Global Property Securities - 'Rentability’ and the lure of energy-focused landlords

Why environmental considerations could have the biggest impact on global REIT returns.

As more carbon emission regulation comes in globally – as we expect it will – Real Estate Investment Trusts (REITs) with emission reduction plans are likely to be better-placed than their peers as the cost of carbon increases.

And while the introduction of carbon emission regulation could take some time, and may vary in different countries, leading REITs with a focus on energy efficiency and emissions measurement are finding more immediate benefits.

As a specialist investor in REITs globally, we are seeing opportunities in valuation adjustments of companies based on their carbon emission reductions and energy efficiency.

More and more, commercial tenants are seeking out buildings and landlords with higher energy ratings. And our invested capital is seeking out REITs with a genuine focus on emissions reduction, including the harder-to-measure embodied carbon associated with development.

“Rentability” is a major factor contributing to secure rental-income streams and cash flows that drive a building’s valuations over time. We expect that inefficient or “brown” buildings will become increasingly harder to rent as decarbonisation, employee wellness and operational efficiency themes mature.

We expect tenants to increasingly steer away from less sustainable buildings as they seek out energy cost savings – cost savings that are typically shared between the tenant and the landlord.

Even though it has been hard to separate the fact that “greener” buildings are often the newest buildings in the market, carbon-reduction efforts do play a prominent role in preserving the value of greener, more energy-efficient buildings in our experience.

In Europe, five countries — France, Sweden, Denmark, Finland and the Netherlands — have introduced regulation on embodied carbon emissions inclusive of scope 1, 2 and 3, according to Euractiv (March 15, 2022). Scope 1 and 2 refer to direct and indirect greenhouse gas emissions, while scope 3 relates to emissions produced as a consequence of the activities of the company from sources not owned or controlled by the company.

France was the first country to introduce this type of legislation in October 2019 when it implemented the Tertiary Decree, requiring all commercial buildings over 1000 square metres to reduce their energy consumption (vs 2010) by 40 per cent in 2030, 50 per cent in 2040 and 60 per cent in 2050, or to respect a maximum consumption threshold defined by building type.

More recently, France implemented further regulation covering embodied carbon associated with development.

The United States currently has no nationwide regulation covering carbon reduction of buildings. There is evidence, however, of movement at the state level, according to the National Association of Real Estate Investment Trusts.

New York City’s Local Law 97 could see fines issued for companies that exceed energy efficiency and greenhouse gas emissions limits from 2024. Similarly, the Title 24 Law in California looks to address energy usage and carbon emissions in future tenant spaces.

In Asia-Pacific, many REITs are adopting scope 1 and 2 emission-reduction targets; however, only a few are implementing embodied carbon emission-reduction targets and programmes. This is starting to change, particularly in Australia and Japan.

We expect carbon emissions to continue to be a focus for investors and regulators as the sector does more of the heavy lifting.

Real estate currently contributes around 37% of the world’s CO2 emissions in 2021, according to United Nations Environment Programme.¹

Investing in REITs with policies in place to reach net zero and improve their energy efficiencies bring multiple benefits to investors. Along with cost savings through energy efficiency and improved rentability as mentioned above, we also see this as an important risk mitigation factor as carbon regulation gets implemented across the globe.

Whilst the priority should be a focus on embodied carbon reduction through measurement and design, carbon offsets also play an important role. Carbon offsets are currently unregulated globally, so a high level of scrutiny is required by companies prior to investing in these.

Overall, we believe listed real estate is a good place for investors to capture changing global property dynamics. These trends include the growth of e-commerce, the rise of data consumption, ageing populations, as well as new societal changes stemming from a post-pandemic environment such as decentralisation of living and working and other long-term trends like falling homeownership rates.

Further, we expect listed real estate will be a good place to capture the shift towards greater climate regulation and the repricing of assets in the light of the costs of future carbon offsets and preferences for energy efficiency.

As seen in the Australian Financial Review