ESG factors
ESG factors refer to a company’s performance in three key areas: environmental sustainability, social responsibility, and corporate governance. For example, a property’s environmental sustainability might be evaluated based on its energy efficiency and other sustainability measures. Social responsibility might refer to a property’s impact on its tenants and on its surrounding community. Corporate governance refers to the structure and management of a company owing the property.
ESG factors refer to a company’s performance in three key areas: environmental sustainability, social responsibility, and corporate governance.
Quantifying ESG on Real Estate
The first step is to collect relevant ESG data at property level. These include corporate sustainability reports, third-party ESG ratings, industry benchmarks, and regulatory filings.
Additionally, metrics like energy and water consumption, waste generation, and carbon emissions provide insights into the environmental impact of a property.
Social metrics such as employee turnover, tenant satisfaction, and community engagement provide insights into the social impact. Governance metrics like board diversity, executive pay, and anti-corruption policies provide insights into the governance impact.
Finally, ESG scoring involves using a standardised methodology to evaluate a property’s ESG performance. There are several scoring systems available, such as the (GRESB) or green building certification programs like and .
Property managers should collect and analyse these data to understand the property’s ESG performance against market benchmarks.
Valuation methodology
There are three market practice approaches for real estate valuation: Cost, Sales Comparison and Income. Among these, the DCF method (Income Approach) is a very good option to measure ESG impact because it can transparently reflect specific assumptions related to all valuation inputs throughout time. Direct capitalisation methods can also be considered but they offer less granularity than a DCF.
Valuation inputs
ESG factors can impact real estate valuation on 7 inputs.
1. Income
Both tenants and investors will be looking to occupy space in buildings or invest in buildings with higher ESG ratings to improve their own overall ESG rating. Several studies indicate that rents should benefit from a premium especially with high sustainable specifications (eg: with BREEAM Outstanding/Excellent certifications)
2. Voids
Lower vacancies and shorter void periods between tenancies may also be expected for properties justifying higher ESG ratings.
3. Operational expenses (opex)
Opex include all expenses related to the property’s operation such as utilities or maintenance costs. Opex can be allocated fully or partly to tenants. Studies suggest that buildings with modern technology induce higher maintenance costs. These are nevertheless offset by more efficient systems that decrease operating costs such as energy consumption. In the long run, lower opex should be applied to properties with higher ESG ratings which will in turn enable higher net operating income.
4. Capital expenditures (capex)
Refurbishment costs to achieve high ESG ratings are currently higher than expenses for standard refurbishment but appears necessary if properties want to remain attractive for tenants and for investors.
5. Discount/capitalisation rates
The discount rate is the investor’s required rate of return on an investment’s holding period and is not as much calculated as it is chosen. The choice is highly dependent upon the evaluation of three factors: desired rate of return, perceived property risk and market condition.
The capitalisation rate is an assessment of the yield of a property over one year and reflects the risk perceived on it. Exit capitalisation rate applied for terminal value calculation in a DCF reflects the market’s assessment of long-term net income growth.
Valuers can apply a premium on both rates for less sustainable buildings reflecting the risks in relation to potential rental decline, longer voids or long-term necessary capex. On the other hand, lower rates can be applied to properties with higher ESG ratings.
6. Financing
Property valuation results are generally unlevered. However, debt commitment is considered as a key risk indicator for real estate investment as well as for property under development. An increasing number of green loans are more and more available which results in lower finance costs for properties targeting high ESG ratings.
7. Useful life
While less applied in classic income approaches, the useful life can steadily increase for properties with high ESG ratings thus decreasing depreciation. This input is used in the German valuation approach “ImmowertV” which is standard for German real estate funds.
Among these valuation inputs, opex, financing and capex can benefit already from empirical evidence and can be directly quantified. The others still need a judgemental assessment from the valuer which should be based on its local expertise and market experience.
Conclusion
At PwC, we are exposed to more than 2,000 real estate valuations per year from various renown experts covering all geographical markets and we accompany real estate owners, funds, investors and developers on this analysis. We believe indeed that investor and occupier requirements on ESG will accelerate the development of new and refurbished buildings meeting sustainability criteria.
Whether premium in property values will materialise or not, there is no turning back in regards to ESG. The regulation is here to stay and the demand for greener real estate is required by all players of the industry.
However, while current demand for assets with high ESG ratings would have resulted in green premiums, the current inflation and energy crisis will probably allow these properties to be more resilient and limit market value discounts for the time being while further increasing obsolescence for buildings that do not meet similar criteria (“brown discount”).
Whether premium in property values will materialise or not, there is no turning back in regards to ESG. The regulation is here to stay and the demand for greener real estate is required by all players of the industry.
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