One of the reasons for the considerable challenges posed by the retrofit requirements to increase the sustainability of the UK industrial market is the age of the stock. Only 20% of industrial stock has been built between 2000 and 2019, while 43% was built in the 1980s and 1990s. 38% is more than 40 years old.
Historically, industrial and distribution warehouses have suffered less from obsolescence than offices and have also benefitted from relative ease of new build development. As a result, much of this stock remains largely fit for purpose. This is particularly the case given current high levels of demand for all sizes of units in the industrial sector. In many instances, this excess demand has reversed locational obsolescence as disused 1970s edge-of-town industrial units are now perfect for last-mile logistics.
However, older stock built before current standards tends to underperform in sustainability measures. These ageing assets are encountering environmental obsolescence as climate policies and energy efficiency requirements become more stringent.
Source: Costar, Avison Young
Source: Avison Young, DLUHC
The introduction of MEES has already had a positive impact on the measured energy performance of the built stock. The average rating of EPCs achieved by industrial properties has increased by 3% per annum since 2016 – coinciding with the introduction of the 2018 grade E requirement – to now average a grade D. The longer-term requirement of grade B by 2030 will have a similar impact, continuing the momentum of energy efficiency upgrades in industrial stock.
Source: Avison Young, DLUHC
Source: Avison Young, DLUHC
GREEN PREMIUM/BROWN DISCOUNT
As a result of the environmental obsolescence risk posed by the impending MEES and the costs of reaching the minimum rating, combined with growing sustainability demand more generally, we are already able to see a relationship between EPC performance and values.
Higher EPC grades are correlated with higher rental values in industrial properties. This is likely to also be impacted by a building’s age, location and quality, with better EPC grades more likely to be held by newer, prime, high-quality stock, thus attracting higher rents. However, the relationship strengthened between 2016 and 2021 following the announcement and introduction of MEES requirements, compared with the pre-MEES 2010 to 2015 period – with the caveat that this coincided with the increase in occupational demand across the sector. The increase from grade G to grade A rents rose by 2 percentage points between the periods, while the increase from F to E (the compliance boundary for the 2018 and latterly 2023 MEES) rose by 11 percentage points. This suggests that there is a positive correlation between EPC grades and rental values, driven by MEES.
A similar relationship is visible with industrial capital values. The gap between the grade G and grade A average capital values per sq ft increased by 16% from the 2010 to 2015 and 2015 to 2021 periods. Additionally, the difference between the grade G and grade E rose by 2% in the timeframe.
Taking these two value relationships together suggests that making improvements to a building’s EPC rating could provide greater security in investments and income by increasing the property’s appeal to buyers and tenants. Further, we expect these correlations to strengthen as additional MEES requirements come into effect.
Source: Avison Young, DLUHC
Source: Avison Young, DLUHC
A ‘green premium’ on the top performing assets is currently visible – and increasing in rental values, with the differential between grade B and grade A average rents increasing by 2 percentage points between the pre- and post- MEES period. The growth of the difference over the grade F and grade E compliance boundary of 11 percentage points also evidences a ‘brown discount’. Further, this discount is expected to grow as MEES deadlines draw nearer, bringing a greater risk of environmental obsolescence for sub-standard buildings which could result in them becoming stranded assets.
OVERSHOOTING THE MINIMUM
The uplift in Part L regulations will come into force mid-2022, and will likely continue to tighten in order to meet the government’s carbon reduction plan further. With EPC banding derived from the building regulations, landlords should be prepared for a higher standard of grade B by 2030.
Landlords are encouraged to set their targets higher than the minimum standards as regulations and levies are expected to become increasingly targeted to reducing carbon, such as the climate change levy and carbon taxes. These are currently set very low, to the extent that some developers will just pay the tax, but this will change and there is increased evidence of shadow carbon pricing in order to foreshadow absorption of taxes, spreading the cost and action as a form of risk management.