Environmental IQ

Carbon price will make sustainable property a winner – 86% of tenants say environmental performance is critical/

By Leon Gettler

8 July 2011 – Capital market players say sustainable property might soon become a better investment proposition. A carbon price will force up energy costs. In a carbon market, building owners and investors who know how to slash operating costs will have a competitive advantage.

Emlyn Keane, head of property management and sustainable performance at AMP Capital, says the prospect of higher electricity charges will put pressure on building owners to reduce operating costs. A greener building produces real energy savings which means lower costs. That makes the building more attractive to investors.

“It means that where we do an investment analysis of an upgrade project around sustainability and put a price on electricity and work out a pay-back period, if there is an extra tax on top of the energy cost, I can then do a far more attractive business case to put something into a building that will improve its sustainability credentials,” Keane says.

“These buildings are largely net leases and the tenants will be paying a lot of the carbon tax as it passes through the operating expenses. They will press upon the owners, what are you doing in this space to reduce my energy costs.

If you have landlords who are paying the costs directly, it will have an immediate strong driver for them to invest in sustainability upgrades of the building. And if you’re a fund manager and the property manager can reduce the operating costs, then that’s a higher driver to increase rents.

“If you go out into the market with low operating costs, it becomes an attractive element to leasing the space.”

AMP tenant survey finds high regards for environmental qualities

The biggest investment risk with property is an empty building with no tenants and no cash flow. Keane says a recent survey from AMP Capital of 700 tenants found that 86 per cent said they considered environmental credentials – meaning lower energy costs and a more productive working environment – were critical when deciding whether or not to take out a lease. For property investors, sustainability is about risk management.

Sustainability also allows building owners to increase rents, making them more attractive to investors. AMP recently upgraded the National Australia Bank building in George Street Sydney to a four and half stars NABERS rating. The rent went up and the return on investment was immediate.

A recent report by the IPD Property Index found that sustainable buildings delivered better returns. It showed that over the two years to March green, or NABERS and Green Star rated assets outperformed non rated assets.

Still, some say the jury is still out on whether sustainable property is a good investment and delivers superior returns. Certain investment managers say it’s still too early. The problem for property investors is that the returns might be long term. But that, Keane says, is the nature of sustainability.

Keane says: “In essence, the word sustainability is about sustaining for the long term.”

AMP Capital was so convinced that sustainability was a good investment proposition that it restructured its property division to align it with sustainability.

Sustainability working with property

Rather than having a separate sustainability group rolling out its own initiatives, it brought that into property so that everyone was working to the same agenda.

“We recognised early that it was going to be something that was part of property management and not an add-on that was here today and gone tomorrow,” Keane says.

“It’s intrinsic to everything we do, whether it be leasing, whether it be maintenance contracts, whether it be utility supply negotiations and tenants.”

But some fund managers are not completely convinced. Fund manager Adam Murchie from Forza Capital says many potential investors demand to see concrete evidence that sustainable property will deliver superior returns. It’s not something they demand from other assets.

“It’s unfortunate that in this era of liability that everybody wants to point to something as to why they have taken a course of action whether it be developing a sustainable building or investing in one,’’ Murchie says.

“You are asking someone to make a decision now that may not manifest itself in a portfolio for five or 10 years. So an institutional super fund will have league tables that are based on three, six and 12 month performance so the retail mums and dads deciding where to park their money are looking at three, six and 12 month numbers.

“But an institutional fund holds people’s money for 40 years or longer. How do you match that up when you are being measured on very short term but trying to make decisions for the long term?”

VicSuper, not convinced

Peter Lunt, head of investment research and governance at VicSuper, for example, is not convinced that sustainable buildings outperform. Nor does he see sustainable property becoming an asset class, despite more of it coming on to the market.

“I don’t believe it’s heading that way towards becoming an asset class,’’ Lunt says. “Fundamentally, you are investing in bricks and mortar and the behaviour of that asset should be no different to the broader risk-return parameters you would expect from property.

“My own view is that we would see no difference in net return back to us. From the people I have spoken to, it’s very hard to isolate the value that comes from whether you’re investing in green property or refurbishing it to green standards.

“Secondly, I think it’s too early to tell. We have been through one property cycle since the age of green building started and there is not enough of a track record to say there is any outperformance.

“Now, there is some evidence to suggest that you can retain your tenants a bit better and that tenants are a bit stickier which tends to suggest you get better valuation. However, when I ask our guys what the valuers are saying, they say nothing.”

Even if electricity prices become more expensive with a carbon price, it does not necessarily make the sustainable building more attractive, he says. It depends on whether the tenant is paying net or gross rent. Does the tenant see the bill or does the landlord? There are too many unknowns, he says, and it is too complex to make a general call.

“It may make sustainable buildings more attractive but it depends on how the carbon price will be implemented and the effect on the outgoings of the building,’’ Lunt says.

“In theoretical terms, your valuation should be good but if you have a rental agreement tied to inflation and your rent goes up to cover the higher input costs, you are back the same sort of yield.”

Valuers not sure about impact of a carbon price

He says no one knows how the carbon price will affect the sustainable property market. “I have asked valuers, and they don’t really know either,’’ he says.

Nonetheless, VicSuper is one of the many superannuation funds investing in sustainable property, as are institutional investors.

Some use consultants to advise them on property. VicSuper, for example, uses Frontier Asset Management,

Australian Super uses Frontier and Mercer. When they do their due diligence on a property, they will call in sustainability specialists and consultants to look at all aspects of the buildings.

They look at how many stars and the NABERS rating. AMP Capital looks at both carefully.

“When we look at property from a sustainability point of view we look at what its current performance is and that means NABERS. Any building that we are looking to purchase, if it’s on the market we will know what that NABERS rating is,’’ Keane says.

Adam Murchie

Adam Murchie

“What we will then do is look at what it will cost. We will know what it’s going to cost us to get it from what it’s currently performing at to what we believe reduces the vacancy risk.

“We tend to look at Green star more in the step change of the asset. It’s a holistic tool whereas with NABERS you can break it down into one rating for energy, one rating for water and one rating for waste. With Green Star, we see what the capabilities of the asset are.”

Murchie says more advisers are also looking at governance of the building managers, whether they have embraced sustainability, whether they are keeping staff, whether they have any affiliations like for example to the United Nations Principles for Responsible Investment or membership of groups like the Investor Group on Climate Change.

AMP Capital uses a corporate responsibility prism that assesses performance in four areas: workplace, community, environment and market place.

Never mind the building – what’s the manager worth?

Murchie says, “It’s much broader than investing in a sustainable building. You might have the greatest building in the world with a sustainable rating but it’s run by a manager no one would give five cents to, let alone five million dollars.”

They will approach real estate investment trusts with questions about the average rating of the profile of the buildings, be it NABERS or Green Star.

They will ask whether there have been changes over the past year and if any are expected over the next two. They will demand to know what their costs will be. And they will make inquiries as to how the organisation works with sustainability.

If they plan to upgrade a building, they will bring in technology specialists for airconditioning and lighting.

Investors are attracted to sustainable property for a number of reasons. The first is risk mitigation and future proofing buildings from changes in the regulatory environment, rising costs and demands from increasingly sophisticated tenants.

Another reason is compliance with new mandatory disclosure requirements. Under new rules introduced in November 2010, commercial buildings of over 2000 square metres have to disclose and advertise up-to-date energy efficiency ratings.

Brian Churchill

Brian Churchill

These ratings must be updated every year and be publicly accessible. They also have to be detailed in all advertising for the sale, lease or sublease of commercial properties.

Local Government Super

Brian Churchill, property portfolio manager at Local Government Super, says the mandatory reporting requirement is now a big driver for property investors to put their money into sustainable buildings.

“It’s now not a nice to have, it’s a must have,” Churchill says.

Churchill says an even more compelling reason for funds to invest in sustainable buildings is that it gives them access to a broader market.

“Government agencies won’t go into a building with less than four and a half stars and government tenants occupy about 25 per cent of the market. So if you build a three and a half star building, there is one quarter of the leasing market you have eliminated as possible tenants,’’ Churchill says. “Then, you have all the corporations like banks that are high on sustainability, so if you have the minimum, the field is getting smaller and smaller.

“You are trying to mitigate your risk and you want to have a product that’s available to as wide a field of occupants as you can possibly get.”

Churchill says the big investment opportunity for funds lies in upgrading buildings. He says that while the Property Council has estimated that the cost of upgrading a three star building to four and a half stars at $700 per square metre, Local Government Super has upgraded five buildings at $160 per square metre using superior technology.

More to the point, it upgraded them without shifting out tenants, thus maintaining cash flow. “We think that’s quite a competitive advantage,’’ Churchill says.

It’s not so hard to upgrade – widen your universe

“The exciting bit is you would normally brush aside an older building and say it’s very expensive to upgrade. But with new technologies, it’s not so hard, it’s a lot more feasible and a lot more inexpensive. Suddenly your universe is wide because you are able to take older assets and get them up to a performance standard that matches a new building.”

As an example he cites a 1991 building in Sussex Street, Sydney upgraded by his super fund. It is now ranked five NABERS stars and has the lowest energy intensity of any building in the city.

UBS – it’s more than investment returns

UBS senior property analyst John Freedman says much of the capital expenditure in the office market has little return. But the capital expenditure in upgrading a building goes beyond economics. Sustainability is like that.

He says developers and building owners are driven by what they believe tenants want. As a result, they are putting forward green initiatives to entice tenants.

John Freedman at a recent IPD green property investment index update

John Freedman at a recent IPD green property investment index update

In the office market, tenants moving into new buildings almost regard it as a box to be ticked and expect a certain level of sustainability initiatives,’’ Freedman says.

He says institutions and super funds are “looking at it from a life cycle cost point of view in terms of energy costs and replacement costs and the impact on the environment.

“They are very conscious that over time there is likely to be a carbon market and that emissions will cost them. They want to minimise those costs but recognise there is an investment up front to do that.

“Building buyers are carefully watching that in regard to premium buildings. For secondary buildings, they are starting to think about the cost of retro-fitting and that will drive a larger gap between the performance of new buildings which meet certain levels versus older buildings which don’t and might have to be retrofitted,” Freedman says.

But he says the returns from the retrofitting need to be put in context.

Don’t expect capex returns

“Similar to a lot of other capex [capital expenditure] in the office market, you may not get any return on it. It’s a cost of staying in the game.

“If you don’t do it, your ability to attract the better quality tenants may be weaker, or you may face a smaller pool of tenants because some of them won’t move into your building unless a certain level has been reached.

“Having done this, you should attract higher paying tenants and you may get them more quickly. That helps drive better investment returns.

“In our view a lot of office capex generally has zero return. You do it to stay in the game and when you get the building revalued at the end of it, you get your costs back and that’s it.

“It’s rare in my view to do major capex to an office tower and find the value has gone up much if at all above your capex, unless you are in a boom market.

“Unfortunately at this point, green initiatives are probably similar but obviously they have an environmental sustainability and governance benefit that goes beyond the economic issue.”

While overseas superannuation funds like the Canada Pension Plan Investment Board have invested in the Australian property market by acquiring the ING Industrial Fund through a consortium led by the Goodman Group, Freedman does not expect the inflow of overseas capital will have an impact on the sustainability property market.

“Overseas investors by their nature tend to buy prime property at the premium end,’’ he says. “Premium end means premium location but it also means relatively new buildings and so therefore they are likely to be buying buildings that are greener anyway. It may have some influence but not necessarily great,” he says.

He does not see sustainable property becoming an asset class. Nor does he think it should. “I think that would be sad,’’ he says. “Isn’t it the point that sustainability becomes an integrated part of the industry’s approach to the way it operates?”