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Will a sustainable investment strategy pay off?

uk

An increasing number of investors focus on sustainability, property investors included. The question is whether as property investor you are forced to compromise on the return on your investments when opting for a responsible and green investment strategy. In fact, theory and studies widely indicate that investors may benefit from improved operating profits as well as higher pricing levels if they make sustainable property investments. 

The property industry accounts for some 40% of global energy consumption and up to 30% of annual greenhouse gas emissions in the world1. Consequently, the potential for reducing the climate impact is believed to be substantial. A growing market awareness of climate change and the need for sustainable initiatives have caused a shift in general investor and consumer behaviour. Investors and consumers are therefore increasingly prepared to pay a premium when they invest in or buy products aligned with their personal values. By the same token, sustainable building has become a more central component of the investment strategy pursued by many investors. Mainly pension funds have put sustainable investment on the agenda with a strategic objective of combining profitability and overall social responsibility in their efforts to reduce climate impact.

1World Economic Forum, BNP Paribas Real Estate 

Whereas there was little evidence in the past to support that a green investment strategy may be profitable in the property market, it is today far more well-documented that this is in fact the case. Although sustainable building is still in its infancy in Denmark, it has to a great extent proved its worth abroad, and we are generally starting to see that sustainable new buildings tend to drive up both operating profits and selling prices relative to buildings that are not certified as sustainable.

Broadly speaking, we see three drivers that currently determine, to a greater or lesser extent, the price difference between certified and non-certified buildings: higher rental income, lower operating costs and lower yield requirements driven by reduced risk and stronger demand.

1. We see mounting tenant demand for lease premises in contemporary, efficient and energy-certified buildings, with indoor climate as one of the top priorities. Not only do businesses have expectations of improved staff health, well-being and productivity, but being a tenant in a sustainable workplace setting also has a certain signalling value that may help to promote a favourable corporate image. All this helps to support the propensity to pay and, by extension, it supports the rent levels of this type of property.

2. On top of a possible premium on the rent, current operating profits also stand to increase due to lower operating costs, mainly on account of savings in terms of water, heating and electricity consumption, provided investments are made in green technologies and sustainable measures. Multiple small-scale studies have by now documented that the net present value of the profit achievable by reduced operating costs should be sufficient to cover additional construction costs. And although savings often benefit the tenant in terms of lower consumption charges, it conversely means that the tenant may pay a marginally higher rent.


3. In addition, we see that the pricing of environmentally certified buildings exceeds the pricing of non-certified buildings. This largely ties in with the fact that certified buildings are associated with lower risk, for this and other reasons trading at lower yield requirements. For instance, the long-term vacancy risk is believed to be lower, the introduction by mortgage banks of ‘green bonds’ has driven down financing costs marginally, while liquidity in the segment is higher, with several investors increasingly earmarking certain capital allocations to green investments exclusively. The growing market liquidity is supported e.g. by several investors’ publicly announced strategies and recent acquisitions2.

 

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Short-term prospects of price premiums on account of environmental certification
 
As major investors are increasingly focusing on sustainable investment as one of their strategies, liquidity in the market for this asset class has grown considerably. The trend is therefore that demand and, by extension, the propensity to pay for environmentally certified buildings is marginally higher, and when the demand for certified buildings picks up, it should in theory drive up the prices of certified buildings relative to non-certified buildings in the short term.
 
Figure 2 shows the two different demand and supply curves for non-certified buildings (ncb) versus certified buildings (cb) in a simplified market model. As illustrated, the resulting equilibrium quantities and prices indicate that the prices of certified buildings in the short term exceed the prices of non-certified buildings. This is due to a higher propensity to spend and relatively limited short-term supply. 

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However, the market for certified buildings is not homogeneous. Additional costs and the propensity to pay are bound to increase as certification standards become higher, e.g. from DGNB Silver to DGNB Platinum. This results in different equilibrium prices and quantities for different levels of certification standards.

In the long term, the price premium on the market price is however expected to erode as the production costs of certified buildings gradually diminish. This pushes the supply curve down, causing an increase in the aggregate number of sustainable buildings as well as driving down prices.

Nevertheless, we consider it highly likely that certified buildings will continue to offer a competitive edge in future as it is fair to expect that building certification becomes a market standard. Longer term, this paradigm shift will serve to render non-certified buildings obsolete.

Appetite for sustainable property investments continues to grow

Mounting concern over global climate change increasingly impacts consumer and investor preferences, and like in other markets, a voluntary environmental certification system has emerged in the property market.

However, the certified building stock still accounts for a small market share, among other things because the demand for sustainable lease premises has been limited in the past, with investors therefore only being moderately incentivised to initiate construction or refurbishment to achieve some kind of certification or energy-label optimisation. 

Liquidity in the market for sustainable investment property has however seen a sharp increase as underlying investors in many circumstances demand an increase in capital allocated to green investments. Together with the stronger demand and limited supply in the short term, prospects of higher operating profits and lower risk have had the effect that today’s market pricing of investment property classified as sustainable is very different from the pricing seen just a couple of years ago, when we saw no significant gap between the pricing of certified and non-certified buildings. We are very confident that capital allocations to green and sustainable property investments will only increase as investors become more aware of this trend and realise that a sustainable investment strategy will actually pay off.  

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