The future of commercial real estate in the UK

As the U.K. Government seeks to achieve zero carbon emissions by 2050, it only made sense that decarbonisation of building stock, which accounts for 31% of national emissions, would be required. And now, after two years of accelerated trends in remote work, the London office market lags behind pre-pandemic levels as firms continue adapting to hybrid working and prioritise compliance with green regulations. And the scale of the challenge is not insignificant. With over 1 billion square feet of office stock across the U.K. below the proposed minimum EPC 'B' rating, commercial real estate owners will need to make hard decisions about the future of their assets and the smart investments that could save them.

What’s behind the carbon emission regulations in the U.K.?

In the U.K., buildings are responsible for 23% of all carbon emissions (direct and indirect emissions totalling 118 MtCO2/year). Some 30% of these emissions come from non-domestic buildings and approximately 70% from commercial real estate (CRE), so it made sense the government would seek to decarbonise the sector. Rapidly.

In 2008, the U.K. passed the Climate Change Act, committing the Government to cut national greenhouse gas (GHG) emissions by at least 80% from 1990 levels by 2050 and agree on progressive ‘carbon budgets’ to drive progress toward this target. Further legislation introduced in 2016 via The Energy Efficiency (Private Rented Property) (England and Wales) Regulations 2015 made it unlawful to lease residential and commercial buildings with an Energy Performance Certificate (EPC) rating below “E” from 2018 onwards. These energy measures would put U.K. office lettings under threat, so there was also a very real chance that property valuations would take a hit as well. As Aliya Ram and Kate Allen explained for the Financial Times:

“A fifth of all British office buildings risk becoming unlettable within five years as a result of new energy efficiency measures that pose a threat to the value of property investors’ portfolios.”

Graeme Murray, head of sustainable engineering at property consultants CBRE, said the changes were already having an effect on property values. “You are already seeing EPC ratings being factored into transactions.”

Then, the Net Zero Strategy was published in 2019, which, if supported by effective policies, would see the U.K. bring all GHG emissions to Net Zero by 2050. The Fifth Carbon Budget (covering 2028 to 2032) requires emissions to be reduced by 57% by 2030 compared to 1990, and The Sixth Carbon Budget–The U.K.’s path to Net Zero, sees further plans to decarbonise by 2035, requiring emissions to be reduced by 78% compared to 1990. And now, financial incentives seek to make progress on that front. So obviously, first in line to take losses will be the owners of lower-grade office buildings, given that since 2018, commercial properties have required an EPC rating of at least ‘E’ before they can be subject to a new lease. And come 2027, that requirement shifts to a ‘C’ rating.

Now we’re seeing parallels to the 2018/2019 retail [property] crash, facing a perfect storm of weaker demand for space, higher construction, think, retrofitting costs, fewer lenders, buyers, and higher interest. So, while investors have struggled to price climate risk into their decision-making, price premiums have emerged, as you can see in this data below from MSCI, for buildings that have sustainability ratings from organisations like the Building Research Establishment (BREEAM) and National Australian Built Environment Rating System (NABERS) versus those yet to achieve these standards. Office space in London classified as ‘green’ currently commands a 25% sale premium. Data compiled by JLL also confirms that green-certified buildings have historically achieved a financial return on investment.

Bloomberg recently profiled the chief executive officer of Great Portland Estates Plc, Toby Courtauld, who has been betting on another developer retreat. It is an interesting read. He believes it is the tsunami of rising interest rates, a looming recession and new rules to stave off climate change that threaten to make much of the office buildings obsolete. Courtauld anticipates that all but the greenest workplaces will face a brutal repricing. Jack Sidders writes for Bloomberg:

“The level of rent was just not an issue,” Courtauld says, describing GPE’s negotiations with its tenant. “The top issue that they were most concerned about was sustainability.”

How sustainable is U.K. commercial real estate?

Environmental regulations had come at the worst moment for landlords without either the money or skills to make their buildings sustainable. The Levelling Up and Regeneration Bill, Energy Performance Certificate (EPC), and Minimum Energy Efficiency Standards (MEES) were already in place, which required landlords to achieve an EPC rating of ‘E’ or above with non-compliant buildings forced to improve energy performance or face fines and closure. And then there was the pandemic, so we’re looking at a different problem where we’re really talking about stranded assets, which is apparent when we consider that the London office market lags behind pre-pandemic levels as tenants seek compliance with green regulations. According to Savills, 87% of the U.K. office stock has an EPC rating of 'C' or below. Consider that the implementation of the minimum requirement of EPC "B" by 2030 will cover approximately 87% of the U.K.'s office stock and some £93 Billion of U.K. Commercial Real Estate is at Risk of Becoming Stranded Assets.

• By April 2025, all commercial properties (that are not exempt) must have a valid EPC;
• By April 2027, the government intends to raise the minimum EPC rating from an ‘E’ to a ‘C’;
• By April 2030, the government intends to raise the minimum EPC rating to a ‘B’
  

Source: Savills. How Sustainable is the Office Stock in the U.K.?

The role of green leases in achieving carbon reduction outcomes

It is true that buildings account for 39% of global energy-related carbon emissions, and some 75% is your in-use cost. Waste accounts for 5% of this commercial building carbon footprint. This drive to lower emissions is causing companies to look deeper at the real estate they occupy to make sure it is in line with their carbon policies. JLL’s 2023 Responsible Real Estate Survey found that corporate occupiers are already looking to prioritise carbon-centred criteria in their next lease. Lowering water usage, waste monitoring, data sharing and so on, building that into the design and operation of the building and positioning them as features to drive competitiveness.

Green lease clauses first emerged over 15 years ago, yet they remain largely self-defined as there is still no industry-wide guidance on minimum standards. One of the most significant shifts for landlords will be the increasing emphasis on sustainability, with analysts suggesting the commercial real estate market has split, with strong demand for high-quality buildings in desirable locations that meet environmental requirements while there is a lack of interest for others. In reality, landlords will have to work a little harder to secure their rent income.

JLL’s Decarbonizing the Built Environment research has found that 42% of investors and 34% of occupiers are currently implementing green clauses in lease contracts, which typically include commitments to the use of sustainable materials and renewable energy sources and the adoption of recycling initiatives. That said, as Ryan Hesketh writes for Bloomberg:

“It is widely known in the industry that EPCs do not well reflect the actual energy use or carbon emissions of a building once built.” Building certifications based on predicted energy use don’t necessarily translate to energy savings.

“One of the biggest reasons estimates get energy use wrong is human behaviour: Even buildings designed to some of the highest prevailing standards depend on how the property is used.”

Tenants who have drawn up their own carbon reduction plans will look to property management, who will have a big role in this. As noted in the RICS U.K. Commercial Real Estate Impact Report:

“With the vast majority of commercial properties lacking sensors and other smart building management systems, there is a considerable challenge in understanding and managing building performance, which is compounded by information barriers between landlord and tenant on energy use, emissions and waste data.”

Adopting circular economy principles to reduce waste and embodied carbon emissions is vital in addressing climate change. And whilst at the country level, governments will introduce their own regulation, corporate occupiers will demand a minimum EPC as part of their ESG strategy.

The U.K. recently adopted a modest version of the Australian programme NABERS, NABERS U.K., but the programme is not mandated or overseen by the government. Yet. NABERS measures actual emissions rather than just potential ones, waste included.

Even without a rigorous NABERS programme, WSP prioritised waste and single-use plastics, achieving Carbon Trust Zero Waste to Landfill certification and continues exploring opportunities globally to reduce waste-related GHG emissions, noting in their OCT 2022: U.K. Environmental, Social, and Government Update:

“As well as several other undesirable impacts, every bag of waste sent to landfill has an associated carbon footprint.”

Ultimately, only stricter regulations will cut carbon emissions.