I’ve had to spend some time recently reading about how valuers should incorporate the environmental/energy performance of commercial real estate assets into their valuations. It’s an issue that I find difficult to take too seriously. I’ve no doubt that there’s lots of plausible reasons to expect a positive relationship between environmental and financial performance. The tangible and intangible benefits of lower operating costs, improved lettability and saleability, lower depreciation, indoor environment quality etc. have been long preached – albeit less proved. There’s still a strong story to tell. But it ends to be more narrative than calculative.
A key problem in isolating price effects is that lots of the performance variables are also linked to the age, quality, specification and design of buildings which are, in turn, linked to energy efficiency and carbon emissions. Lots of variable affect the valuation of a building. In the standard income method, value is essentially a function of four variables – rent, yield, time and transaction costs. Differences in rent and yield (the two non-factual variables) between buildings tend to be driven by location, building specification, building design, age, tenant quality, unexpired lease term, operating costs and, er, environmental performance. I may have missed some. Typically, in sales particulars it is the location, building attributes, tenant attributes and lease attributes that are heavily stressed.
There’s no Valuation Information Paper telling valuers why they need to incorporate differences in operating costs, unexpired lease terms, location, tenant quality etc. into valuations. The environmental performance seems to have been privileged here. It seems to me that valuers such as Sarah Sayce and David Lorenz with an interest in sustainability and climate change have found a receptive and sympathetic institutional response from professional bodies that want to be seen to be responding to this highly important issue. I wouldn’t for a second question the integrity of the individuals and the institutions in this regard. I think that they’re trying to do good. Not surprisingly, valuers have focussed on valuation. What about fund managers, asset managers, developers, contractors and other professionals in the commercial property supply chain? However, I’m not sure that Valuation Information Papers have really offered any practical help for valuers.
Maybe a decade ago, I had a conversation with a researcher about the practical hurdles that existed for valuers who were being criticised for acting as a barrier to the adoption of so-called ‘green’ buildings. The researcher was part of a well-funded project charged with developing a model for incorporating the environmental performance of commercial real estate assets into a financial appraisal model. The researcher blithely asserted that, because it was important to do it and they had promised to do it, they would do it. They would overcome the practical difficulties of quantifying the effects of environmental performance on depreciation, rental growth, exit yield, void rates etc. It was never going to happen. We’ve only got a broad-brush understanding of what drives these variables, nevermind how they are affected by the environmental performance of assets.
I suspect that it goes back to our propensity to want simple answers to complex questions. We still don’t know that much about how tenant quality, design or unexpired lease terms affect Market Value. It is tricky enough to estimate the typical effect of a building characteristic on its Market Value. However, for something like sustainability, it is even more problematic, effects are likely to vary over time and between buildings with different levels of environmental performance. It’s hard to extract the effects – if there are any – from transactions. Valuers could estimate how much variables such as energy efficiency should affect Market Values – but there can be a lot of subjectivity here.
I appreciate that this sounds negative. In the absence of clear and numerous market signals from deals (sales and lettings), I don’t think that there is a practical solution for valuers. Just because a solution is needed doesn’t mean that a solution exists. However, if someone is prepared to pay for a solution to be developed, someone else will invariably have a go at producing one. Even if failure is highly likely, we tend to learn quite a lot in the process.