Part 3: Real Estate Tenants: Free Riders or Simply Uninformed?
CHRISTOS ANGELIS, CAIA - Director at Masterdam
BLAME GAME BETWEEN TENANTS & LANDLORDS
The European Green Deal (EGD)[i] is expected to be a catalyst for change in European real estate by initiating a major Renovation Wave[ii] in the existing building stock. EGD will grant supervisory powers and financial resources to the relevant European Union (EU) bodies to execute the plan at member state level. As discussed in Part 1 of this article series, one of EU’s most effective tools is to impose stricter regulations on the minimum energy efficiency requirements for leasing real estate space based on the Energy Performance Certificate (EPC) [iii] system.
Real estate owners are arguably anxious about the impact of EGD on their holdings. There is limited information at this stage that creates uncertainty amongst landlords. Their main concern is that the cost of the so-called renovation wave will come out of their pockets with limited financial support for private owners in sight and no possibility to pass through part of the cost to tenants through rent increases. From the landlords’ perspective, real estate tenants are taking a “free ride” under the EU’s grand scheme by simply having to comply to higher EPC requirements when renting space. At the same time, existing tenants will directly benefit from lower utility costs due to energy retrofit projects paid by the landlords.
The inability to increase rents during the term of a lease agreement is a major handicap for real estate owners. Tenants need to approve a revised lease contract with a higher rent in exchange for sustainability improvements in their building or units, which is not an easy decision for most companies with no real estate background. Furthermore, as commercial lease terms are becoming shorter in the past 15 years, tenants are becoming less economically incentivized to discuss energy efficiency initiatives with landlords. Instead tenants can simply move to another building upon their lease expiry, which has higher energy sustainability specifications. The economic turmoil due to Covid-19 also complicates things. Approaching tenants with rent increase requests in the current market environment will most likely disrupt the relationship with the landlords and could lead to vacancies.
TENANT PROFILE & APPROACH TO SUSTAINABILITY
Similar to real estate owners, tenants are not a homogeneous group. Their profile and economic incentives vary widely depending on their ownership, company size, business sector, space required and affinity with real estate. Their sensitivity and commitment towards sustainability is heavily dependent on their profile.
- Government Tenants
- Operating Businesses
- Large Commercial Tenants
- Small-Medium Size Commercial Tenants
- Residential Tenants
Government-backed tenants are typically long-term users of real estate space and they tend to sign leases of seven years or more. Moreover, they are coordinated by the relevant government agencies adhering to the highest regulatory standards when signing new leases. In theory, they have the necessary guidance and economic incentives to rent space in sustainable buildings. The reality is that there is a high divergence between member states in terms of budget and sophistication regarding real estate. Technical support by the EU would be more than welcome to bring all countries at the same level.
Hotels, restaurants, student housing, care homes, co-working, self-storage and other real estate intensive businesses typically have a different approach towards leasing space compared to conventional commercial tenants. Firstly, they tend to sign long-term leases typically 10 years or more, with extension options. Secondly, their focus is on economic profit at location level, which is contingent on total occupier cost. Hence, any reduction of service costs has a direct effect on their bottom line. Such tenants are open to discussions with landlords regarding sustainability improvements if the economic benefit is concrete and quantifiable for their business.
LARGE COMMERCIAL TENANTS
Large companies have the budget and corporate real estate advisors to actively explore energy efficiency projects with their current landlords in exchange for rent increases. There are a few bright examples of major companies engaging in such agreements. On the other hand, it is common practice for large tenants to be approached by real estate developers in order to anchor or fully occupy newly built properties. Although occupying space in a new, highly sustainable building with modern architecture and high specifications is great for marketing and branding purposes, it does not necessary comply with the principles of circular economy. Excessive ground-up developments result in higher vacancy in the respective markets hurting current landlords and generating high CO2 emissions during the construction phase. This is contrary to EGD’s goals of increasing sustainability in the existing building stock and transitioning to a circular economy.
SMALL- MEDIUM-SIZE TENANTS
Tenants under this category are perhaps the most difficult to commit to energy efficiency projects initiated by their landlords. Small-medium size enterprises (SMEs) typically sign short-term leases up to five years, with flexible extensions. Furthermore, they lack the financial resources and real estate sophistication to fully understand, quantify and negotiate such deals with real estate owners. The problem is that SMEs typically comprise the majority of tenants in a multi-tenant commercial building. Even if the larger anchor tenants reach an agreement with landlords, the support of smaller tenants is also required in order to make the projects viable. Similar to government tenants, increasing awareness and providing technical support is key for bridging the information gap.
Residential tenants typically rent their units for an average of three to five years, depending on the type of residential asset (e.g., studios, multi-family and single-family). Moreover, tenants are responsible for their utility bills as well as for general building service charges. Energy efficiency upgrades should result in lower total occupancy costs for individual tenants both at unit and building level. However, there are a few complications to consider. Energy efficiency works need to be conducted inside the units, which may create great inconvenience when the units are occupied. Furthermore, residential rents are heavily regulated in most EU countries. Increasing rents during the tenancy or upon gaining vacant possession might be complicated and politically sensitive. This is especially valid in major European cities where housing affordability is low.
HOW CAN EGD PUT AN END TO THE BLAME GAME?
Commitment to sustainability should not be one-sided. It goes without saying that real estate owners are ultimately responsible for their properties and should come up with concrete plans on how to improve their energy efficiency. However, tenants are also responsible as users of real estate and need to contribute accordingly towards a better future. Cooperation between tenants and landlords on sustainability projects should be promoted and encouraged. EGD can facilitate this process through a series of suggested measures.
The lack of awareness and detailed explanation of the economic benefits deriving from higher building sustainability is an important factor for tenants to be reluctant to commit to rent increases for energy efficiency projects initiated by their landlords. EGD could launch an extensive information campaign with the help of local authorities at the member state level to provide technical support to tenants, especially SMEs, in their review of lease proposals in relation to energy efficiency projects. Moreover, landlords could be instructed to provide comprehensive information in a standardized format regarding the direct economic benefits of their renovation plans to their underlying tenants. These simple measures could substantially increase the level of trust between tenants and landlords.
ALLOW RENT INCREASES DURING THE TENANCY
A major intervention from EGD would be to allow rent increase provisions in standard lease contracts when the landlords execute energy sustainability projects. The rent increase level can be tied to EPC increase with a “cap” to protect tenants. Furthermore, landlords should commit to lower service charges in line with the energy savings achieved. This approach will unlock value potential for both tenants and landlords. Tenants will pay a higher rent in exchange for lower service charges or own utility bills. Landlords will be rewarded with a higher rent resulting in a higher valuation from day one.
Under IFRS 16[iv], lease agreements are capitalized and become a liability for the company. EGD could explore ways to provide tax incentives to tenants tied to the EPC of their leased space or on the rent increase as a direct result of energy sustainability projects by landlords. This approach will incentivize tenants to consider such initiatives and start a constructive dialogue with real estate owners.
A more direct measure would be for EGD to propose the introduction of a carbon tax applicable to tenants similar to the tourist tax paid by hotel guests. The revenue generated by the carbon tax could be placed in a reserved account and could be used for energy sustainability projects in the building itself or in the wider district.
Real estate owners are currently holding their breath as more information is becoming available about the EGD and its potential impact on their investments. The ongoing blame game between landlords and tenants on who pays the cost of sustainability is counter-productive to say the least. Tenants seem to be in a highly advantageous position with sole obligation to follow the regulatory EPC requirements. When existing tenants are presented with energy efficiency projects initiated by the landlords, they have the free option to simply decline on signing new leases at a higher rent. Many tenants, especially SMEs, lack the expertise to assess these types of deals and are quick to reject them due to their complexity and ambiguity regarding the expected energy savings. This situation discourages owners from allocating CAPEX for sustainability measures unless it is required by law.
Lack of cooperation between tenants and landlords is a major hurdle that EGD should address. EGD could facilitate the process by increasing awareness and providing technical support to tenants when assessing such projects. Moreover, EGD could make concrete interventions in the EU leasing market in order to allow landlords to share the cost burden with tenants under a fair and transparent framework. A first step would be to allow rent increases during the tenancy coupled with service costs reductions. Furthermore, tax incentives could be provided to companies regarding the accounting treatment of their leases in line with the sustainability level of their space. A more radical step would be to impose a carbon tax to real estate tenant using the revenues for energy efficiency projects.
It is yet to be seen how the EGD will approach real estate tenants in the context of energy retrofitted projects. In my opinion, tenants should also be held accountable and contribute to EGD’s vision for a carbon-neutral urban environment.
In the next article, we will discuss the European Green Deal from the perspective of real estate developers.
CHRISTOS ANGELIS, CAIA,Director at Masterdam
Chris is a real estate corporate finance advisor at Masterdam and the Head of CAIA Netherlands. As an investment professional, he is committed to a better urban environment by supporting real estate innovators. He has more than 12 years of experience as a portfolio manager and investment advisor in European real estate markets. Chris holds a MSc in Finance & Investments from Rotterdam School of Management (cum laude) and has attended executive education courses at INSEAD Business School. He has been a Chartered Alternative Investment Analyst (CAIA) Charterholder since 2012 and a member of CAIA Netherlands executive committee since 2015.