Trends for 2022

(Note: to assist with accessibility, a transcript of the above video is also available)

The imperative for action is very real: the real estate sector is responsible for around 40% of greenhouse gas emissions, and 80% of today’s commercial real estate properties will still be in use by 2050. This means much greater focus is needed on improving the green credentials of that building stock – over 1 billion square feet of today’s office space is estimated to be below an EPC B rating.

Who pays?

Tackling the problem requires action, which also comes at a cost. The question of who bears the cost is a debate that has yet to be resolved. Landlords and tenants need to collaborate more in order to determine who pays for improving a building’s green credentials. Although Green Lease drafting has been around for over 20 years, there is still no market position for Green Leases which helps set the balance of liability. A more definitive approach is needed. Open-ended agreements to collaborate and share data are a good start, but greater clarity is needed around responsibilities and commitments to make material improvements to the green credentials of buildings. The UK Green Building Council’s Net Zero Whole Life Carbon Roadmap, launched at COP26, sets out the need for collaboration, which will help Green Leases to become an effective tool in solving the challenge of where the balance of liability lies (between landlord and tenant) for improving the environmental performance of buildings.

Funders will also exert a significant material influence on the Real Estate market in 2022 as they take notice of the impact that poor energy efficiency and performance can have on their investment portfolios. There is strong evidence that the funding community is already taking an interest in energy and environmental performance of their portfolios. This will impact funding decisions and the development of Green Finance mechanisms, with green capex lines likely to become more common.

Competition to fund green may drive down the cost of what would otherwise be expensive debt, but ‘defensive’ green capex is also a way of maintaining or increasing values, and would also be necessary for funders wanting certainty on their exit.

Residential challenges

The UK still has a housing crisis, despite Boris Johnson’s ‘Build Back Better’ campaign of August 2020 and the launch of the Government’s Planning White Paper. Despite an initial flurry of activity -  and a degree of controversy over many of the proposed changes – much of the proposed planning reform is now on hold, with a new Government department – Department for Levelling Up, Housing and Communities (DLUHC) – and a new Secretary of State considering new ways forward.

Changes have been made, however: the new Class E designation for town centres gives flexibility to changes of use on the high street without needing planning permission, and the broadening of activities that can be undertaken through permitted development have led to some major changes in town centres. Our view is that more must be done to ensure that sustainability, good design, placemaking and legacy are considered in today’s planning system, along with a renewed commitment to the provision of affordable housing.

Environmental improvements

The passing of the environment act last year introduces new legally-binding environmental targets and a new body, the Office for Environmental Protection. It also enshrines in law that developers must deliver at least a 10% increase in biodiversity on the schemes they build, which is a significant step forward.

2022 – a year of progress for the construction industry

Although it is easier for new build commercial property to overcome the challenge of net zero, there are still considerable hurdles to overcome: an estimated 35% of the lifecycle carbon found in a typical commercial building is emitted before the building is even opened. However, starting from scratch enables parties to plan sustainable solutions from the outset, for example, specifying use of alternative materials such as decarbonised cement and steel; using BIM to promote circular economy principles; and promoting carbon-friendly construction processes such as offsite manufacturing.

The bigger challenge is how to improve the carbon footprint of existing buildings, which will primarily need to be achieved through the use of renewable energy sources, efficiency in building operations, and clearer and more accountable measurement of building efficiency.

Developers will also need to maximise reusage of existing structures where possible rather than building from scratch, as British Land has done at 100 Liverpool Street, with their JV partner, GIC. They retained 50% of the existing 1980s structure which went a long way towards enabling them to achieve net zero on that building.

Purchasing carbon credits (or offsets) is another way to reach net zero emissions, and some companies are also making commitments beyond carbon to biodiversity and water. Some of our clients, such as Lendlease, are going further, and committing to absolute zero through the elimination of all emissions without the need to offset.

Contracts can help

For the necessary collaboration to take place, we believe contractual mechanisms can help, by encouraging the sharing of risk and improving project culture.

Some of the best ways that construction contracts can achieve these goals are:

• by providing for early contractor involvement so that the build contractor can contribute to design development and planning of the construction phase, for example, enabling enough lead time to be given to consider offsite manufacturing solutions;
• by developing framework arrangements with trusted suppliers who share targets for the elimination of embodied carbon and with whom long-term relationships can be established;
• by providing for KPIs that set out a shared purpose in relation to net zero targets; and
• through shared financial incentives if green targets are met.

Such provisions go hand-in-hand with a collaborative approach towards technology. Digital solutions need to be used in the operational phase of a building’s lifecycle as well as the build phase. BIM is gaining renewed focus from the UK Government in the context of the new building safety regime, and a greater number of clients are engaging with it.

EPC reform needed

The current consultation proposals for EPC reform should provide a necessary catalyst for meaningful change in the environmental performance of buildings. From 2030, those leasing a building will need to have an EPC rating of B, meaning that landlords will need to start planning what needs to happen to improve their building. This places renewed focus on the debate about who bears the cost of those necessary improvements – landlord or tenant.

Change is much-needed, as the current system is arguably “not fit for purpose” because an EPC rating is based on the cost of the energy the building uses, not on the actual carbon emitted by the premises into the atmosphere. Under the current system, therefore, there is little incentive to install heat pumps because they use electricity and/or liquid petroleum gas that are currently more expensive resources than natural gas. To counter this, the Government is considering a new 'in use' rating to ensure that the EPC regime is fit for purpose, by measuring and comparing energy consumption performance vs actual carbon emission performance for larger commercial buildings.

The proposed changes to the EPC regime are likely to have an impact in the short term. Landlords will need to review their portfolios and put in place budgets and business plans for improvements and look to refresh EPCs with a view to achieving better ratings. Occupiers will need to factor the review of green credentials of new commercial space into their decision making processes before entering into lease negotiations.

Renewed focus on tenants

As the Covid restrictions continue to lift, the UK government is introducing a new rent arbitration scheme to resolve outstanding ringfenced Covid arrears. It is currently estimated that this will affect around 7.5k cases (compared to the predicted number of more than 50k). The landlord restrictions on enforcement were supposed to be subject to one final extension to December 2021 but they were extended to the end of March 2022. We hope that this will be the last extension. Anecdotally, most landlords have succeeded in reaching deals with their tenants. There are challenges ahead, however:

• The retail and hospitality market are still struggling and we expect this will take at least another year to clear, leading to continued distress in these sectors during 2022 and beyond, with an impending wave of restructuring and insolvency;
• The reduction in the normal churn of insolvencies throughout the pandemic leads us to believe that there are a large number of ‘zombie’ companies which are very likely to become insolvent in the near future. Restructuring plans are also likely to be used more, along with CVAs.

Stranded/Distressed assets ahead?

Large tenants are increasingly making public commitments to net zero, leading to a close examination of the energy footprints and environmental performance of their buildings. This is changing the dynamic as between tenants and landlords and should lead to greater collaboration as tenants work with landlords to achieve net zero objectives. The risk of not being collaborative is that tenants will move to newly-refurbished buildings, leaving older, often well-known properties behind.

In the long-term, there is a real risk that the drive to net zero will led to stranded assets, and in-turn, a new class of distressed assets. Imaginative thinking will be needed to bring them back to life, making them more energy efficient going forward.

Predictions for the Real Estate sector in 2022

• Greater collaboration between landlords and tenants over who pays for building upgrades required to achieve net zero commitments.
• There will be a growth in ‘retrofit capital’ from more established REF market players, as well as new market entrants looking to help with this opportunity.
• There will be a greater rate of restructuring and insolvency, with CVAs and restructuring plans being popular in 2022 as the UK market continues to open up and Covid restrictions are (hopefully) lifted.
• The UK planning system risks another year of confusion and lack of reform as the Government continues to consider major planning reform.
• 2022 will be a year of greater collaboration between suppliers on major construction projects, with an uptick in the use of Framework Agreements to enshrine shared visions for net zero, and encouraging innovation on new-build and retrofit construction projects. These framework agreements should also help to mitigate other risks currently facing the sector.

As the Queen said when opening COP26 – the time for words has now moved to the time for action.