• Understanding the environmental impact of construction is becoming increasingly important to stakeholders.
• Regulations are driving property owners and developers towards integrating energy efficiency improvements.
• ESG considerations are growing in relevance for lenders considering lending against real estate.
• The retrofitting approach is gaining support but a debate on whether it is the appropriate approach remains active.
• The path to net zero remains unclear, however, encouragingly collaboration and regulation is resulting in change within the real estate sector.

Introduction

A hotly debated topic at this year’s MIPIM was strategies for the mitigation of carbon emissions within the real estate industry, including those emanating from the construction phase of new buildings or refurbishments, and from the demolishing of buildings at the end of their economically useful life.It will be interesting to see how the conversation evolves at Expo Real later this year.

Some statistics illustrate the importance of this topic:

• In major cities such as London, operational carbon emissions from buildings account for as much as 70 per cent of a city’s carbon emissions.
• Two-thirds of the buildings that exist today will still be standing in 2050.
• In 2021, around 37 percent of all carbon emissions from energy use and industrial processes came from the construction sector.

Central to any discussion on this subject is the case-by-case decision of whether to retrofit an existing building, or to demolish it and build a brand-new building. Taking these statistics into account, there is a clear need to look at what happens to existing building stock and whether it should be retrofitted rather than demolished.

In making such decisions, developers will need to weigh up the balance between “operational” carbon (i.e., the carbon released from the ongoing operation of the building) and “embodied” carbon (i.e., the emissions caused by making building materials, transporting them to a site, demolishing a building and constructing a building from scratch).

Policy Argument

Policy is also driving change.

For example, under the Minimum Energy Efficiency Standards (“MEES”), the EPC rating for commercial buildings, is increasing to B in 2030. This means there is now a clear longstop date by when commercial property owners need to carry out improvements to existing buildings.

In addition, further to the Task Force on Climate-related Financial Disclosures (“TCFD”), larger UK companies and / or LLPs which are within scope (e.g., UK companies and / or LLPs with more than 500 employees and a turnover of more than £500 million) must now make annual corporate-level climate related disclosures. The impact on those in scope of the TCFD is significant as they need to ensure environmental due diligence is ingrained in their core business activities. These would therefore require asset-level decisions such as whether to retrofit a building or demolish it.

Lending and Risk Analysis

To an extent, ESG already forms part of the risk analysis for new financings, however it will be even more important for lenders considering lending against buildings which need retrofitting to bring them up to MEES and other relevant standards during the term of a financing. This is a discussion ripe for collaboration between lender and sponsor.

Considerations at the underwriting stage may include whether the borrower is seeking finance to address the energy efficiency problem and, more fundamentally, whether an older building should be retrofitted for those purposes.

Similar issues will arise over the term of a lease, and parallel discussions will therefore need to take place between landlord and tenant.

In advancing the conversation, we might see more discussion about financial incentives in loan documents for good performance metrics and, equally, more innovative tools to measure such metrics.

Industry / Corporate Sentiment

The British Property Federation (“BPF”) supports a “retrofit first” approach and, in a report released in February of this year, called for, among other things, planning reforms to prioritise the re-use of buildings and a VAT exemption for refurbishment works.

Large market players are also paving the way for others to follow their example and retrofit existing buildings; for example, the major refurbishment of Citi Tower in Canary Wharf, to be completed in 2025 / early 2026.

It is important to bear in mind that retrofitting can be on a much smaller scale than this and does not need to include a refurbishment of the whole property; simply upgrading the lighting or implementing a waste strategy and a ban on single-use plastics can have a positive impact on reducing operational carbon outputs, and the cost of such measures can be recouped over relatively short periods ranging from two to four years. In the longer term, the market may be coalescing around a consensus that retrofits can offer a more cost-effective way to create highly sustainable modern office spaces that can ultimately attract competitive rents.

Against Retrofitting

Any conversation on retrofitting would not be complete without looking briefly at the other side of the argument. Despite the perceived shift towards retrofits, Marks & Spencer has recently claimed, in defence of its controversial planning application to demolish its flagship store on Oxford Street (currently the subject of a public inquiry the decision of which is expected at any time now) that, in the long term, the more energy-efficient new building “will more than offset any emissions from the redevelopment”. It will be interesting to see more analysis of the data they cite.

To Sum Up

Even in the real estate sector there is no clear and set path to net zero. At the prime end of the market, by working together, investors, occupiers and lenders can drive green investment in their preferred direction of travel to a certain extent. However, in the wider market it is likely that additional regulatory pressures and collaboration will be the factors that really stimulate change. Whatever your views on this topic, we expect discussion and negotiation among stakeholders to continue.