Of Bricks and Bytes: How data strategy is changing real estate | PROPMODO BOOKMARKS→

Real Estate’s Climate Progress is Lagging, But Pressure is Increasing

Cities have set ambitious real estate decarbonization goals, to say the least. New York City, for example, aims to reduce carbon emissions from 1990 levels by 85 percent by 2050, with the ultimate goal of net-zero emissions. Boston is aiming to be carbon neutral by 2050, Washington, D.C., wants to slash emissions by 60 percent by 2030, and San Francisco aims to be a net-zero city by 2040. Several other cities around the world plan to do the same, partly because of new ESG regulations that enact carbon limits on large buildings.

The granddaddy of all climate change goals is the Paris Climate Accords, the international treaty signed by 196 countries in 2015. The Paris Accords’ long-term goal is to keep the rise in mean global temperature below 2 degrees Celsius (3.6 Fahrenheit) above pre-industrial levels, preferably limiting the increase to 1.5 degrees Celsius (2.7 Fahrenheit), to reduce the impact of climate change significantly. To achieve these levels, estimates say global emissions will need to be reduced by roughly 50 percent by 2030.

We’ve heard how much the built environment contributes to a large share of global carbon emissions for a while now. We’ve also heard the talk of net-zero corporate pledges to meet this sense of urgency. But we haven’t heard as much about the progress of these efforts and where the real estate industry stands in meeting these ambitious decarbonization goals. So far, the numbers aren’t pretty.

Carbon emissions from building construction and operations hit a record high in 2021, according to data from the Global Alliance for Buildings and Construction. Energy-related emissions from building operations reached ten gigatons of CO2 equivalent in 2021, 5 percent higher than in 2020 and 2 percent higher than the pre-pandemic peak in 2019. Investments in global building energy efficiency increased last year by 16 percent, but a burst of new construction and a growth in building floor space outpaced efficiency efforts. Global Alliance’s report warned that “the gap between the climate performance of the real estate sector and the 2050 decarbonization pathway is widening.”

The spike in building emissions in 2021 was caused, in part, by construction that returned to pre-pandemic levels. Energy use rose in tandem as offices re-opened and workers returned to the office, at least partly because of hybrid working schedules. Many developing nations increased the use of fossil fuels in buildings. Overall, the built sector was responsible for 37 percent of global carbon emissions in 2021, which included embodied carbon emissions from the production of glass, steel, concrete, and other building materials.

More countries are including buildings in their climate pledges as part of the Paris Accords, so progress is being made. The number of countries incorporating buildings increased to 158 in 2021 from 88 in 2015. Still, only 26 percent of countries have mandatory building energy codes, though that number is rising, too. Adrian Joyce, director of Renovate Europe, perhaps put it best recently when she said, “It’s difficult to motivate billions of building owners to take action.”

Motivating building owners will be challenging because of the massive amount of capital required to meet net-zero goals. A recent JLL report reveals that in the global north, building retrofitting rates need to triple from about 1 percent today to at least 3 percent of existing buildings per year to meet net-zero goals. That will take an estimated $3 trillion in the office sector alone. This is not even considering much of the developing world, where real estate carbon and energy efficiency aren’t as high of a priority. Retrofitting existing buildings is vital because 80 percent of existing office buildings will still be in use in 2050. 

Guy Grainger, Global Head of Sustainability Services & ESG at JLL, admitted that while the $3 trillion price tag for retrofitting office buildings was “large,” it may very well not be enough. As Grainger puts it, “it’s likely to be a conservative estimate, probably an underestimation, as it presumes only one deep retrofit per building between now and 2050.” He said the investments would probably require new financial risk-sharing models between governments, building owners, lenders, and occupiers.

But Grainger also said that “a $3 trillion investment is a fantastic opportunity to stimulate the green economy and create green jobs and trades.” The recently passed Inflation Reduction Act will help with part of this. The IRA invests more than $50 billion into green technologies that have the potential to lower energy bills, boost renewables, provide tax credits for tech like carbon capture, and further decarbonization. According to the Rocky Mountain Institute, the IRA, combined with other recent legislation, could reduce the American built sector’s climate pollution by up to 100 million metric tons, getting the nation between 10 and 30 percent closer to its 2030 goal to cut emissions in half.

While the Inflation Reduction Act will help, it won’t cover all the costs. And the reality is that regulations and ESG forces only apply to a relatively small portion of buildings in the “global north,” and even here in America, there’s a sizable share of smaller building owners who don’t have the resources, capabilities, or the incentives to take action. But the motivation to act is starting to change, even for smaller building owners who sometimes aren’t covered by the ESG regulations being passed in cities like New York and Washington, D.C. 

As the flight to quality trend in the U.S. office sector shows, buildings that don’t meet energy standards could have a dreaded “brown discount.” Several studies have shown that buildings with better energy and carbon efficiency get a “green premium” on rents and lease-ups. A recent Cushman and Wakefield study found that LEED-certified Class A urban office sales generated more than 25 percent per square foot premium over non-certified peer buildings. The green premium doesn’t just apply to luxury, Class A buildings, either. The research revealed that LEED-certified Class B buildings achieved an even higher premium of 77.5 percent over non-certified peer offices.

Equally important is that building owners who have green properties should see their capital cost decrease. Money that flows into the real estate industry primarily comes from sovereign wealth and pension funds and then into capital markets and REITs. The change and demand for green buildings are coming from the top down in the form of ESG pledges from sovereign wealth and pension funds, and that seismic shift is spreading throughout the real estate industry. Fifth Wall, a venture capital firm that has heavily invested in green real estate tech, estimates that about 40 percent of the world’s total assets under management are now investing under some form of ESG mandate. Buildings will be worth much less if they’re not meeting efficiency standards. The insurance industry is also reframing its actuarial models to consider climate risk and ESG standards.

This is the domino effect that, in addition to building carbon emissions laws at the municipal level, will push nearly all real estate owners to retrofit their properties. In an interview last year, Fifth Wall’s Greg Smithies, who co-heads the VC’s climate technology team, said the estimates coming out of the U.N. climate conference COP26 were that over the next 20 years, around $14 trillion of global buildings will be uninsurable if they don’t meet climate and efficiency standards. “It’s very difficult to make money on a building if you can’t insure it and therefore can’t lease it out,” Smithies said. 

This sounds ominous for real estate owners, especially if they don’t have the up-front capital to scale energy retrofit projects rapidly. Many owners will need creative ways to get that capital, and they, fortunately, do exist. Several green finance mechanisms exist where owners can work with partners who can fund projects upfront and then be repaid with the energy savings generated. Owners can look into Commercial Property-Assessed Clean Energy Financing (C-PACE). This is a financing structure where owners borrow money for energy retrofits and then make payments through an assessment of their property taxes. Another possibility is financing through green banks, which are public or quasi-public institutions that use varying types of financing methods to accelerate energy efficiency projects. 

The availability of capital will be critical in the real estate decarbonization journey. And the shift in mindset toward sustainable buildings is already driving more investors toward assets and projects that are more sustainable. The mindset change applies to tenants and occupiers, too. “Many corporate tenants are exploring green leases and only look to occupy buildings that contribute to their net zero goals,” Francisco J. Acoba, Principal at EY Americas Strategy and Transactions, told me.

A green lease helps tenants and landlords align their interests in energy efficiency, and they are all different by necessity. One clause that’s often included is cost sharing. For example, triple-net leases usually produce misaligned incentives, as landlords have little motivation to invest in energy retrofits because tenants reap mostly all the benefits from lower utility bills. A green lease helps provide incentives to both parties to make the necessary energy efficiency changes. About 34 percent of global occupiers already have green lease clauses, and a further 40 percent plan to sign them by 2025, according to JLL.

Building owners will soon be required to meet stringent carbon and efficiency standards, and this trend doesn’t look to be slowing down. Municipalities are passing stricter laws and energy codes that are prodding owners to go further on sustainability, and the pressure of ESG is becoming widespread in the real estate sector from all angles. As it stands, the global built sector is not on track to meet decarbonization goals and help the world meet the Paris Accords targets. But a sense of urgency is creeping in, and the pressure on the real estate sector will only grow more heightened as the years go by.

The journey toward real estate decarbonization will be an expensive, uphill climb requiring massive amounts of capital and logistical challenges. BlackRock CEO Larry Fink recently said that “climate risk is investment risk.” Fink has also cautioned executives in all industries that the world is at the start of a long (but rapidly accelerating) transition towards a green economy “that will unfold over many years and reshape asset prices of every type.” As the largest asset class in the world, real estate is squarely in the crosshairs of this reshaping of prices, and even if the goals set for it seem overly ambitious, it is looking more and more like meeting them won’t be optional, no matter what the cost.

Image - Design