Part 4: Real Estate Developers: Hostage of Trophy Hunting Investors & Certification Standards?
By Christos Angelis, CAIA - Director at Masterdam
THE RELEVANCE OF THE EUROPEAN GREEN DEAL FOR DEVELOPERS
Real estate development in the European Union (EU) is regulated by the Energy Performance of Buildings Directive (EPBD) [i], which was updated in 2018 and has been adopted by the EU member states. 2021 is an important year for developers. Starting from January 2021, all new buildings have to be nearly zero-energy (NZEB)[ii] with limited exceptions. This requirement has already been imposed on new government buildings since 2018.
At first glance, the current directive is in line with the goals of the European Green Deal (EGD)[iii] towards a zero-carbon environment. However, new buildings represent a very small part of the total building stock in the EU. Many new developments take place on empty land plots increasing the current stock and making older buildings obsolete. Even demolishing older structures to engage in ground-up development contradicts EGD’s motto of initiating a major Renovation Wave[iv] in the existing building stock. Furthermore, EGD’s plan is to promote the principles of Circular Economy[v] in real estate. Ground-up developments rarely follow these principles since they do not use parts of the existing structure or materials.
Real estate developers are well-positioned to engage in elaborate renovation or redevelopment projects. Nevertheless, ground-up developments tend to be cheaper, and less complicated from a construction perspective with guaranteed high energy efficiency levels by design in line with certification standards such as BREEAM[vi] and LEED[vii]. It is no wonder that all glossy brochures from real estate developers and ESG sensitive property investors feature newly built, sustainable properties with high sustainability certification scores. In contrast, you will rarely see a redevelopment building being advertised on company websites for improving its energy label from D to B or A-. Although such an energy label jump would be 100% in line with EGD’s goals, it will always be less marketing friendly compared to a BREEAM Excellent or LEED Gold.
The European Green Deal can be a catalyst for real estate investors and developers to focus on renovation / redevelopment of existing buildings instead of opting for new built projects. In my opinion, this can be achieved through technical support, stricter planning restrictions and potential tax incentives. The ultimate goal is to increase the energy efficiency of the overall building stock and minimize gas emissions from the construction and the operation of real estate. A handful of ultra-sustainable new development projects will not move the needle towards a zero-carbon urban environment.
THE BUYER IS ALWAYS RIGHT
Institutional investors, asset managers and investment consultants are gradually embracing ESG in their investment policies and due diligence processes. This trend has initiated a wave of discussions within the industry bringing ESG to the forefront of real estate investment. There are countless white papers available which are sponsored by asset managers and industry organizations, containing interesting recommendations on how to incorporate and measure sustainability standards in real estate. Despite best efforts by investors, the outcome is rather predictable: the higher the sustainability profile of the underlying buildings or envisioned projects, the more attractive the investments will be from a sustainability perspective for investors. Active efforts in improving energy efficiency without top results are simply not rewarded.
Real estate developers have been monitoring the change of investor preferences very carefully. Developers understand that high price premiums can be achieved if they develop buildings with the highest sustainability standards certified by professional organizations such as BREEAM and LEED. This creates the following paradox:high ESG investor requirements and fixation on sustainability certifications prompt real estate developers towards ground-up developments rather than renovation / redevelopment projects.
The inconvenient truth for ESG investors is that acquiring properties with low sustainability profile and improving their energy labels to the maximum of their renovation potential may be more ESG compliant compared to demolishing buildings in order to erect new ones with ultra-high sustainability standards. Ground-up developments typically do not comply with circular economy standards and they contribute to more gas emissions during the construction process. Renovation / redevelopment projects can make a big difference with lower environmental impact.
CIRCULAR STATE OF MIND
Real estate development projects tend to be opportunistic with a short holding period from land acquisition to exit. In many instances, the development process reflects this mindset in terms of budget, procurement and execution. The concept of circular construction is relatively new to the industry. Hence, a significant number of developers and construction companies simply do not have the technical expertise to implement the principles of circular economy in their projects.
Circular construction starts with the building structure and materials. Maintaining parts of the building and using existing materials will be compliant with the standards of circular economy leading to lower gas emissions. However, redevelopment projects tend to be more complex and may result in delays or cost overruns if the developer is lacking experience. It is easier to budget and execute ground-up developments which yield more predictable results.
Stopping at building structure and sustainable materials is half the job. Developers should prioritize creating flexible buildings where major upgrades or structural changes in technical installations, IT, and space layout / fit-outs are possible. As a result, real estate owners will not have to replace them in due course but instead upgrade or modify them according to the new specifications. The positive environmental and economic impacts deriving from having this flexibility can be substantial.
Finally, new buildings should be constructed in a way where major building refurbishments or redevelopments are possible when the buildings reach the end of their economic life. This forward-looking approach will facilitate both investors and developers in the future to reuse materials from the building and to maintain a significant part of the existing structure intake. This could lead to lower costs, lower uncertainty and a positive environmental impact.
HOW COULD EGD HELP?
EGD’s priority on the renovation of existing buildings should be clearly conveyed to investors and developers. Raising awareness and providing technical support to developers would be a great step forward. These initiatives should be coupled with stricter planning regulations favoring renovation projects over ground-up developments. Finally, tax incentives could be introduced to reward developers / investors for improving the energy efficiency of buildings under renovation or redevelopment schemes.
Modern renovation / redevelopment projects are typically more complicated than ground-up developments increasing execution risk. Furthermore, developers need to educate themselves on the principles of circular construction since it is a relatively new concept. EGD could launch an extensive information campaign with the help of local authorities at member state level to provide technical support to developers and construction companies. It is also recommended to engage with innovative construction and civil engineering companies throughout the EU with track-records in the aforementioned building techniques.
EGD, in co-ordination with national governments, should impose stricter planning restrictions when it comes to ground-up developments. If developers were to find it more difficult to secure permits for ground-up developments, they would spend the time and effort to make projects viable through renovation and redevelopment programs. Certain European cities are already requesting that real estate developers exhaust all potential redevelopment plans before presenting ground-up alternatives. This is especially pertinent in inner-city locations where maintaining part of older structures also preserves the historical aspect of the area.
It is important to reward developers for improving the sustainability of the existing building stock as they assume more risk through execution of renovation / redevelopment projects. One way could be to grant tax incentives on the construction budget based on the improvement of the energy label at completion. This will incentivize developers to take on redevelopment projects and to aim for the highest sustainability level possible.
It is rather frustrating that certain real estate investors have associated a handful of highly sustainable, state of the art new buildings as living proof that the industry is turning the page towards ESG. The elephant in the room is existing buildings with lower sustainability standards. Capital should be allocated towards improving the overall sustainability of existing buildings instead of engaging in greenfield or brownfield ground-up developments just because the delivered properties would be great for marketing. Developers are following the money and if investor perception towards sustainability doesn’t change from trophy assets to improved assets, ground-up developments will be favored over renovation / redevelopment projects to guarantee high sustainability scores and lucrative exits.
It is in the best interests of the EU to become an advocator for renovation / redevelopment projects following the standards of circular economy. The European Green Deal can raise awareness and provide technical as well as financial support in the form of tax incentives to developers. At the same time, stricter planning restrictions would prioritize the improvement of the existing building stock and would maintain a strong balance between new built and refurbished properties.
In the next article, we will discuss the European Green Deal from the perspective of debt financing providers.
CHRISTOS ANGELIS, CAIA, Director at Masterdam, 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.
[iii] A European Green Deal