Built Environment: Outlook for 2022 – Real Estate

Alison:
Hello everyone, I'd like to welcome you to the first episode in this real estate podcast series, looking at key themes for 2022. My name is Alison Murrin, and I am the expertise counsel in the real estate department at Ashurst. I'm delighted to be joined by Richard Vernon, who is a real estate partner at Ashurst.

Alison:
Richard, thank you so much for joining me. I'm so pleased to have the opportunity to tap into your expertise over the next 20 minutes or so to discuss one of the major themes for 2022 and beyond, and of course, that is the decarbonization of the built environment and how our industry is going to make the transition to net zero a reality.

Alison:
Of course, COP26 concluded a few weeks ago in Glasgow, and nearly 200 countries agreed to strengthen their emission cutting targets for 2030 by the end of next year. However, there was no getting away from the fact reaching an agreement at COP26 was definitely challenging, and of course, the agreement was watered down at the very last minute. And indeed, Greta Thunberg described COP26 as simple more, "Blah, blah, blah."

Alison:
But, Richard, I think whatever we think about the success of COP26, it's impossible to ignore the fact that the pressure is increasing on the built environment sector, to make decarbonization targets a reality. We just can't ignore the fact that the built environment generates 40% of CO2 emissions. And, if we have any chance of meeting the 1.5 degree C warming limit set out in the Paris Agreement, we would have to eliminate all CO2 emissions from buildings by 2040, which is just no tall order. I think, it seems to me, that requires a huge mobilization from our industry.

Alison:
So I wanted to ask you, Richard, first, what we need to do to achieve this mobilization, and who needs to step up and make it happen?

Richard:
Thanks, Ali. I think in order to make real headway on the ground, not just in theory, it's going to take all stakeholders in our sector, in the built environment, to collaborate. We'll use the word collaborate in a number of areas that we're going to talk about today. That collaboration means pooling skills and resources to really make this happens.

Richard:
That means, whether it's architects, developers, contractors, investors, occupiers or the lenders involved, and all those in the wider supply chain, all have a real part to play when we're designing, constructing, financing, all the real buzz words around repurposing our buildings. And also, our towns and our cities generally. And, our industry is already making progress and we've seen a number of organizations making significant commitments to achieve that net carbon zero goal.

Richard:
But, this has to be coupled with an achievable plan of action, to reach those targets. And effective action plan, which brings in priorities, timelines, budgets and resources. And as you can imagine, although a number of organizations are quite far down the road in setting out their sustainability journey, there are many others who are just at the beginning.

Alison:
Yeah. It seems that, from what I'm hearing from you, Richard, just pledging to be net zero is not going to count for much unless there's a clear pathway to achieving that. I must say, I've heard a great deal about the steps that are being taken to reduce operational carbon, by improving the energy efficiency of buildings and switching to greener fuel sources.

Alison:
But, I recently read a quite scary statistic, actually, that embodied carbon, which typically comes from building materials and construction operations, can amount to anywhere between 20 to 50 percent of the total carbon emissions of a new building. It seems to me that it's not just about being more energy efficient, but we have to reduce embodied carbon in buildings. That is critical if we're going to ever achieve net zero and carbon neutral construction targets. I wondered what your view was on that point.

Richard:
Well, Ali, I completely agree. As we know, embodied carbon is not only just, not to say just, but the greenhouse gas emissions caused by manufacture and the supply, the construction products we use, but it's also the construction process itself. And of course, by reducing embodied carbon, we can limit the negative impacts on global warming caused by those buildings.

Richard:
It's really important to note that embodied carbon needs to be addressed in a lifecycle perspective, as results can greatly differ when looking at the short term or the longterm. It's especially clear that it's adopting that lifecycle perspective is necessary when looking at those retrofits and refurbishment projects that we're doing. We need to consider the whole carbon lifecycle of a building and incorporate circular economy principles into the design, construction, operation and of course, decommissioning of any building.

Richard:
This, of course, is much, much easier to do for new buildings. The real problem we face is that 80% of the buildings that will be here in 2050 already exist on the ground today.

Alison:
Yes, that's quite a fact to take account of, isn't it? 80% of our buildings already exist. That makes me think that one of the big questions that we need to address and our industry needs to turn its mind to is how we go about turning so called brown buildings into green buildings. Your view, Richard, I'd really appreciate your thoughts on that.

Richard:
Well, I agree. Without significant action from many significant players in our sector, we're going to find ourselves with a number of stranded assets. Many investors now view climate risk as inseparable from what is traditionally financial risk. Those brown buildings you refer to, it's inevitable that brown discounts will increasingly be applied buildings that fail against carbon targets.

Richard:
Having an agenda is one thing, having a plan is another. But, successfully delivering that plan is something else entirely. In real estate, among lots of challenges, we see two major ones. The first is that, whilst there is a great hunger to invest in finance, build and occupied greener buildings, there is simply not enough of a pipeline. Demand far outstrips supply.

Richard:
But secondly, there's a real conflict there, between landlords and tenants in the commercial space, over who is responsible for what and who pays. In the residential sector, of course, sadly that was vividly brought into public consciousness after the tragedy of the Grenfell Tower fire, when the question over who was legally responsible to pay for the costs of remediating cladding was anything but clear. And of course, that whole picture rumbles on now.

Richard:
In theory, there is clear alignment and desire from both landlords, including investors and funders, and tenants, to create those greener buildings. Landlords want to boost the green credentials of their buildings, and tenants are looking for buildings to occupy that chime with their own sustainability targets and commitments. However, of course, this alignment may lead to arguments over who should pay, particularly where the benefits between owner and occupier are shared.

Richard:
Some of the key issues to consider include the impact on the value of properties which fall below those energy performance standards. The risk, as I say, of stranded assets, lending restrictions possibly, and what will happen to insurance premiums, how those works will be funded to improve those buildings. And, what policy and financial frameworks are needed to support that investment? We've seen that, really, any organization which is serious about climate related risks and opportunities for their business will need to measure, assess and disclose energy usage and carbon emissions from their buildings, and implement a portfolio-wide decarbonation plan.

Richard:
This will require the real estate sector to really improve its data gathering, governance and data processing, in order to increase trust. And also, to minimize false or misleading claims about green credentials out there. We recognize that gathering that information is particularly challenging for occupiers and landlords, and green lease provisions are continuing to evolve to meet that requirement, but much, much more needs to be done.

Alison:
Thanks, Richard. There were some really interesting points there. I'm particularly interested in relation to your point about implementing a decarbonization plan. The reason why is that the UK Green Building Council has very recently launched the Whole Life Carbon Roadmap, which sets out a common vision and agreed actions for achieving that zero carbon in construction, operation and demolition of buildings.

Alison:
I think it's almost the first of its kind and it really sets out all the necessary steps that are needed to decarbonize the real estate industry across the whole value chain. It's obviously going to be a great resource for an investor or developer, a contractor or an asset manager looking to develop or improve their own decarbonization plan. I suspect it's going to become essential bedtime reading.

Alison:
I know you've looked at the roadmap and I'd be interested to hear what your things are about the roadmap, and it's potential to put words into action.

Richard:
Thanks, Ali. That roadmap is definitely going to be a game changer for our industry, if we get the buy-in. It recommends that both landlords and occupiers should urgently establish a net zero carbon strategy for how property is procured, and the operation and occupation of commercial real estate. It really looks at how stakeholders should put in place action plans, including requirements on the landlords on one hand to set building energy efficiency targets, formulate plans to transition away from fossil fuel heating, and also ensure that data sharing and transparency which I mentioned. But also, on the tenants side, they do need to take some ownership here, for the elements of energy usage that they can control. Setting clear reduction targets with a focus on the energy performance of their fit outs, and also collaborate with their landlords on those fit out projects. Low carbon heating and data sharing, for example.

Richard:
The roadmap sets out policy recommendations also, for central and local government, to help drive this and enable the transition needed to decarbonize the sector. These go beyond the recently published UK Government's heat and building strategy, and cover existing homes, existing non-domestic buildings and new buildings as well, for the infrastructure which connects our buildings and industry.

Richard:
But, focusing on commercial buildings, the policy recommendations include mandatory energy disclosure as part of performance based rating systems across multiple sectors. This could be aligned with additional policy levers, such as minimum standards, and also fiscal incentives in the forms of penalties or rebates linked to existing or new taxation mechanisms, as well as clarity and sufficient forewarning on the phase out dates for gas and oil heating systems, which of course is coming our way.

Alison:
Indeed, it is. It's interesting, Richard, that you mention government policy. And of course, at present, the government is relying on the minimum energy efficiency standard, or MES, to drive the energy efficiency in buildings. It occurs to me that, potentially, the UK Green Building Council's recommendation for a performance based rating system suggests that possibly MES is not fit for purpose in the longterm.

Richard:
Yes. As you say, of course we know that MES regulations are due to ramp up from the first of April 2027, it's likely, if the consultation comes through. But subject to certain limits and exemptions, properties will need to have an EPC rating of C before let. And of course, that will increase to a B rating by the first of April 2030.

Richard:
What we've seen that [inaudible 00:12:58] estimates, it's over one billion square feet of office space in the UK is below that proposed minimum EPCP rating and that's going to require substantial investment to change. So how long will that take and who will pay of course, back to the payment debate.

Richard:
But, lease drafting is also evolving to deal with MES and we've seen that occupiers really need to review leases carefully to ensure that increased costs are dealt with fairly. An occupier will want to ensure that it is not liable for an owner's costs incurred in improving an EPC rating of a property so that it's lettable. But, there arguably should be an appropriate contribution, where works to the property will lead to savings in running costs for the tenant. And in fact, the interests of owners and occupiers are often aligned. Most companies will have their own ESG strategies and environmental reporting requirements are going to increase, as we move towards net zero. Green lease provisions should not only be seen as a benefit to owners, tenants as well. Well balanced drafting can also help occupiers to meet their own environmental targets.

Richard:
But, as you mentioned, the problem is that the EPC is an asset rating. It doesn't reflect actual in-use performance of a building. And as time goes on, investors and lenders evaluations and decision making are likely to evolve to focus on performance based ratings, rather than EPCs. Elevating the importance of in-use performance within the valuation of buildings, particularly as institutional investors based in the UK begin to disclose the operational energy and carbon performance of all held properties at asset level across their portfolios in annual reporting.

Alison:
I'm getting a real sense that there's a common thread running through all of this, that actually the time has come for all stakeholders to work together to a common goal. I'd be very interested to see how you think this is going to play out, and particularly in the landlord and tenant situation, where it's so traditionally seen as an adversarial relationship. So encouraging those parties to come together and collaborate is going to be a challenge, and your things, Richard, greatly appreciate those.

Richard:
The word collaborate again, obviously I mentioned that towards the start of this chat and an essential theme of the roadmap is adopting that collaborative approach between landlords and tenants. Green leases, as the expression has been around for many, many years, but that's a good example of where much greater collaboration is needed. We've talked about it, but in reality, we still don't have a settled market position for either existing leases or how to draft new leases of space. That balance of liabilities between landlords and tenants, that's well established in commercial leasing practice over many decades.

Richard:
But of course, environmental performance and environmental improvements are a relatively new concern. The market has not yet set a satisfactory standard for splitting those costs. This will need to change and we're seeing a growing interest in adopting green lease clauses from all sides, and anticipate that stakeholders are really going to pick up a pace on this in 2022. But ultimately, for effective action on climate change and the ambitious carbon neutrality targets to be met, those green provisions need to become so embedded in the real estate sector, that they are an accepted market standard for every commercial property.

Richard:
Ashurst is working with industry bodies, tenants, landlords and funders to agree best in class green leases, including repair and improvement clauses that are designed to cover sustainable and circular economy principles. We're advising on the structure of development agreements, to ensure clear responsibility for ensuring that new and refurbished buildings achieve those required MES standards. And, we're supporting those stakeholder clients to devise business plans and risk mitigation strategies to facilitate those required energy efficiency works, to develop innovative solutions for meeting the capital costs of those works. And also, to take informed decisions to address assets which may become stranded.

Richard:
But, the real estate sector's net zero agenda is not being driven solely by the concerns about depressing values. There are also positive steps being taken to improve the built environments in which we live and work, which will create buildings that demand a greenium, as it's now been coined, as well as contribute to wider environmental and social benefits.

Alison:
Thanks, Richard. That's really, really interesting. It just occurs to me, when you mentioned about values and the concerns about depressing values, that we should of course also think about the role that the finance sector may have in driving this change. I think clearly we know that financial institutions have significant influence in the real estate industry, through their lending decisions and their effect on market transactions.

Alison:
Do you think lenders will drive the transition to net zero?

Richard:
Well, I think we've talked a lot today about the landlord and tenant relationship. But of course, as well as most commercial space being leased, most of that space is providing asset security for funders. So yes, funders are going to play a key part to this.

Richard:
They need to be considering both an action plan now, for existing portfolios, but also how to address what is coming down the track, in terms of new funding they're looking at. We've talked about data. Knowledge is key and what is needed as a priority is a detailed understanding of the current state of buildings from an energy efficiency perspective, the cost adoption of works that are possible to improve that efficiency and where that will get you to. But also, what's not possible. Funders will, of course, be heavily invested in wanting a clear exit strategy on assets that are currently below par, to ensure that cap ex is directed an energy efficiency improvements to achieve the required values for sale or possible refinancing.

Richard:
I think we expect to see a huge growth in funding defensive green cap ex, to counter potential deterioration in values. But, are we going to see a new type of distressed asset coming our way? That's quite possibly, with loan to value covenants being challenged. And not in the usual way, driven by lack of liquidity or normal market drivers, but driven by the new market valuing energy efficiency alongside traditional valuations. So yes, Ali, funders will definitely play a key role in the transition to net zero.

Alison:
Richard, it's been really interesting to hear all your views on the challenges and the opportunities for the built environment on the journey to net zero. I think, over the last 20 minutes, it has not changed my view and probably neither has it changed the view of our listeners, that there is absolutely no doubt that this is going to be a major theme for 2022 and beyond.

Alison:
But, just in the last few minutes, just before we finish, is there anything else that we should be on the lookout for in 2022 that will affect our industry?

Richard:
Well, Ali, as you say, I think 2022 is going to be exciting times. I think COP26 has been a brilliant kick to the market generally, but specifically to real estate. It was great having built environment as a standalone day at COP26 and that just shows the importance that the sector has to play in this.

Richard:
But alongside that, our government is looking at other things, of course. It's promised to a review of the landlord and tenant legislation to commercial property, particularly Landlords and Tenants Act, 1954, a review well overdue. We're also going to be watching carefully, the progress of the Commercial Rent Coronavirus Bill, and this is going to be covered in a separate Ashurst podcast by my colleagues. We're also going to see further detail on the Building Safety Bill, and again, you can hear more about that from my construction colleagues who are going to cover that in a podcast later this month.

Alison:
Thanks, Richard. Well, it's definitely shaking up to be a very busy 2022. I just wanted to take the opportunity to finish by thanking you for joining me, and also to wish all our listeners a very happy festive season.

Richard:
Well, it's my pleasure. Thanks, Ali.

Alison:
If you enjoy Ashurst Legal Outlook, why not check out our other two podcast series as well? Ashurst Business Agenda tackles the big strategic issues that business leaders face. And, ESG Matters at Ashurst reveals how business leaders are rising to mounting environmental, social and governance challenges. You can listen and subscribe to Business Agenda and ESG Matters wherever you get your podcasts.