Decarbonizing real estate: How to price the net zero transition to avoid a ‘carbon bubble’

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Kalin Bracken, Lead, Real Estate, World Economic Forum

• Real estate is the world’s largest asset class and also one of the most significant contributors to global carbon emissions.
• Actions to decarbonize the sector have accelerated, but transitioning existing building stock remains a serious challenge.
• Transition costs need to be factored in now to ensure that the industry does not face a ‘carbon bubble’ valuation crisis.

Real estate is the largest asset class in the world and it’s also one of the most significant contributors to global carbon emissions. As recognition of the existential threat of climate change grows, actions to decarbonize the sector have also gained momentum, however the speed of change must exponentially accelerate to meet key climate targets.

One of the greatest challenges lies in transitioning the existing building stock, 80% of which will still exist in 2050. Renovation rates hover around 1-2% per year, however, and the percentage of those that are green retrofits is likely much smaller.

Furthering this challenge is the absence of broad market recognition of both the cost to transition these buildings and the cost of delaying, or failing to.

Failure to account for net zero transition costs results in overvaluation – or a carbon bubble

The Urban Land Institute Europe (ULI), a global network of cross-disciplinary real estate and land use experts, recently stated that “European property owners, investors and valuers have failed to account for the cost of transitioning to net zero, resulting in a widespread overvaluation of offices, shops and residential property… if transition risk costs are not factored in now by owners, then the industry could face a major crisis.”

The ULI warns of a possible ‘carbon bubble’ where the continued lack of pricing this transition risk keeps asset values artificially high and further perpetuates the chance that they ultimately become too costly to retrofit, resulting in widespread stranding of assets.

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A stranded asset is one that has prematurely lost its value, often immediately, due to certain factors such as regulation changes or changes in demand. In this context, it is directly related to emissions.

The risk of this occurring is not a distant future possibility, but rather an imminent reality of this decade. According to recent research from JLL, the 2022 GRESB (Global ESG benchmark for real estate related financial products) results show that the average Carbon Risk Real Estate Monitor (CCREM) stranding year of GRESB-submitted buildings is 2025.

Risk of carbon bubble an imminent threat

Further driving the increasing price disparity between green and brown – often referred to as the brown discount – are both demand side drivers and regulation, according to JLL.

Many governments are either already doing so or planning to financially penalize owners that do not meet certain emissions standards adding to the cost of inaction.

Demand for green buildings is also growing, especially from large corporations pursuing their own climate targets and continued research demonstrates that many commercial occupiers are willing to pay a premium for extremely efficient buildings.

Many investors do price climate risks, including the cost to transition assets to become more efficient and meet certain standards set by government bodies, and those required by their investment partners.

But they do so in a proprietary way, bespoke to their own organization and investment thesis, and rarely share the results with broader stakeholders.

The lack of a standard approach for assessment and disclosure means buildings will often continue to trade at current market values because there are still buyers willing to acquire them that may not be factoring in these costs fully, or lack the sophistication and awareness to do so.

According to ULI’s Transition Risk Assessment, the following carbon bubble risks can be modelled currently and can be added to standard analyses in order to better reflect actual costs:

• Costs of decarbonization
  Present: The amount of investment required to decarbonize an asset in alignment with the 1.5ºC pathway (costs of materials, labour, advisory).
  Future: The potential impact of geopolitical related uncertainty, inflation and supply chain issues.
• Energy costs
  Present: The change in energy costs before and after decarbonization efforts (factoring in current inflation, possible storage and sale back to the grid, etc.)
  Future: Future earning potential and inflation-linked assumptions on future pricing.
• Carbon price
  Present: All forms of existing carbon pricing (that most likely impact asset owners and tenants indirectly through energy costs for example) (does not including offsetting).
  Future: Potential future mandatory carbon pricing such as global Taskforce on Climate-related Financial Disclosures (TCFD) requirements or others that may impact owners and tenants directly.
• Depreciation
  Future: Depreciation of technologies and hardware related to decarbonization activities
• Rental income change
  Present: Possible change in rental income as a result of decarbonization.
  Future: The impact of wider market influences beyond the asset’s own decarbonization pathway.
• Tenant voids
  Present: Tenant void periods as a result of tenants needing to vacate to allow for decarbonization retrofits or longer void periods at lease expiry to accommodate retrofits. Future: Estimates of future rental income loss for voids needed for future work.
• Embodied carbon
  Present: Financial responsibility for embodied carbon within an asset. This is the carbon that is emitted as a direct result of the construction phase, renovations, and end of life disposition.
  Future: Carbon emitted from future renovations or disposition. A rising carbon price, and improving embodied carbon efficiency and technologies will add to the risk of a carbon bubble.
• Exit yield
  Present: The role decarbonization will play on total possible impacts to the property yield at sale. These can include influences ranging from tenant quality to energy costs to investor demand.
  Future: As in the case of the present day, the impacts can be wide and variable, and the risks must be quantified using a systematic method.

Discover

What is the World Economic Forum doing to support the Future of Real Estate?

While investable real estate has grown by more than 55% since 2012 (PwC), the COVID-19 crisis has underscored weaknesses in relation to human and planetary health along with drastic inequalities, leaving a stark reminder of the influence the built environment has on societies and the vulnerabilities that exist in times of crisis regarding how spaces perform.

As the real estate industry looks towards recovery, the need for transformation is clear. Portfolios must be rebalanced, and distressed assets repurposed. Technology must be fully embraced, and sustainability and wellness must be at the core of design and operation. The affordable housing crisis that already existed pre COVID-19 must be systemically approached to ensure access to adequate and affordable housing. If the Real Estate industry is to deliver transformation, it is more important than ever to ensure that policy, financing and business solutions are aligned in delivering better buildings and cities.

The World Economic Forum has brought together CEOs from the Real Estate industry to develop a Framework for the Future of Real Estate to help drive the industry’s transition to a healthier, more affordable, resilient and sustainable world.

There are additional transition risks cited by ULI such as reputational risk, insurance and the access to debt capital that are not yet possible to model, but the industry should nonetheless be mindful of and eventually factor in as they become more quantifiable.

Properly accounting for both the potential costs of decarbonization and inherent value in doing so, along with the cost of inaction, is essential to any industry and real estate is no exception, especially given the value of global real estate and the impact of buildings on public and planetary wellbeing.