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Changing tide of regulation may leave some assets stranded

Teun van den Dries

Just a few weeks ago at COP21, the climate conference in Paris, world leaders committed to challenging targets on climate change - and specifically CO2 reduction.

Over the past six months, some major investment firms have committed to significant reductions of CO2 emissions in their portfolios. As governments and electorates expect carbon reductions, businesses face a painful period of adjustment. In the front line are producers of fossil fuels, which worry about their oil and gas fields becoming ‘stranded assets’ that will be wiped off their balance sheets under tighter CO2 rules.

And the property world can expect to experience a similar effect. About 5%-8% of a typical investment portfolio is in property and residential and commercial real estate together are responsible for around 40% of all global carbon emissions. Of course, this isn’t just altruism for its own sake; green buildings make good business sense as they attract lower vacancy rates, better tenant retention and higher rents.

The UK shows how government regulation can drive refurbishment. The UK government has mandated a minimum EPC (Energy Performance Certificate) label for commercial buildings by 2018 and buildings that fall below the standard must be vacated. Although listed buildings are exempt from the regulations, this will facilitate the disposal of non-compliant buildings and improve the stock.

Pension funds and other institutional investors that have large property holdings in their investment portfolio are starting to factor emissions into portfolio management and this in turn will drive their investment towards sustainable buildings.

There is a growing trend by major property investors to upgrade or divest in order to improve a property portfolio. Dutch pension funds ABP and PGGM are good examples of this, committing to significant reductions in their carbon footprint over the next four years of 30% and 50% respectively.

Property development and investment are driven by demographic as well as economic growth. Demographic pressure in the developed world has continued to drive predictable growth in residential property and this shows no sign of stopping. However, commercial property hasn’t followed suit. New work practices and online shopping have radically altered the balance of supply and demand. Some assets, such as mono-functional office parks and smaller regional retail centres, will be pushed into the frame for demolition by this lack of demand combined with unsuitability for upgrade. Like the oil and gas fields that will never be tapped, they will become stranded assets.

The current building stock does not quite meet current demand and might be in the wrong size or in the wrong place, but extensive new construction doesn’t seem to be required. It remains to be seen whether the developing world will catch up incrementally or in one giant bound. In the same way as many people in Africa made a mobile their first phone, bypassing a landline, appetite for commercial property may suddenly slow there too.

As the focus for property investors shifts from fresh construction to upgrading existing stock, new strategies will be required to upgrade that existing stock, use existing assets more effectively and identify and remove the stranded assets. When these strategies are in place investors will be better able to follow the sustainability lead set down by governments in Paris in December 2015.

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