How are tightening energy efficiency rules affecting UK real estate?
Commercial landlords are racing to meet harsher building energy efficiency rules in the UK.
In 2019, the UK government launched a consultation that would set privately rented commercial buildings on a trajectory towards tougher minimum energy efficiency standards by the end of this decade.
The standards, also known as MEES, were originally introduced in the Energy Efficiency (Private Rented Property) Regulations in 2015.
These requirements were tightened by the subsequent consultation and, if passed into legislation, will eventually mandate a minimum energy performance certificate standard of B by 2030, with buildings needing to hit the lower C standard by 2027. EPC standards illustrate a building’s energy efficiency and range from a top rating of A down to G.
In April, a further tightening of current rules came into effect. A ban on new lettings of non-domestic properties with ratings below E in England and Wales was extended to existing leases. Experts say this will have major ramifications for landlords and their tenants.
The government’s push towards greener real estate has left investors and landlords rushing to update buildings’ energy efficiencies. This is particularly challenging for existing leases, with the presence of occupying tenants making it more difficult to significantly overhaul a building’s sustainability credentials.
The rules have also had an impact on the pricing of real estate assets, with those deemed compliant with higher standards attracting a so-called “greenium”, a green premium.
The market is moving away from energy-inefficient buildings. While stranded assets may pose a problem for owners, experts say that they offer an opportunity for investors.
Diverging rules
Landlords of domestic and commercial properties face different standards in the UK when it comes to energy efficiency. The rules are far more lax for domestic landlords.
Since April 2020, landlords have no longer been allowed, in theory, to let domestic private properties covered by the MEES rules if they have an EPC rating below E, unless they have a valid exemption in place.
Those planning to let properties with F or G ratings must make improvements that drag the building up to E rating, while existing tenanted properties beneath the minimum threshold must be improved immediately.
These landlords, however, do not need to spend more than £3,500 making these improvements. If an E rating cannot be reached within this expenditure, they can simply register an “all improvements made” exemption. According to the government, internal or external wall insulation alone is likely to cost between £4,000 and £14,000.
In 2020, the government proposed increasing the energy efficiency performance standard to EPC C for new tenancies from 2025, and all tenancies from 2028. In its consultation, it suggested lifting landlords’ maximum spend from £3,500 to £10,000, based on its assumption that landlords will spend £4,700 per property to reach a C rating. In May, the government confirmed that it would respond to its consultation — which closed in January 2021 — by the end of 2023.
The rules are a lot tougher on the commercial real estate sector, however.
The risk of enforcement action appears to be a risk worth taking given the significant capital expenditure landlords will have to incur in improving the energy efficiencies of their properties and the disruption it would cause to incumbent tenants
Rory Bennett, Linklaters
The first of two consultations took place in 2019, which was subsequently followed by a white paper that confirmed the timeline for privately rented, non-domestic buildings’ journey towards an EPC rating of B. The government predicted that this would cover around 85 per cent of non-domestic rented stock.
A second consultation, in 2021, added the interim EPC C goal for 2027 and sought to improve how the PRS applies to older buildings. It also proposed moving the enforcement of these rules away from compliance at the point that a building is let, offering a six-month exemption window for certain premises.
In April, a further tightening of the rules came into effect. An existing ban on new lettings of non-domestic properties with ratings below E in England and Wales was extended to existing leases.
The April 1 deadline “seemed to slip by, with many landlords not having, technically speaking, secured compliance”, Rory Bennett, real estate ESG lead at law firm Linklaters, tells Sustainable Views.
Non-compliance can result in a fine ranging from £5,000 up to £150,000. However, Bennett says: “The risk of enforcement action appears to be a risk worth taking given the significant capital expenditure landlords will have to incur in improving the energy efficiencies of their properties and the disruption it would cause to incumbent tenants.”
Investors and their advisers do not, in reality, have much time to retrofit their buildings ahead of the 2030 deadline — a trajectory that is complicated by the presence of tenants in their properties.
“Seven years is not long in real estate,” Richard Vernon, head of real estate at law firm Ashurst, tells Sustainable Views.
Leasing challenge
According to the Department for Levelling Up, Housing and Communities, 4.5 per cent of non-domestic buildings in England and Wales had A EPC ratings at the end of March. Thirty per cent had B ratings, while 36 per cent had C ratings.
The government expects around 1mn non-domestic buildings to be improved by the proposals made under its 2019 consultation.
The necessary improvements made to buildings, ranging from updating lighting to more comprehensive insulation replacement, vary in cost and feasibility. Scaling the EPC ratings can add significant cost.
Ed Dixon, asset manager Aviva’s head of responsible investment for real assets, points to a recent feasibility study for an office in Birmingham, in the UK. The cost to raise the building’s rating from F to E was less than £100,000, while getting it to A would cost around £1.1mn.
The plan for the asset is key, he says. “Are we targeting a more premium product by buying this asset and refurbishing it? Are the works going to be part of a much broader refurbishment?”
He adds that other funds instead may try to keep their outlay to a minimum and wait until the asset becomes vacant at a later date so that it can be completely refurbished.
Tenants already in place pose an additional problem, says Matthew Bonning-Snook, property director at property investor Helical.
“Trying to do all of this when you’ve got tenants in place is nigh on impossible if there’s a great deal of work to be done,” he tells Sustainable Views.
Minor alterations can be done with tenants in the building, but these need to be priced into the investment strategy when the building is bought, he adds.
“No investment committee is going to give approval unless there’s a story mapped out, attached with a cost plan,” Bonning-Snook says.
There is a lot of opportunity out there for buying up cheap stranded assets and then doing them up, and that’s really, really helping the retrofit agenda
Marylis Ramos, Savills
Landlords and tenants will need to work together to upgrade buildings, including identifying who will pay for the upgrade costs, acknowledging that tenants will benefit from lower energy costs once the building’s energy efficiency has improved, according to Vernon.
Tenants can refuse landlords entry to their properties, however, while landlords will argue that failing to upgrade their buildings will leave them in breach of the law.
“Most leases aren’t going to allow this to happen. Landlords are sat there [and] tenants are sat there with a set of documentation that just simply doesn’t allow for this to be sorted out,” Vernon says.
Stranded assets
Real estate values are being affected by the sustainability drive, experts believe.
“EPCs alongside other sustainability-related certifications are clearly a focus for the buyers and we have seen a green premium,” Federated Hermes director for ESG and responsibility Katerina Papavasileiou tells Sustainable Views. “When a building is perceived to be more environmentally friendly, there is a significant impact on its value.”
While the new rules may be onerous for property owners and tenants, they also offer considerable opportunities to both.
Marylis Ramos, director in real estate company Savills’ earth advisory team, noted that some tenants are using lease breaks as an opportunity to trade up to more energy-efficient properties.
“There is a lot of opportunity out there for buying up cheap stranded assets and then doing them up, and that’s really, really helping the retrofit agenda,” she says.
European green lead
Despite upcoming and far-reaching regulation impacting the sector, real estate companies across the world remain reluctant to adopt green building certification across their property portfolios, according to a report by the Global Real Estate Engagement Network — a group of asset owners and asset managers targeting listed and non-listed real estate companies to set science-based 1.5C carbon emissions reduction targets.
In its listed real estate engagement report for 2022, GREEN found that companies might need to carry out additional and deeper retrofits than currently planned for, due to their lack of disclosure on physical and transition risks.
The engagement network, which represents approximately €2tn of assets under management, noted that the worst-performing companies tend to focus on green energy procurement and the use of offsets instead of improving energy efficiency and adopting heat electrification. The group warned that this does not reduce transition risks for investors, given that the actual buildings are not being improved.
A third of large-cap real estate companies analysed by GREEN have set a net zero target, albeit one that does not include a “convincing” implementation plan, the report says. This number is much lower for small-cap companies, where less than one in five have either set net zero or science-based targets.
Net zero implementation plans are considered insufficient by the group as companies often only report their CO2/energy performance data with current targets, but leave out future objectives.
Geographically, Europe is leading the green race, with US companies more averse to including Scope 3 emissions or agreeing to extensive retrofitting. Through its engagement efforts, the group noted that “some US companies see stricter legislation as the only way to achieve deep retrofit investments”.
GREEN director Vincent van Bijleveld urges investors to push the sector forward in making more substantial progress. “Real estate is responsible for more than 30 per cent of carbon emissions,” he says.
“Investors need to start encouraging companies to take steps to lower the financial and non-financial climate risks from real estate.”