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11 October 202110 minute read

COP26 and the future of real estate

The journey to net zero

With COP26 just around the corner, there will be few businesses not sharpening their focus on sustainability strategy. While most have already implemented measures to help reduce their carbon footprint, the increasing gravity of the climate crisis, and growing list of countries setting bold commitments to reach carbon neutrality by 2050, appear certain to accelerate the need for change.

The real estate industry has no small part to play in this, with the built-environment being responsible for almost 40% of greenhouse gas emissions globally. The reality is that it will be impossible to achieve a net-zero economy without significant changes in our industry. The direction of travel is clear: zero carbon real estate will become a necessity, rather than an aspiration, with policy decisions increasingly aligned to it.

How will the property sector go about achieving this? In the short to medium term, we will undoubtedly see huge sums spent on adapting existing buildings to make them more energy efficient. Millions of square feet of commercial, domestic and public sector real estate will need to be retrofitted and decarbonized to bring them up to modern standards. While this is an essential step (around 80% of all buildings that will exist in 2050 have already been built) it is nevertheless an exercise in changing the past rather than building the future. The true future of real estate for 2050 and beyond will involve a holistic integration of sustainability into every aspect of our buildings; from pre-design and funding to construction, use, management, and even the end of a building’s life. Notwithstanding the importance of adapting existing buildings, COP26 will need to address how we build for the future. With this in mind, we will take you through some of the key stages in the lifecycle of a real estate asset, touching on some key examples of how sustainability flows through it.

Sustainability and the lifecycle of real estate

The beginnings: Green finance

Sustainability should be a key consideration for any development project, from the point of inception. It is becoming increasingly relevant to the way in which an asset is funded, in addition to simply how it is designed, built and operated. The first UK REIT to sign a green revolving credit facility was Derwent London in 2019 and green finance has become increasingly prevalent ever since. Aviva Investors recently signaled their intention to originate GBP1 billion in sustainable real estate debt over the next four years, and ING is offering its own green building incentive loans. Last year, over USD700 billion of sustainable and green debt was issued globally.

But what do we mean by green finance? Essentially the term refers to any form of financial service that incorporates ESG criteria (including, of course, sustainability) into investment decisions. Green loans can be used to fund “green projects” which include developing buildings that meet regional, national or international standards or certifications. Many lenders offer margin reductions on green finance, making them attractive to borrowers if their project meets the relevant criteria. If the borrower performs well against those criteria, it will pay a lower rate to the bank, which creates a strong incentive to comply with environmental and sustainability obligations. The instrument itself can take a number of forms, including green bonds (used mostly for climate and environmental projects), sustainability bonds (mostly aimed at “green” or “social” projects), social bonds (used for projects with positive social outcomes), sustainability-linked loans (where the cost of the loan is linked to specified sustainability objectives) and green loans (used for any “green” purposes).

While it seems clear that green lending will form an increasingly important part of real estate finance going forward, prospective borrowers will need to be prepared for a high degree of rigor and due diligence on the part of the lender. Banks are increasingly aware of borrowers seeking to “greenwash” their financing arrangements, giving them a veneer of environmental kudos, when in reality they are little different to ordinary debt instruments. For that reason, borrowers will need to demonstrate a genuine commitment to meeting “green” funding requirements, which can be wide ranging, covering carbon reduction targets in new projects, biodiversity targets for development sites and energy usage across wider property portfolios.

Green financing is part of our future, but lenders have made it clear it cannot be used as a marketing tool. As with many aspects of SESG, authenticity is key.

The design

One of the many ways in which real estate can contribute towards net zero targets is in relation to energy efficiency. The energy efficiency of a building is measured in two ways. Firstly, by the rate at which energy is lost through the building structure and secondly, the rate at which energy is consumed by its occupiers.

In the UK, a regulatory framework ensures that property (both private and commercial) cannot be sold, leased or occupied unless it meets a minimum energy efficient standard. In England and Wales, the Energy Efficiency Private Rented Sector (England and Wales) Regulations 2015 (MEES) made it an offence to let residential or commercial property with an F or G rating. The minimum standard applies to any new letting, on the renewal of any existing lease and on any subletting or assignment.

The MEES Regulations do not apply in Scotland and, for the time being, the Scottish government has not imposed a minimum energy efficiency standard in relation to non-domestic buildings. There are, however, minimum energy efficiency standards for domestic properties and social housing.

Newly constructed properties will be built in accordance with current building regulations, requiring them to be built according to a specific energy efficient standard. However, the challenge for the real estate sector lies in retrofitting existing stock. For many, a balance must be struck between compliance with energy efficient standards and the cost of upgrading their assets.

Some retrofits are cheap (eg installing LED lighting) whereas others can be costly and involve major disruption to occupiers (such as overhauling heating and cooling systems). A collaborative relationship between a landlord and tenant will be crucial in these circumstances to ensure that the cost of such improvements are shared fairly.

In recent years, technology has advanced to allow for the prevalence of so-called smart buildings. Smart buildings are any structures that use automated technology or processes to promote more efficient use of resources, including heating, lighting, air condition and ventilation. It works by centrally controlling and analyzing data from a variety of operating systems in the building so data from all building systems and equipment can be viewed via a singular platform. It is hoped that the ability to analyze data in this way will lead to the enhancement of environmental performance and better operational efficiency.

The legal side

Regardless of how well-intentioned a developer, or landlord, may be in pursuing sustainability, its success will be dependent on ensuring that occupational tenants are aligned with its objectives. The benefits of green finance, and constructing energy-efficient buildings would be greatly reduced if they are ultimately occupied by tenants whose behaviors do not match. For that reason, sustainability is becoming an increasingly important consideration in the drafting of occupational leases. Most institutional investors now have a clear list of requirements, if not specific clauses, which must be incorporated.

The drafting of alterations clauses is key here. Having invested considerable sums in achieving high energy efficiency, owners are unlikely to be keen on tenants carrying out alterations that may have a detrimental effect on environmental performance. Aside from consumption of energy and greenhouse emissions, this could extend to increased water consumption, waste generation or consumption of other resources. On the subject of waste management, many landlords insist on a provision requiring tenants to adhere to requirements relating to the collection and recycling of refuse. It would not be a good marketing strategy for an investor to achieve exceptional carbon performance, only to then generate an unacceptable level of unrecycled waste.

Other common clauses include an agreement to adhere to an energy management plan to aid the sustainability of resource use, maintain and share energy data, and an obligation on the landlord to provide common services in a sustainable way. The latter is a good example of how the importance of sustainability credentials will permeate the industry, with third-party suppliers being required to show their own contribution if they are to win service contracts from landlords.

With such a rapidly changing landscape, and an increasing number of ways in which occupiers and landlords can contribute to sustainability, no amount of “green” drafting will cover everything. As a result, the most common wording you will find is a more general “cooperation” clause, encouraging the parties to act collaboratively, and in good faith. This, if backed up by landlords and occupiers with a genuine desire to contribute, outweighs any amount of prescriptive drafting.

The operation

Operators can look to reduce the carbon footprint of their assets by considering a switch to purchasing electricity generated only from renewable energy sources, to power their stock. These corporate power purchase agreements, or PPAs, are essentially long-term contracts entered into between a power generator and the end consumer. These differ from traditional PPAs, which are entered into between a seller and the purchaser, usually a power generator or trader.

Entering into a corporate PPA showcases an organization’s green credentials and demonstrates their desire to operate in a more sustainable manner. This, in turn, is likely to attract investment and talent.

As we have mentioned, collaboration between landlord and tenant is key to promoting energy efficiency in a sustainable way. While it will be easy for data to be monitored from landlord controlled areas, the difficulty lies in obtaining data from areas exclusively let and occupied by tenants because they may be unwilling to share such information or such data is unreliable.

Although it may have previously been met with resistance from some tenants, it is important to realize that ESG reporting can enhance the occupier experience in the longer term, and this in turn makes real estate assets more attractive to investors and potential occupiers. For property owners and investors, ESG reporting is key to their sustainability targets.

That being said, what are the challenges with data gathering? Firstly, there is the matter of existing and historic FRI leases that make no provision for data sharing, or for the landlord and tenant to work collaboratively. Landlords may nevertheless seek to argue that the tenant’s obligation to comply with statute would facilitate cooperation.

Secondly, a tenant may argue that if data reporting is necessary as part of the landlord’s remit then why then should they, the tenant, bear the cost. However, the tenant may ultimately be receiving a benefit if data reporting on energy efficiency will lead to better decision-making or an improved holistic experience for the tenant.

There is also the question of the data collection technology itself or the lack thereof and which party should bear the cost of procuring, installing and operating such equipment.

Real estate’s journey towards zero carbon is undoubtedly one of the key issues currently faced by our sector. It applies to every aspect of what we do; from development to investment, property management and funding. COP26 represents a key opportunity for the world to step up to the challenges and responsibilities that lie with all of us. Only time will tell how our industry responds.