Lack of Price Divergence Between High and Low Rent Areas Suggests Real Estate Market Doubts Climate Goals

// Nordic Insight - Genesta’s editorial platform for independent perspectives on real estate.

The absence of a significant pricing differential between high-rent and low-rent locations suggests that while heavy investments[1] in carbon emission reduction for real estate may be noble, there remain doubts about their profitability. To make the profitability of heavy investments likely, we argue that a significant change in beliefs and actions by market participants is necessary; the market participants must be convinced, by their governments or otherwise, that the stated global carbon reduction goals will be met. Absent such belief, real estate fund managers will be incentivized to adopt a lighter approach to carbon reduction investments, an approach that assumes that the global carbon reduction targets will only be partially met.

Furthermore, we argue that investing in high-rent areas serves as a risk mitigant against the potential increased costs for carbon emission reducing capital investments, offering less risk and greater opportunity.

Background

Increased energy efficiency in real estate is necessary to meet governmental carbon emissions targets. Achieving this efficiency will require significant capital expenditure investments. Our argument in this article is based on the following suppositions:

1. The capital expenditure investments required will be significant. Notably, this assumes that material carbon reduction cannot be achieved through technological innovation and decarbonization of the energy grid alone[2].
2. All else being equal, these capital expenditure investments will be reasonably consistent across different locations within a metropolitan area.

The latter point is crucial; it will not be significantly more expensive on a per square meter basis to renovate a city-center, high-rent office building than to renovate a similar office building in a suburban location that yields lower rents. Suburban office locations may require many years’ rent to fund the investments necessary to reduce carbon emissions, whereas in the CBD, the same reduction may be achieved using a single year’s rent. This applies for all sectors, not just for the office sector example. The implications for the real estate market from this simple fact are profound.

We want to emphasize that the results presented below only hold true in a world where suppositions 1 and 2 above are true, otherwise the argument falls.

[1] By heavy investments we mean investments that are on par with achieving the carbon reductions targets widely communicated globally, such as in the Paris Agreement, with a typical building built in the period from 1970-1990 as the starting point.
[2] By no means do we argue that the outcome has to be this way. We do see scenarios where technological innovation and decarbonization could lead to significant reductions in carbon emissions without heavy investments in the assets, although that is probably not the most likely scenario.

The Math Example

To illustrate our point, consider the following office sector example:

Assume you own three buildings, all built in the year 1995 to the same technical quality, and all are fully leased. One is in a prime location in central Stockholm, yielding rents of 9,500 SEK per square meter. The second is situated in Sundbyberg, an established office market outside the city center yielding rents of 3,600 SEK per square meter. The third is located in Kista, yielding rents of 2,200 SEK per square meter. All buildings currently have an EPC (Energy Performance Certificate) that needs to be upgraded to EPC B by the end of the decade. The cost for this upgrade is estimated at 12,000 SEK per square meter, same for all three buildings.

Here’s the breakdown:

1. Central Stockholm Property: Can fund the necessary investment using 1.26 years' rent.
2. Sundbyberg Property: Requires 3.33 years' rent.
3. Kista Property: Requires 5.45 years' rent.

Table 1: Basic Assumptions

In the example, we use a simple discounted cash flow model, assuming a WACC of 8.0% annually and a growth rate of 3.0% nominal. The capex investment of 12,000 SEK per m2 assumed to take place in year three of the holding period.

Table 2: Hypothetical Effect on Pricing Across Different Capital Expenditure Requirements

It is noted that the properties with lower rents not only experience an overall larger expected value loss, but that the variability in outcome across different levels of required capital expenditure also is higher for these properties, as summarized in the last column showing the standard deviation.

Our Expectation of Increased Divergence Aren’t Materializing

We hypothesized that as net zero carbon targets were being announced years ago, we would see a pronounced divergence in pricing between prime locations and and weaker locations across all sectors. Instead, we have mainly seen a divergence in pricing between stronger and weaker locations that is broadly on par with the divergence seen in a risk-off environment. The only sector to see an unusual divergence in pricing during the past four years has been the office market, and that divergence we think is largely explained by the market bifurcation that followed the Covid-19 crisis and the work-from home trend.

Indeed, across the sectors and on average, the divergence observed is comparable to what we have considered normal in a risk-off environment, such as those experienced in 2002-2003 and 2009-2011.

Possible Explanations

There are a few possible explanations as to why we are not seeing the predicted divergence:

• The Market is Wrong: The market believes there will be a rapid decrease in energy usage but fails to adequately price in the required investments. While plausible, we generally base our investment decisions on the belief that other market participants are mostly right and rational.

• Convergence Drivers: Some other force might be driving convergence between high-rent and low-rent areas, and this is offsetting any divergence caused by carbon reduction. We discredit this explanation as we fail to identify any such possible forces. Typically, in a risk-off environment, all else equal, the pricing of stronger and weaker markets tends to diverge, not converge.

• Market Skepticism of Climate Goals: Market participants do not believe in the stated climate goals. They assume that the goals will either be abandoned or that the government won’t enforce the necessary measures. This explanation seems the most credible. Given governments' track records on climate commitments, it would be rational for real estate market participants to assume that climate goals will not be met. Rather, it is assumed that the goals will suffer the same tragedy of the commons that we have seen in much prior environmental goal setting.

Implications for Investment Strategy

We identify two major implications for investment strategy:

• Assumptions on Environmental Goals: Investment decisions should not be predicated on the assumption that the stated environmental goals will be met. Acting on this assumption could lead to significant over-investment in ESG-related projects. If such investments are made, they should be recognized as negative alpha investments undertaken for the common good. It is easy to argue that such negative alpha investments do not comply with the targets set out for most fiduciary fund managers, and are thus not eligible investments, bar prior investor approval.

• Investment in High-Rent Areas: If and when market participants believe that the climate goals will be met, the pricing between high-rent and low-rent areas will diverge significantly. Investing in high-rent areas currently involves much less risk and offers greater opportunity.

Further Considerations

• Regulatory Environment: The regulatory environment plays a crucial role in shaping market expectations. If governments introduce stricter regulations and enforce compliance, the market's belief in the achievability of climate goals might strengthen. However, the current lack of stringent enforcement or clear roadmaps for implementation casts doubt on these goals being met. This regulatory uncertainty contributes to the market’s skepticism and the observed convergence in pricing.

• Technological Advancements: Technological advancements in energy efficiency and sustainable building practices could alter the cost dynamics significantly. If new technologies emerge that reduce the cost of upgrading buildings to higher EPC ratings, the investment burden would be lower, potentially making ESG investments more attractive and feasible. Monitoring technological trends and advancements is essential for making informed investment decisions.

Conclusion

The absence of increased divergence in pricing between high-rent and low-rent areas indicates skepticism in the real estate market about the achievability of climate goals. If climate goals indeed won’t be met, heavy investment in carbon emission reduction for real estate may prove unprofitable. Fund managers wanting to maximize return should consider a lighter approach to investments in carbon emission reductions.

The absence of increased divergence also makes a strong case for investing in higher-rent areas and passing over lower-rent areas. Investments with higher rents will be much better placed to assume any future requirements for investment in carbon emission reduction and hence involve less risk and offer greater opportunities.