is how the income from a property will vary over time. Clearly, investors will pay more for an asset if its income is expected to grow than if it is flat or falling. While supply and demand cause marketwide rents to generally rise and fall, over time individual buildings deteriorate physically and functionally.

If, as seems the case, companies are becoming more concerned about environmental issues and their corporate images, then non-green characteristics could become increasingly less acceptable or desirable to tenants than green alternatives. As such, non-green properties will end up with lower rents and take longer to re-lease. This means non-green properties will depreciate more quickly and carry higher risks than their green counterparts. Furthermore, landlords will also find it harder to raise rents in energy-inefficient properties where tenants are already paying higher energy costs. The same reasons may make non-green properties less desirable to other investors. These factors will increase the buildings’ illiquidity risk premium and reduce their exchange price. Clearly, the more investors and tenants care about sustainability—and evidence suggests they will care a lot!—the greater the impact will be on the values of non-green properties.

To best serve their clients’ interests, investment managers have a clear duty to understand these issues and their effect on property values. To future-proof their investments from increased risk and depreciation, they must implement cost-effective measures to green their existing assets. If managing real estate sustainably enhances returns, investment managers have a fiduciary responsibility to do so. Unless it demonstrably harms performance, they also have a moral duty to do so.

P.F. McNamara is the director of Research at PRUPIM, an indirect subsidiary of Prudential, a United Kingdom-based company. “Prudential UK” is not affiliated in any manner with U.S.-based Prudential Financial.

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This article appeared in the July 2007 print issue of GreenSource Magazine.

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