12 minute read 11 Nov 2022
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Looking at ESG’s positive impact on property values

Authors
Brett M. Johnson

EY US Strategy and Transactions Real Estate Valuation Solutions Leader

Client-serving principal; experienced advisor helping clients navigate complex capital allocation matters. Keen focus on real estate for both investors and users of space. Dedicated father, husband.

Katie Miller

EY Americas Strategic Operations Leader

Empowering high performing teams at EY. Wife and mom of three great kids.

12 minute read 11 Nov 2022
Related topics Real estate, hospitality and construction
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It’s easy being green: As the regulatory and capital environment favors ESG, investment in green buildings proves valuable for landlords.

In brief

  • Landlords who prioritize ESG at their properties can expect higher rent, tax credits and incentives, and overall higher market value of their real estate investments.
  • A recent EY case study quantified the impact of ESG investing on property values.
  • Investment in property technology and green building upgrades better positions landlords in a dynamic regulatory and capital environment.

Environmental, social and governance (ESG) issues have become a strategic priority for real estate executive teams and boards in recent years, and now ESG is at the top of the agenda for C-suite executives. According to the 2022 EY US CEO Survey, 82% of respondents see ESG as extremely important or more important than other factors when it comes to strategic decision-making, up from 43% in 2019.

Further, the regulatory environment is challenging real estate companies to provide greater transparency into their sustainability practices. In March 2022, the US Securities and Exchange Commission (SEC) reinforced this priority when it released a draft climate-related disclosure proposal. Among other things, the proposal would require domestic and foreign SEC registrants to disclose qualitative information about climate-related risks and various quantitative metrics, including GHG emissions. The SEC disclosure proposal would require Scope 1 and 2 emissions, those directly produced by the registrant, to be reported. Scope 3 emissions, which occur offsite across the supply chain, would only need to be reported if they are material.

Legislative action has already begun nationally and in major cities across the US, introducing both “carrots” and “sticks” to prompt action among commercial real estate investors. For example, the Inflation Reduction Act (IRA) includes significant benefits to green buildings by offering increased deductions for installing solar panels, heat pumps and charging stations for electric vehicles. In New York City, most buildings over 25,000 square feet were required to meet new energy efficiency and GHG standards beginning in 2021. Stricter limits are expected to come into effect in 2030, as mandated by Local Law 97. The goal is to reduce emissions produced by NYC’s largest buildings by 40% by 2030 and 80% by 2050. In Los Angeles, policy mandates new buildings must be carbon neutral by 2030. Los Angeles City Council has a plan to shift from natural gas to electricity and reduce GHG emissions by 60% before 2035. Other cities around the country are anticipated to follow suit with similar legislation.

In addition to being a strategic and regulatory priority, a healthy and sustainable environment has become the standard for what people expect when they enter a building. Occupants want a space that contributes to their health and wellness, and increasingly, alignment with corporate sustainability strategies. The challenge for real estate, hospitality and construction companies is to take this market reality and deliver a facility that both meets rising stakeholder expectations and generates a return on their investment.

While the initial outlay of capital may seem burdensome to many real estate owners and investors, ignoring tenant needs and demands can inadvertently inhibit anticipated value growth. In addition to understanding tenant expectations, there are numerous benefits offered to companies willing to take the plunge into the ESG realm from a real estate perspective, including (but not limited to) tax credits, incentives and favorable financing. From both a social and financial perspective, owning green real estate is a path to a more sustainable future.

Building owners and occupants need to rethink ESG

For building owners and investors, the cost of green buildings has proved intimidating, considering the expense of creating a more ESG-centric building. But this is a shortsighted view of the opportunity that exists in today’s sustainability-driven environment. There is proven value in retrofitting an existing space and earning the sustainability certifications that come with it. Healthy buildings enhance occupant satisfaction, improve rental rates, lower operating expenses and thus increase property value. That value is of great interest to the forward-looking real estate investor. With a generational shift underway that has seen millennials make up a larger share of the investor community, there is an opportunity to convert what once was viewed as an expensive outlay of capital into a pathway to a lucrative return on investment.

For prospective tenants, the improved workspace concept means tenants are searching for buildings with better air quality and more natural light, which is linked to less absenteeism, less turnover and higher work productivity. Whereas in the past, as much as 83% of a company’s value could be found on its balance sheet, intangible assets are now much more relevant to a company’s bottom line. Engaged employees, happy tenants, a diverse board, a strong brand and access to institutional capital — all these ESG metrics will influence a company’s valuation, in turn creating additional value to the real estate they occupy.

Green buildings have proven to reduce risk and create superior exit opportunities for investors. By lowering legislative and obsolescence risk, capitalization rates are compressed, thus creating premiums commanded by the market. As ESG becomes a more common framework investors can use to measure the value of real estate, demand for this space should increase and support even higher levels of marketability coupled with larger discrepancies in value.

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The valuation of a green building vs. non-green building: a case study

How does investment in an ESG-focused property generate value for investors? To assess the financial impact of sustainability, Ernst & Young LLP (EY US) recently conducted a hypothetical case study to analyze and quantify the impact of ESG on property valuations. Specifically, EY professionals looked at the key assumptions used in the income approach to highlight the areas where ESG has an impact on property value. While most investors would agree that a green building would be more valuable than its otherwise identical non-green building, the end result due to the compounding impact on the various assumptions is likely less known.

The study format centers on a hypothetical comparison analysis. It juxtaposes two 500,000-square-foot office buildings in Chicago structured with triple net leases.

The first property is a Class A office property designed to be adaptable to a changing environment. It has been retrofitted to meet the requirements of a LEED-, WELL- and Energy Star-certified building. Property technology has been implemented to improve metric tracking and feeds into an analytics dashboard that enables the owner to evaluate and adjust property conditions on a real-time basis.

The second building does not have these features. The property is a Class B office building, 1970s vintage, in need of efficient heating and cooling systems. The property lacks automated building systems as well as green and healthy building certifications.

EY professionals compared the two buildings across a number of metrics typically used to estimate overall real estate value. Based on EY research and our professionals’ real estate valuation experience, ranges of potential impacts from green building investment are summarized below:

A summary of detailed observations can be found below.

  • Revenue assumptions

    • Rental rates – Rental rates represent one of the most sensitive drivers of property values. A green building can generate higher rents, as tenants prioritize ESG strategies across all facets of corporate strategy, including the use of real estate. In this case study, the green building was assumed to yield between 2.5% and 5.0% higher base rent per square foot over the non-green building, which is in line with the market rate for LEED-certified office buildings, thus boosting the gross potential revenue generated at the property. Tenants are willing to pay increased rental rates justified by the offset in savings in operating expenses and an increase in the aforementioned intangible assets influencing a company’s value (e.g., engaged and happy employees).
    • Vacancy and collection loss – The EY case study found a potential 1 % to 2% decrease in vacancy rates. Green buildings often benefit from higher occupancy rates as the space tenants occupy must align with the values of their respective corporations, naturally weeding out non-green buildings in their hunt for office space. Generally, as companies commit to net zero targets and embed ESG as a part of their corporate strategy, leasing “green space” becomes imperative to align with their corporate values. The result is a building with lower vacancy and collection loss due to increased tenant demand and the increased likelihood of renewal. Note that renewal probability is likely higher as well when underwriting a property’s value.

    As a whole, green buildings have experienced higher rental rates and lower vacancy and collection losses, resulting in a significant increase to effective gross revenue. In the EY illustrative case study, effective gross revenue was approximately 2.5% to 5.0% higher for a green buildings retrofitted to meet the requirements of LEED, WELL and Energy Star certifications. In addition to the revenue items mentioned, certain savings on expenses translates to a larger spread in net operating income (NOI), further contributing to the premium associated with a green building.

  • Expense assumptions

    • Common area maintenance (CAM) – The green building in the EY case study was concluded to benefit from a 2.5% to 5.0% reduction in CAM expenses due to the presence of energy-efficient building systems. The result is decreased CAM costs for real estate owners and decreased pass-through costs for both current and prospective tenants. Studies have shown that green buildings consume less energy, use less water, emit less carbon dioxide and produce less solid waste. These cost savings lead to a boost in asset value, slower depreciation and increased marketability.
    • Insurance – While insurance costs remained the same between the green and non-green buildings in the study, investors should consider additional costs associated with areas that have an elevated probability of a climate-related natural disaster.
    • Real estate taxes – Currently in Chicago, no local real estate tax incentives are offered to green buildings; therefore, the EY team assumed an equal local tax rate for both properties. As taxes are a function of value, a higher value would result in an increase in total taxes paid out for a green building. So, while the demonstrative example has a higher tax payment for the green building, it is important to consider alternative tax incentives being offered that can significantly reduce the tax burden on both a federal and local level. Specifically, the IRA expands the 2023 deduction from the current $1.80 per square foot to between $2.50 and $5.00 per square foot and also offers tax rebates for installing solar panels, heat pumps and charging stations for electric vehicles on-site. Furthermore, in the future, large urban centers are expected to follow leads of New York City in issuing regulations targeting landlords, which will result in additional penalties generated for noncompliance and thus increasing the overall tax payment for non-green buildings. Real estate owners should consider tax credits, grants, incentives and refunds in light of local and state laws that implement a penalty for not being compliant with GHG reduction targets.
    • Capital reserves – As a landlord, significantly more investment is required to maintain a non-energy-efficient building. While an investor would need to budget for additional up-front expenditures to bring a building up to “green standards,” the future capital reserve requirement would be less to maintain. In the case of the EY study, it was concluded to be 2% to 4% less. Additionally, investors can see further benefit of investing in an ESG-centric building by turning to “green financing,” which is favorable financing associated with sustainable development projects.

    While green buildings experience higher effective gross revenue, they also see a further benefit in lower expenses, resulting in a larger spread in NOI between green and non-green buildings. In addition to a higher NOI, green buildings have seen increased benefits through lower capitalization rates in recent transactions.

  • Investor return expectations

    After understanding the impact to revenue and expenses, it’s important to understand the investor expectations and perceived pricing associated with a green building (i.e., capitalization rate). Green building transactions have seen compressed capitalization rates once sustainability-focused investments have been made and financial benefits are recognized, given the lower legislative risks and lower obsolescence risk, coupled with the increased marketability. In the EY case study case, teams used a rate that was approximately 10 to 25 basis points lower . Our research indicates a capitalization rate spread between green and non-green buildings could be as high as 200 basis points, creating an additional benefit for investors. Going forward, as additional regulations are put in place at the national, state and local level, a further spread is expected.

Case study findings: green building investment has a compounding effect on market value

The takeaway from the EY case study is clear: green building investment has a compounding effect on property value. A focus on ESG produced a range of impacts to revenue and expenses at the case study property; those impacts, in aggregate, can result in a potentially significant value increase for real estate investors.

As expected, the most sensitive inputs to ultimate property value such as a premium on rental rates, savings in operating expenses and a resulting lower capitalization rate have a compounding impact to value. The EY study’s green building yielded between a 10% and 21% increase in market value compared to the non-green building . As discussed, green buildings generally see significantly higher values given the benefits stated above. Keep in mind, if you lower the capitalization rate another 50 basis points to a 75-basis point spread between the green and non-green building, the value would continue to spread exponentially. Further flexing the inputs can compound on this value spread, and with additional legislation and penalties against non-green buildings, the spread is anticipated to continue widening.

On average, Chicago office buildings in the Central Loop submarket transacted at $292 per square foot (keep in mind, this may include ESG-friendly buildings). But, for illustrative purposes, if you were to assume a 10% to 21% increase, this results in an incremental increase to value of approximately $29 to $61 per square foot, enough to offset your capital outlay and thus generating a positive return on investment. In short, investing anything less than the $61 per square foot is accretive and yields a positive financial return. Additionally, many international investors will not consider a non-green building as a viable investment, given the more stringent reporting laws abroad, thus decreasing the marketability.

Key takeaways

Putting ESG at the heart of your real estate strategy has a direct impact on underlying asset value. Landlords who invest in ESG will see higher property values for the following reasons:

  • Compounding effect: Investment in green buildings impacts both revenue and expense-level items in a property’s P&L statement; the compounding effect of the changes, large and small, can result in a potentially significant value swing for investors.
  • Elevated profile in a challenging environment: EY US has previously reported the current propensity of corporate occupiers to lease for a shorter duration, given the greater adoption of remote work. Investments in a green building can potentially offset the loss in revenue from longer-term leases by commanding lower occupancy rates and higher rental rates.
  • Enacted and proposed legislation: Investors of green building updates today will be prepared to address the proposed legislation targeting landlords of tomorrow. Across the US, more than 10 city councils have announced intentions to achieve net zero by 2050, with buildings at the heart of their decarbonization strategy. Legislation is expected to follow suit to ensure compliance, as observed in key markets such as New York and California.
  • Regulation: The introduction of the SEC’s climate disclosure mandates will accelerate transparency and expediency in sustainability reporting. Additionally, the SEC will begin to measure real estate investment trusts (REITs) against each other. US-headquartered public-listed equity REIT portfolios included nearly 503,000 properties at year-end 2020. Scores will be assessed and building tenants may find they are occupying a building that did not fare very well in that assessment. With the higher level of transparency demanded from regulators, investment in a green building may influence a tenant’s propensity to renew.
  • Technology: Technology and a strong data analytics platform frequently underpin green buildings, enabling landlords to respond to regulator and stakeholder inquiries on a consistent basis. You can’t measure what you can’t see – and property technology (PropTech) offers a critical way to identify, measure and reduce GHG emissions. PropTech is available across the development lifecycle to decarbonize real estate, and while some cutting-edge technologies are still in development, many are available today and can be installed immediately.
     

Bailey Stasevich and Jack Werch of Ernst & Young LLP contributed to this article.

Summary

Basic valuation principles indicate that higher rent, lower vacancy and lower operating expense translate to lower risk and higher property value. EY analysis finds that the intersection of ESG and asset value is clear: investment in a green building translates into higher market value.

Everyone is in a different stage of their sustainability journey. No matter where you are on that journey, there are ways to make a building green and substantially boost the value of your asset. Now is the time to put sustainability at the heart of your real estate strategy. After all, it pays for itself.

About this article

Authors
Brett M. Johnson

EY US Strategy and Transactions Real Estate Valuation Solutions Leader

Client-serving principal; experienced advisor helping clients navigate complex capital allocation matters. Keen focus on real estate for both investors and users of space. Dedicated father, husband.

Katie Miller

EY Americas Strategic Operations Leader

Empowering high performing teams at EY. Wife and mom of three great kids.

Related topics Real estate, hospitality and construction
Upvote