Why Green Is Good and Brown Is Down

This article was written by CBRE Canada Chairman Paul Morassutti

As awareness around sustainability and decarbonization builds in Canada’s commercial real estate industry, questions related to the “green” value premium (or conversely, the “brown” value discount) abound.

One of the most common questions I receive is: What is the value premium associated with green buildings? While the question is legitimate, especially in light of the considerable capex involved in decarbonizing a building or portfolio, I believe it may be wrong question to focus on. The real question is: What is the risk of not being green?

Green Building Definition – What is Green?

Before we consider the impact on value, we must first define what constitutes a green building. There is no shortage of potential definitions: Net zero carbon as defined by the Canadian Green Building Association (CAGBC), Net Zero Ready, LEED, LEED Platinum, BOMA Best, and WELL certified, to name a few. There’s also the potential for Energy Performance Certificates to become more of a factor as they are in the UK as well as numerous other acronyms already in use in Europe and the UK.

A recent survey completed by the Royal Institute of Chartered Surveyors (RICS) indicated that lack of common standards and definition of green buildings is a key obstacle to investment in sustainable buildings in the UK and Europe.

If we assume that, at a minimum, a green building would be one which has a sustainability certification of some sort, then why all the confusion about value? In Canada, we have been building office buildings to a LEED standard for close to 20 years. In downtown Toronto alone, there are 46 Class A office buildings with either a LEED or BOMA sustainability designation. Many LEED-certified buildings have sold and yet the discussion regarding LEED value premiums faded away years ago.  

280 King Street East was built in 2005 and was one of the first LEED-designated office buildings in the city. This development sparked discussion about whether the merits of building to a LEED spec were worth the higher hard/soft construction costs. There was intense interest in knowing if tenants pay a premium or if the building value would be higher. The discussion then was almost word-for-word the same discussion that we hear today.

And while it was quite legitimate for developers to question construction costs and returns given the enormity of office development and required capital, the issue was settled once occupiers (starting with the big ones) made it known that they would only be occupying these types of buildings going forward. As soon as developers understood that building a non-LEED office would result in an economically obsolete building the day the doors opened, the discussion was over. LEED became the de facto building code in the office sector.  

The dynamic today has evolved but is effectively no different. Substitute “net zero” for “LEED” and it is the same. The number of tenants who have made net zero commitments is growing every year. Developers will respond by providing product that matches demand. Doing so ensures that their buildings will appeal to the widest group of tenants and will remain competitive into the future. 

The Case for a Green Premium is Compelling

Notwithstanding the comments above, the general case for green building premiums grows stronger by the day. Factors that support Green Premiums include:

1. Demand from both occupiers and investors is growing.
   For many occupiers, compromise is not in the cards. They want to occupy premises that are aligned with their net zero commitments, and the unreported reality is that there is a shortage of this type of space.  Similarly, investors want to own future-proofed product. A recent Realpac survey indicated that almost half of its members have Net Zero Carbon targets and 68% are currently reporting on their Scope 1 and Scope 2 emissions. These percentages are growing with each year. Whether it is brand new construction or decarbonizing existing portfolios, sustainable buildings will play a prominent role in preserving asset value as occupiers increasingly shy away from properties with subpar environmental performance. Simply put, if buildings appeal to broader tenant and investor bases, they will be worth more. 
   
   
2. Sustainable buildings have lower operating costs.
   Lower operating costs mean a building can achieve higher face rental rates and the combination of the two results in higher Net Operating Income.
   
   
3. Increasing regulatory risk.
   The number of ESG regulations affecting property owners has soared over the past few years as governments and industry bodies mandate green reporting standards. In New York, Local Law 97 came into effect this year and will require buildings to meet energy efficiency and GHG limits beginning in 2024 with stricter limits kicking in by 2030. Buildings that emit too much greenhouse gas will face stiff penalties. Many other North American cities are adopting similar policies, including Vancouver, which recently became the first Canadian city to regulate GHG’s produced by large buildings (Annual Greenhouse Gas and Energy Limits Bylaw). We expect building performance standards to increasingly become the norm rather than the exception.
   
   
4. Availability of debt capital is certain to change.
   Virtually all of the big Canadian banks have strong net zero commitments, and all are members of the Partnership for Carbon Accounting Financials (PCAF). Financed emissions, those emissions attributed to lending, are the real issue. Some groups estimate that the combined carbon footprint of Canada’s eight biggest banks is over twice that of Canada as a whole. Banks will not be able to advance their net zero goals by lending to brown assets.
   
   

While the case for a Green Premium is compelling, the downside risk of brown buildings is even greater. Stranded assets, meaning assets that have emissions higher than they should have and where it is not economically feasible to decarbonize, face a punishing future, especially in the office sector. Fewer tenants, fewer lenders and fewer buyers await these assets in the future.

The Appraisal Dilemma - Part I

Owner: “We are spending considerable capex in decarbonizing our assets and our appraisals are not reflecting any value premium”.

Appraiser: “Appraisers do not set the market, they reflect it. Without comparable sales of green buildings, we cannot rationalize Green Premiums. We need evidence”.

And thus the standoff.

The Appraisal Dilemma – Part II

Some have suggested that a new valuation methodology that specifically deals with sustainability could be useful, while at the same time reiterating that comparable sales evidence is necessary before Green Premiums gain traction.
I believe the methodology framework is already in place. While no one disputes the primacy of actual sale data, if appraisers believe that the solution to this problem is to wait for clear evidence of premiums embedded in new benchmark sales, they may be waiting a long time.

Let’s first consider how a Green Premium (or conversely, a brown discount) would be reflected in an appraisal. The first area is operational and relates to the forecasting of cash flow. Many of the benefits noted above (higher rent due to operational efficiencies, lower structural vacancy, capex, etc.) are baked into the Net Operating Income/Cash Flow forecast. Appraisers already make educated assumptions about NOI/CF growth, and sustainability considerations should be treated in the same manner. Appraisers already incorporate capex/amortization assumptions in their appraisals – is an energy-saving capital expenditure that different from an office lobby renovation?

Underwriting NOI/CF is part of the equation. This leaves the selection of capitalization rates and IRR’s (yields) as the other main variable. And admittedly, in the early innings of ESG awareness, this can be tricky. But it is not impossible.
When selecting a cap rate, an appraiser or investor must weigh all of the investment attributes of the asset – market considerations, macro and micro locational characteristics, physical considerations, amenities, tenant profile, lease expiry schedule, contract rent vs market rent comparison, rental growth, among others. Sustainability is an investment attribute and should be considered in the same way – as one of many attributes that can impact the risk profile of the asset being valued.

The question du jour – “what is the Green Premium” - suggests that appraisers should be able to isolate the specific value impact of any of those investment attributes, and ideally this value attribution should be supported by market evidence.

We need to acknowledge that this may not be possible. The old adage that appraisal is both art and science is very true and trying to parse out an accurate value premium for any one attribute is extremely difficult. The best way of doing it is by finding two comparable transactions that are alike in every aspect but one – the difference in pricing can then be logically attributed to that one variable. This is an appraisal theory that works well on paper but in real life – not so much. 

As an example, consider two office building sales. Let’s assume that we want to isolate the value impact of a lease expiry schedule that has no lease exposure for the next five years compared to a sale where there was a significant amount of rollover in the next five years. One has no leasing risk and the other has considerable leasing risk. Clearly the cap rates should be different and appraisals should reflect this.

But how? By pointing to these two transactions? For these comparable transactions to be of any use in specifically identifying the impact of less leasing risk, they would have to be alike in every other respect – same market, same market fundamentals, same timing, same tenant covenants, same physical attributes, same everything. If one could find such a unicorn of paired sales, then perhaps a specific value impact could be identified. Even then, it is only one data point.
In reality, appraisers and investors both have to work with imperfect sales information and always have. The property market is a rather murky world. 

This is the reason that, although LEED assets have been appraised annually for over 15 years in Canada, and many have sold, there isn’t an appraiser in the country who can tell you with precision what the LEED/Green Premium is. As much as we seek to use greater sophistication and analytics in the real estate world, art is still just as important as science.

The Way Forward

If you accept that any of the points made in favour of Green Premiums are valid, then green buildings should display higher values than similar buildings, all things being equal.

There is nothing controversial about that statement since any building that reflects a superior long term competitive advantage, has lower operating costs, lower financing costs and better overall liquidity, always reflects premium pricing. Appraisers will have to exercise judgment, especially with regard to the selection of yields (cap rates and IRR’s) but assessing the overall risk profile of an asset is part of the job. Sustainability features are just another attribute that must be considered amongst many others.

What is difficult to say with certainty, is how long the value premium will last. We would expect to see first mover advantage to those groups who holistically embrace sustainability but eventually, as we saw with LEED designations, the playing field will begin to even and premiums will converge to simply being the norm.

The real risk is doing nothing. Ownership that ignores what is clearly a growing trend will face regulatory costs/penalties and severely diminished liquidity. In the office sector for example, many buildings are already melting ice cubes – properties for which value will only go down. Unlike the Green Premiums converging to become the norm, we expect the brown discount to be long lasting.

At the end of the day, poor stewardship is expensive.

As the Green Premium issue continues to unfold, the CRE industry should consider the following: 

• There is a growing body of literature, studies and surveys on sustainability. Market participants should take advantage of this information. Most institutional funds and public companies publish excellent annual ESG reports. Organizations such as REALPAC and RICS also publish sustainability reports and provide sustainability guidance to their members.
• Owners: communicate with your appraisers. Explain the decarbonization programs underway and connect them to your sustainability consultants, if necessary. If your appraisers are not asking any questions about sustainability features, or if their reports are silent on any aspect of sustainability, you may be using the wrong appraisers.
• Appraisers: Get up to speed. Too much of the appraisal industry in North America is behind the curve on ESG-related matters. You are not expected to be experts in this field, but, at a minimum, you have to be conversant with the issues.
• Everyone: Think globally. While many in North America are grappling with sustainability questions, we can learn from other parts of the world that are ahead of the pack.

Let these comments from European real estate professionals provide helpful guidance:

“There is no investment strategy that is not inclusive of a climate strategy Climate is as important as interest rates and debt. If you don’t include it in the investment decision you make, you are missing out on a lot of the risks and returns that are there in the market” - Xavier Jongen, Managing Director at Catella Residential Investment Management, which manages a $7B portfolio across 10 European countries.

“There is a straightforward, linear risk related to environmental factors. It is much more black-and-white than it was even five years ago. It starts with obsolescence. If your building doesn’t comply with regulations and with the accepted institutional standards, it will suffer a discount in value as well as reduced liquidity” – Pavlos Gennimatas, Managing Director, Hines European Living