While there is clearly a necessity to comply with government legislation, for most asset owners the decision on what retrofit improvements to make will depend on whether they perceive them to be cost effective. Put simply, they will only undertake the work if it sufficiently enhances the value of the asset (i.e. creates a ‘green premium’) or the value of the asset will fall by more than the cost of the retrofit if the work isn’t undertaken (i.e. a ‘brown discount’).
As already established, the options for landlords will be to choose between spending the minimum required to comply with the relevant legislation, investing in bringing buildings up to the highest sustainability standard possible given the age and nature of the asset, or to take no action at all and allow the building to become obsolete.
In previous sections we have examined the likely costs associated with each of these options across a range of hypothetical buildings. We now need to examine these costs in the context of current capital values (derived from prevailing rents and yields for these types of properties in different parts of the country).
Our analysis is somewhat simplified, for example taking no account of any impact on void periods, and using simple initial rent and yield data to derive a current capital value; but we believe the results to be both fundamentally valid and highly instructive. For example, let us look at our typical 1960s industrial building, in this case assuming it is located in the North West, with a typical current rent of £7 psf and a yield of 5%, giving a notional capital value of £140 psf. Adding the estimated cost psf to improve the building, (in this case to the minimum standard required by 2030) of £12psf this gives us a ‘target’ capital value for the improved building of £152 for the works to be worthwhile.
This additional 8.6% ‘green premium’ could be achieved by securing a higher rent, or the building being valued at a lower yield, or a combination of the two. From the matrix below it can be seen that the required ‘target’ capital value of £152 psf could be achieved by:
- An 8.6% improvement in the rent, assuming the yield remains at 5%
- Or a downward movement in the yield of 39 bps from 5% to 4.61% if the rent remains at £7psf
- Or most likely a combination of the two.
The above example focuses on ‘breakeven’ values but we can also use this approach to examine what combinations of rent and yield change would be required to achieve a given target capital value that investors might require in order to justify the work.
If we replicate this analysis for all the different buildings and cost scenarios in our study, across different locations in London and the South East, the Midlands and the North of England, we can generate for each of them a ‘breakeven’ curve as shown in the chart below. The required rental growth (shown on the vertical Y axis) also indicates the capital value uplift required under each scenario. Thus, it can be seen that in the vast majority of cases, the retrofit costs represent less than 15% of the value of the asset.
This implies that a 10% rental uplift combined with a 25bps yield shift would be sufficient to justify the works – a level of ‘green premium’ that doesn’t seem unreasonable to believe will become evident in the market over time. It is worth noting however, using these yield shift-rental curves, at the extreme - taking into account movement at one measure or the other - that 24% of the hypothetical buildings would require rental uplifts in excess of that 10%, this increases to 32% that would require a yield shift in excess of 25bps.
Taking into account the curves below - and the fact that most buildings would see a combination of yield compression and rental growth, suggest that for the majority of investors, the investment required can be justified through the resulting increases in capital value.
Despite this, it is worth taking into account market dynamics, and highlighting the risk of market obsolescence as a result of changing market requirements. As the below chart shows, a 1960s buildings in the North, retrofitted to the best possible standards would require a 44% increase in the rent, or a 160bps downward shift in the yield to justify the capital expenditure. Even when one takes into consideration an appropriate combination of the two, it is clear that this marks the potential for an expediting of market obsolescence.
Source: Avison Young
Given the very strong rental growth and yield compression already seen in the industrial sector, it might be argued that further value uplift of the magnitude required will be difficult to achieve.
The other way of thinking about this issue is the threat of obsolescence and the degree of ‘brown discount’ that may be experienced if the works are not undertaken.
Using the same building example, our hypothesis is that if the building loses capital value up to, or in excess of the cost of the required retrofitting works (ie the value falls below £128 psf) then the capital expenditure required is likely to be considered worthwhile.
In this case, a brown discount of 8.6% on the rent is in line with the premium as above. However, due to the relativity of value, an outward movement of 47 bps would be needed to justify the work – an 8bps difference on the yield compression required to achieve a premium.
Once again, if we replicate this analysis for all the different buildings and cost scenarios in our study, across different locations in London and the South East, the Midlands and the North of England, we can generate the same ‘breakeven’ curve as shown in the chart below, that this time takes into account the rental falls and upward yield movement that would justify the capital expenditure required.
Once again, at the extreme - taking into account movement at one measure or the other - the falls in rental values (shown on the vertical Y axis) also indicates the capital value falls that would create necessity of refurbishment required under each scenario. The number of buildings affected by a 10% fall remains similar to the number of buildings in the analysis above – 22%. However, due to the relativity of the fall in values, the yield shift impact is proportionately higher, with 38% of our hypothetical buildings seeing a yield shift of 25bps.
Factoring both the green premium and the brown discount - and indeed the loss of assets to to obsolescence will be essential in the coming years, as the market decarbonises. While analysis has been carried out through the prism of EPC requirements, this is not the only pressure, as market norms and occupier requirements will likely move the dial even further for investors and developers.
Source: Avison Young