On the 29th March, AREF released a report for its membership of UK Commercial Real Estate fund managers entitled "Sustainable Value: a common approach to the commercial benefits of sustainability in UK commercial real estate". This was the output of six months of collaboration by an AREF working group which included the expertise of BBP members abrdn, Aviva Investors, CBRE Investment Managers and Fiera Real Estate.

While there have been several publications about sustainability and value, many focus on trying to quantify premiums or discounts, or take a proactive view on how sustainability should be considered in valuations. These are important, but what was missing was a practical description of what could or should be done today. How should fund managers recognise sustainability features within the RICS Red Book valuations?

Valuers have a specific and regulated role

A key part of this paper is to explain the role of the Valuer and recognise what they can or cannot consider. A commercial real estate valuation is a highly regulated and complex assessment of an asset. Some valuers use discounted cashflows, others use traditional ‘comparables’. The result is a simulation of a transaction at the time of the valuation and provides an opinion of what the result of a sales process would likely be; the fair market value of the asset.

Valuers require market evidence to support their assessment of fair market value, usually analysing recent transactions to better understand how the market is interpreting value in an asset. This also provides a challenge, as the rapid evolution of sustainability has resulted in a wide range of potential features, many of which will have low market coverage.

Recognising ESG impacts is not straightforward

To be recognised to enhance value, these features must become a part of market evidence and be recognisable within transactions. If all market participants are looking for different ESG related features, they will treat the features differently, reducing the recognisable impact on asset value. If the feature is too complex and specialist, it may not be recognisable even if within a transaction.

Even if the feature is there and the transaction has occurred providing market evidence, the feature is among many others and no buyer is explicitly listing out their purchasing preferences and priorities. So we don’t get an itemised list of what value to apportion. Where we see stated green premiums, they are usually from whole market analysis trying to determine what value was implied within the market.

Today versus tomorrow’s value

Add to this the nuanced difference between value and future value protection, which arguably uniquely affects sustainability features. For example, climate transition risks are unrealised risks which are growing between today and when we have transitioned our economy. As the risk is not yet realised, and there are no examples of fully realised risks, the market evidence is not available to price into transactions or reference in valuations.

That does not mean that fund managers should ignore these risks. A fund is looking to increase value over time, and fund managers will deploy different strategies to deliver returns. These are, in effect, bets on future value. To complete the above example, proactive management of transition risks may not yet significantly impact today’s value, but it is a reasonable bet that a transitioned asset will experience a significant value benefit over a comparable building which isn’t. There are many reasons for this: tenants and potential investors have decarbonisation strategies which say they’ll prefer it, we know it will be less exposed to regulations, it will likely be less expensive to operate and we anticipate it will be easier to finance or insure.

However, currently the market evidence behind this bet is not strong: the number of transitioned assets are few, the definition of a transitioned asset is not always clear and can be confusing (especially to market participants without sustainability skills), and those who have invested in transitioning assets are not typically selling them.

An information challenge

Recognising sustainability in asset valuations is an information challenge. The AREF paper seeks to address this challenge by explicitly setting out standard metrics which all fund managers (and other market participants), and their valuers, are recommended to analyse to determine value. The rationale is explained and we set out how these may impact how valuers recognise the related capital expenditure.

While far from exhaustive and by no means the final word on the matter, drawing together common sense and common practice allows the market to do several things. First, we hoped to provide confidence in these metrics to the market so they are adopted as standard. Fund managers may use other metrics alongside these to make more refined bets, but at least they’ll understand what valuers are using to assess performance. Second, by putting together what is current practice, we were able to also review what ESG metrics are not observed across the market and why. Social or biodiversity indicators are examples of these. Third, we can recommend process improvements to fund managers and valuers, such as standardising market evidence and interpretation of capital expenditure.

By doing these things we’ll improve the quality of market evidence and make the basis of how sustainability features or ESG risk easier to interpret across the market. This will, in turn, improve the signals which allow the market to function in how it prices these features. However, we all hope that the AREF guidance is superseded quickly as the market evolves and functions more effectively in incorporating ESG risks.

Adam Baranowski, Climate Change Programme Lead, Better Buildings Partnership: “The incorporation of sustainability into real estate valuation is a major challenge for the market, but we know it will be an important enabler of the net zero transition. It is essential that real estate fund managers and valuers understand their roles in making this possible, as well as each other’s. This AREF report, which has been produced with support from BBP members abrdn, Aviva Investors, CBRE Investment Managers and Fiera Real Estate provides a clear description of why this is such a thorny issue, and what can be done today to begin to unpick it. It includes practical recommendations around metrics and process improvements which could be applied in any real estate business.”

Access the report here.
 

Written by Sam Carson, Head Of Sustainability, Valuations and Advisory Services at CBRE UK. Chair of AREF Sustainability and Value Steering Group.