The Green Rental Valuation Challenge

Following up on a recent post on the challenges (you should never call them problems apparently) of reflecting the environmental performance of real estate assets in their valuations, I also had to do some work that forced me to think about the transmission of environmental performance to rents. Sometimes developers and/or investors want to know (to two decimal places) how much extra rent they can expect for producing buildings with strong environmental performance.  The arguments about “the need” for valuers to reflect environmental performance in their valuations if developers and investors are to adopt environmentally beneficial technologies etc.  have long been made.  As you might know, I tend to think that this is mainly about valuers obsessing about the importance of valuations rather than any major “need”.

Past experience tells us that valuers tend to formulate simple heuristic procedures when faced with complex valuation problems and end up with simple ‘rules of thumb’. E.g. 10% rental premium for a return frontage, 1% increase in rent for each additional year for a non-standard rent review period, first floor retail is 10% of Zone A etc.  In practice, it’s well-recognised that such simple ‘rules’ failed to take into account important variations.  For instance, there could be major variations in footfall in different return frontages.  The quality of first floor retail space depends on the quality of access.  The losses of having a long rent review period tend to vary with the level of rental growth.

In the same way, we’d expect factors causing rental premiums for buildings with good environmental performance to vary over time, between different tenants and between different markets – and to vary in degree.  You usually see a binary distinction made between “green” and other buildings.  I do it myself here a lot.  There’s rarely any acknowledgement that environmental performance tends to be a continuous variable.  It’s more like age.  We don’t generally classify buildings into old and modern.  We tend to focus on their age or period of time since the last major refurbishment.

I suspect that, ideally, valuers would like to be able to do simple adjustments. Something like…Compared to the average building (whatever that is), for a BREEAM Outstanding, Excellent, Good etc, valuers should add on 10%, 5%, 2% etc. respectively to the Market Rent.  Or compared to a building with EPC D, you should subtract 2%, 10% or 15% respectively for a building rated EPC E, F or G.  Of course, buildings that are BREEAM Outstanding may be outstanding in all sorts of other ways that need to be taken into account as well.  In the same way, buildings that are EPC G rated may have lots of other problems that also need to be taken into account in estimating the Market Rent.  The large scale studies of price effects that have been done tend to estimate what average price premiums were for at a broad market level.  They don’t tell us what the actual price premium is or should be for a specific building. This is the type of information that appraisers typically need to have.  To me, the problem (challenge) is that rental premiums are likely to vary so much over time and space that simple rules are likely to be arbitrary.

Looking at some of the key attractions of buildings with good environmental performance…

Lower operating costs. I’d expect tenants that tended to consume high amounts of energy or other utilities to make greater savings in buildings with good environmental performance.  This will be influenced by their operating hours, density of occupation, equipment used and other behaviour of the property managers and the workforce.  Climate will also be a factor.  In a market such as the US, this tends to be measured in heating and cooling days.  Broadly, we’d expect that occupiers with above average consumption should be prepared to pay most for utility efficient buildings and should, in turn, determine the extent of rental premium caused by this advantage.

Productivity. This, I think, is the big one.  If it could be convincingly proved to businesses that there was a significant positive relationship between building environmental performance and output per worker, then I suspect that pretty much every commercial building would have high environmental performance.  For many organisations, especially in the service sector, it’s tricky even to measure output per worker, never mind how it varies with salary, manager, resources, etc.  At Reading, we moved from an obsolete 1970s building to a brand new shiny building about six years ago.  Did our productivity change?  It’s hard to imagine how you’d isolate it.  Out staff base changed, our students numbers changed, our management changed, our IT changed  at the same time.

In the research that I’ve seen, fairly remote proxies tend to be used to measure productivity such as staff turnover, sickness days, staff satisfaction etc.   So we don’t have much convincingly evidence yet.  However, I’d be surprised if there wasn’t substantial variation between different business sectors in the relationship between building environmental performance and staff productivity.  I’d like to be contradicted but, as far as I’m aware, the empirical evidence on the relationship between building attributes and productivity remains weak here.

Corporate Social Responsibility. This covers the reputational, brand or image benefits associated with occupying buildings with good environmental performance.  It’s no accident that we see clusters of LEED buildings in Houston or San Francisco where concentrations of oil and hi-tech companies for different motives tend to have stronger preferences for buildings with strong environmental performance.  Again, we’d expect the CSR-type benefits of buildings with good environmental performance to vary between different businesses and different business sectors.

Supply. All else equal, we’d expect higher rental premiums where there was a slower supply response to demand for buildings with strong environmental performance.  Cities that experienced above average increases in supply in the last 10-15 years are more likely to have a greater proportion of their stock that has strong environmental performance as voluntary and mandatory environmental standards have increased.  Put simply, cities with lots of new buildings are more likely to have lots of buildings with good environmental performance.

Regulatory risks. Business may also prefer to lease space which are less likely to be affected by potential changes to regulations and taxes.  It’s generally accepted that, albeit sometimes with a ‘two steps forward and one backwards’ pattern, the broad policy direction is of increasing regulatory requirements regarding building environmental performance.  Occupiers of buildings that perform well above current minimum requirements are less exposed to changes in minimum standards or taxation policies.  Having said that, there’s substantial risk in adopting some environmental technologies.  The fickleness of the current Government’s policy on feed-in tariffs etc. is a textbook example of how to generate uncertainty in a growing market.

Depreciation and obsolescence: Assuming that buildings with strong environmental performance tend to have the latest, most energy/carbon efficient technologies for lighting and heating/cooling, waste management etc., we’d expect that there would be a lower risk to tenants of having to pay for upgrades during their leases.

I’m not sure how coherent all of the above is as a case for variations in rental premiums over time and space. An added complication is that nearly all empirical studies present their findings as a percentage price difference between environmentally certified and non-certified buildings. This is essentially a relative measure.  However, especially where benefits are largely received in absolute terms e.g. energy savings are £1 per square foot, assuming this benefit were to result in a £1 increase in rental price per square foot, the relative percentage price premium would vary substantially between high value and low value cities.  In a city with a Market Rent of £10 per square foot, it would represent a 10% premium.  In a market with a Market Rent of £50 per square foot, it would represent a rental premium of 2%. Such variations are unlikely if the benefits of strong environmental performance are mainly absolute.  For instance, if the £1 saving in energy costs generated a £1 increase (that’s if) in rent, the £10 psf, expensive and cheap buildings would experience the same cash increases in rents but very different percentage increases.

I suspect that the inherent noisiness of the valuation process is hard to overcome. Judging Market Rents will remain a function of comparables.  There won’t be perfect comparables.  Buildings will be different in terms of location, age, specification, configuration – and environmental performance.  Different leasing transactions will have different leasing incentives.  Trying to adjust rental valuations for the specific effect, of sometimes difficult to observe, differences in environmental performance is likely to remain problematic, er, challenging.  It’s not a counsel of despair.  Valuers have always had to deal with these problems and this won’t change in the short term.  It’s fair enough to look for simplicity but we need to be sceptical of it.

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