How green leases create value for commercial property

How green leases create value for commercial property

Mid 2022, Stuff ran a piece urging commercial landlords to get up to speed on sustainability, which read like a warning against the backdrop of the U.K. and European legislation intent on decarbonising the commercial property sector. Boston Consulting Group also ran a piece that month highlighting that CO2 concentration at Baring Head had reached 415 parts per million–the highest recorded ever in New Zealand. At a CO2 concentration of 430 parts per million, global warming of 1.5°C is forecast to occur.

The commercial real estate sector is responsible for about 20% of the country’s carbon footprint, so improving its environmental performance would make a substantial contribution towards emissions targets. But broader energy regulations will come. As Scott McKenzie, PMG Funds Chief Executive, explains for RNZ:

“While big listed property firms, roughly 200 firms, have exacting environmental, social and governance (ESG) responsibilities, those firms only hold about 10% of the commercial property stock, with the remaining 90% held either privately or by the unlisted sector.”

Commercial landlords will need to pay for the green transition. It is unreasonable to think that upgrading old buildings will not increasingly become the only option, both legally and commercially. As Jon Manns, head of strategic consultancy at JLL, explains for Stuff:

“The amount of embodied carbon in commercial property meant the efficient use of buildings was critical when trying to mitigate climate change. That means cutting down on building waste, focussing on whole lifecycle carbon use, improving the efficiency of existing stock and assessing whether retention was a viable option prior to demolition.”

For architects, this presents a considerable opportunity as investors and asset owners look for solutions to retain the value of their properties. Forbes published "Don't Tear Down That Old Building: Retrofit For Energy Efficiency", quoting Tamar Warburg, director of sustainability at Sasaki, who said, as many others have, "The most sustainable building is the one you don't build." Former Forbes contributor Regina Cole quotes Rebecca Berry, the president of Finegold Alexander Architects:

"Retrofitting buildings creates jobs, ... and different buildings present different levels of opportunity to fine tune them. Generally speaking, when we talk about making an older building energy efficient, we think about the envelope: the windows, walls, door openings, etcetera.”

The article explains how very old structures were built with regard to energy efficiency and provides unique perspectives and arguments for working with what we have.

What is a Green Lease?

A green lease is a type of lease agreement between a landlord and tenant that includes clauses that provide for environmental objectives, such as how a building is to be managed and used and what opportunities exist to enhance a commercial building that reduces the asset’s carbon footprint. Creating more environmentally and occupier-friendly buildings will increasingly not be a plus but rather a necessity for successful investors. Others agree. A recent Asia-Pacific survey hosted by JLL noted that the adoption of green leases is set to double by 2025, a multiplier that could accelerate economic recovery, with 65% taking the view that green leases are set to replace conventional leases.

How Green Leases create value for commercial investors and tenants

While the pandemic casts a long shadow over commercial property, it creates opportunities for environmentally friendly innovation in the market:

• Reduce utility consumption and financial expenditure: The Institute for Market Transformation estimates that green leases have the potential to reduce utility bills by up to $0.51 per square foot, reducing energy consumption in an office building by 11% to 22%. If green leases were standard across the U.S. office market, this would represent $3.3 billion in annual cost savings.

• New technologies deliver improved rental yields: For example, as reported in the Financial Times, environmentally sustainable buildings have higher operating costs, 31 basis points above average due to their use of new technologies, but achieve an extra 53 bps of rental yield, which means the cash flows to investors are 19 bps higher. “For a building that would ordinarily have cash flows worth £100m, the increase works out at £190,000 — well worth having in an age of zero and near-zero interest rates.”

• Provides a framework for landlord-tenant relationships: Drivers for introducing sustainability aims and goals differ between the parties. For landlords, there is a case for public relations while maximising future investment returns and risk reduction. For corporate occupiers, there is a need to balance environmental requirements and improvements to social infrastructure and buildings that are going to attract and retain talent. Both have something to gain. Green leases provide a shared language for priorities, driving value creation through alignment and contractualising various environmental and social commitments, holding both parties accountable.

• Support corporate sustainability agendas: For tenants and landlords committed to comprehensive net zero carbon targets for 2050, a green lease is vital. Depending on the company size, environmental, social, and governance (ESG) reporting obligations may also be of consideration. Common green lease clauses cover the sharing of data on energy, water and waste, carbon targets, electrification strategies and detailed waste management efforts, including recycling obligations—all tangible metrics.

• Enhanced public relations for investors: For investors, asset owners consider environmental, social, and governance issues in commercial property as a growing investment opportunity. JLL asks if tenants are the next generation of sustainability influencers, stating a recent report, “We are into the phase where sustainability is innovative, cool and considered premium and elite.” Environmentally sustainable buildings not only potentially make investors feel good but also deliver good financial returns. And the world is watching. As we transition to a low-carbon economy, investments are increasingly identified by incorporating ESG factors in the firm’s fund manager research,and other stakeholders will seek to invest/work with those who are committed to carbon reporting, producing sustainability reports and engaged in other disclosure mechanisms.

• Compatibility with sustainability frameworks: In September 2022, the New Zealand Green Building Council (NZGBC) and Property Council New Zealand published their sustainability framework overview. The NZGBC runs the Green Star, NABERSNZ, Homestar, HomeFit, and CarboNZero for Building Operations frameworks. This includes summaries of other schemes, such as the IS Rating scheme for infrastructure, and internationally developed tools, such as LEED, BREEAM, Passive House and WELL. For example, green leases also go hand in hand with the LEED program, recognising best-in-class building strategies and practices and LEED certification results in healthier, more productive places to work. 88 of the Fortune 100 companies are already using LEED.

• Attract and retain talent: The green building industry started out designing buildings that were better for the planet, now, we [industry] recognise that those buildings were also better for people. So, as businesses look ahead to an adjusted return to work scenario, the tenets of green building design and functionality are likely to play an important part in supporting the goals of promoting a safe and healthy work environment. This 2018 Harvard University research indicates that green-certified buildings can reduce energy, health, and climate change costs while lowering the incidence of lost days of work for those who are employed within them.
  
  
• Risk mitigation and future-proofing: As the drive towards decarbonisation and CSR gains momentum, landlords and tenants are increasingly entering into mutual agreements with the aim of reducing the environmental impact of buildings. Reducing a building’s emissions is how the industry will eventually effect real positive change; therefore, the greater risk to a building’s value implied by high emissions should start to be accounted for during the valuation process because of the transition risk. For example, Earnst and Young quantified the impact of ESG investing on property values in their 2022 study, which found landlords who prioritise ESG can expect higher rent, tax credits and incentives, and overall higher market value of their real estate investments. Articles like Green Buildings Worth More to Investors published in the Financial Times and As Risks of Climate Change Rise, Investors Seek Greener Buildings, published in The New York Times, further validate the role of green buildings in reducing investor risk.

Five to 10 years ago, there was a lot of debate about sustainability. It’s nice, but I don’t want to pay for it. But the fact is commercial real estate has a significant footprint when it comes to emissions and climate change, and with the emergence of new regulations, sustainability isn’t simply a signifier of corporate responsibility but a core feature of a financing plan. There are investor pressures today and landlords are betting that green leases mean attracting better tenants and getting ahead of regulations. Today, you don’t sacrifice returns for sustainability, and you create returns with sustainability.