18 Jan 2023
There have been some counterintuitive yet confident statements coming from office REITs over the last few months. A large UK REIT/developer is feeling confident to deliver rather bulky offices in the City of London office market by 2025. Another REIT/developer in Australia expects the ratio development and investment income in office could actually shift toward the former. Counterintuitive, as office space use is expected to decline by roughly 10% as a result of work-from-home trends, while the expected economic deceleration could also weigh on demand.
The reasoning is, however, quite straightforward. Despite plenty of office space, there is only limited supply of what office users actually want: top quality green office space - which implies not only well located offices with amenities, but also low energy and carbon footprint offices. Research of Savills indicated that on average only 22% of global office space is green and the vast majority of this is already occupied. As a result, even when adjusting down office demand, current availability of green office product would be limited to only 11 months of green office take up, according to Savills.
With this scarcity for the right product, office users rely on development to deliver them the craved green office aligned with their own environmentally aware policies. This explains the willingness of the listed real estate industry to deliver into a weak office market. This is, however, also having a profound impact on the pricing for the older office space that is left vacant and repriced to reflect the necessary upgrading in order to reposition the asset as green.
MSCI published a report indicating that green offices are receiving an increasing premium in the investment market. They state the gap has accelerated further during the last two quarters to stand at more than 35% to 25% for the Paris and London office market respectively. The study compared offices with certification from the Building Research Establishment (BREEAM), U.S. Green Building Council (LEED) and GBC Alliance (HQE), versus those that have not yet achieved these standards.
Sale-price gap between offices that have and don’t have sustainability ratings
Source: London and Paris Offices: Green Premium Emerges – MSCI
Although the MSCI research was mainly done for Paris and London, the trend is seen globally albeit in varying degrees. The price differential varies from more than 15% in Singapore and Bangkok to less than 4% in Tokyo according to Savills. The cities where the new (green) supply ratio is the lowest (below one year’s take-up) are the US cities that have limited development pipelines and dated available stock, meanwhile Europe is seeing increased environmental regulation for buildings.
Given further bifurcation in pricing of “brown” and “green” offices and assuming further progress on carbon pricing mechanisms, we expect to see an increasing trend of retrofitting in the future instead of new build. Building new would be increasingly subject to carbon tax, which would make recycling existing buildings via retrofit more attractive, lowering embedded carbon in construction. Many market specialists comment that 80% of office buildings by 2050 have already been built.
Our exposure to offices in our portfolio has been modest due to macro and WFH trends. However, where we have put our money to work is in listed REITs that own office portfolios with high green certification rates and/or mainly focus on retrofitting and upgrading existing office assets in line with the sustainable profile of our fund. There are more drivers of outperformance within our Sustainable Listed Real Estate strategy, but we see increasing evidence that alignment to sustainability trends will help us drive future returns for our investors.
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