Risk of Over-Eagerness (Part 1): Real Estate Path toward Decarbonisation

As the real estate industry moves towards a zero-carbon world understanding the challenges of this journey is crucial. Recent discussions on decarbonization, within the industry, in large part focused on retrofitting and estimation of the brown discount's size. All in all, it is apparent that the commercial real estate (CRE) industry is gearing up to commit significant funds to this initiative. However, challenges have emerged as the era of abundant, cheap money for European CRE investment funds has come to an end. Investors are now seeking better returns in asset classes beyond real estate, leading to increased bankruptcies and starting to significantly affect residential developers and construction companies. In addition, there are substantial challenges posed by the expected refinancing gap over the next five years. City University's "Europe CRE Lending Survey" estimates commercial real estate debt at €1.5 trillion. The AEW research indicates a financing gap of around €46 billion over the next three years, a substantial increase from their previous estimates. Meanwhile, PWC research estimated cumulative financing for the next four to five years to exceed €125 billion. Simultaneously, European CRE transaction volumes have come to a halt, adding another layer of uncertainty for CRE decarbonization spending as there is uncertainty in respect of future real estate assets values.

While the CRE industry prepares to invest heavily in decarbonization, it cannot ignore instances of questionable decisions or occasional neglect of its role in the economic system, both of which can be costly. Concerning the former, it's worth noting that the CRE industry is still recovering from the expansion of retail floor space in the 1990s and early 2000s.

From an economic theory perspective, CRE is fundamentally an economic factor of production - an input, used in the production of goods and services. This is how the CRE industry should perceive its role in the economic system. Nevertheless, the CRE industry sometimes desires to deviate from this primary function, assuming that its primary role is to generate the maximum achievable rents and income, while overlooking importance of its role as a factor of production. There is nothing inherently wrong with such objectives if they are achievable. After all, one of the objectives of any business is to maximize profits. The trouble is that parts of the CRE industry occasionally seem to believe that attempting to maximize profit within an outdated rentier economic model framework might be possible. This, in turn, creates a problem of office space allocation under a rentier economy, which may not support the sustainable development of the local service economy. Instead, the space is allocated to the highest bidders based on affordability. However, the history of modern CRE cycles proves that attempting to operate within a rentier economy model is impossible, and such 'experiments' tend to be costly to the CRE industry.

For example, one questionable trend in recent years involves converting secondary office space into prime specifications in most major EU office markets. In the case of London, where I had the opportunity to observe this transition firsthand, the consequence was that significant parts of the 'secondary' services industry had to relocate outside the borders of inner London. This shift occurred due to increasingly restricted and expensive supply of suitable space for their activities. The secondary service industry is a vital cog of the overall economy of large cities as it largely acts as a supplement to the primary service industry, providing various supporting and outsourced service, making it one of the cornerstones of the economies of big cities. Simultaneously, pushing the tenants of the secondary service industry to the outskirts of cities has increased their carbon footprint, as these businesses now have to travel a greater distance, even though their main operations remain within the city's perimeter.

While it doesn’t seem to apply to London, it appears that capital spent on converting secondary office spaces into prime ones, in some instances, may have been misspent, considering that in a post-COVID-19 world, there could be an excess supply of office space. The CRE industry should assume a 'duty of care' principle towards all actors in the economic system. Therefore, it should acknowledge that neither all occupiers nor all landlords will be able adjust to decarbonization at the same pace. However, such businesses will remain an important part of a wider economic system and will still need to use CRE as a factor of production. Consequentially, the shift towards decarbonisation, while necessary and of paramount importance, should avoid infusing agenda with ideologically charged content in respect of landlords of occupiers needing more time to adjust, allowing them necessary time to adjust without penalising them.

There are additional reasons for CRE industry to adopt a more cautious approach in respect to spending outlays on specific elements of the decarbonisation initiative as picking right timing for associated expenditures will be of decisive importance. CRE transition processes should be particularly mindful of not overly outpacing the political processes that govern the decarbonization transition. The UK government recently made a U-turn in its stated decarbonisation targets, postponing them for an additional 5 years. It cannot be ruled out that other countries might decide to follow a similar course, as it remains uncertain whether this postponement will be a 'one-off' event or if further postponement will occur after 5 years. Another source of uncertainty is the US government withdrawing from the Paris Accord in 2020.

While the US pullout was short-lived, the position of the US regarding decarbonisation targets can no longer be taken for granted. In March of 2023 the US Senate passed the bill blocking “the Biden rule” which allowed pension funds to consider ESG investing. The bill’s premise was that pension funds investment objectives should focus on maximising returns rather than be based on subjective socially conscious agendas, which they assessed the ESG to be. It was furthermore argued that components of ESG were anyhow a long-standing aspect of investment considerations but that the current environment surrounding ESG, appears to abolish investment managers from their primary responsibilities. Such environment it is argued, for example, allows the investment managers to invest into incredibly volatile products, based on narrow investment objectives, which remains unscrutinised as long as ESG targets are aligned. Although this bill was vetoed by President Biden, it appears that US politics have not reached a bulletproof consensus regarding decarbonisation targets.

The lack of governments clarity regarding ESG agenda indicates heightened risks related to CRE decarbonisation initiative.

Therefore, the CRE industry's decision to spend on retrofits and decarbonization increasingly resembles a bet, where the outcome hinges on the right timing of the spending outlay but where likely time horizon is well over 30 years.

Therefore, the CRE industry decision to spent on retrofits and decarbonisation increasingly is resembling a bet, where the outcome of the bet hinges on the right timing of the spending outlay. We emphasise that while the CRE industry approach must be balanced, an urgency to address climate change must be preserved. It's advisable to avoid excessive spending on specific decarbonization components that don't offer immediate and significant carbon footprint reduction until there's greater clarity on the government's decarbonization policy. It is increasingly evident that slight postponement of spending plans in respect of building retrofits together with postponement of spending on some components of decarbonisation might turn to be a blessing in disguise for the CRE industry. The delay will offer the CRE industry more time to plan necessary adjustments, while gaining more clarity on the extension of real estate repricing and the timing of the next economic cycle.

The most significant impediment to decarbonizing the commercial real estate sector lies in the inherent ambiguity surrounding the scope and methodology of such endeavours.

In our follow-up articles we will describe our journey towards a better understanding of the CRE decarbonisation initiative.