The real estate industry has long debated the value of the “green premium”. How much more is a commercial tenant willing to pay for a carbon-neutral office lease? How much can owners expect to see property values and rental incomes rise by committing to sustainable building practices?
This year, however, the debate has markedly shifted. “Attention is now turning to preserving the value of buildings to avoid the risks associated with doing nothing at all,” wrote Christian Ulbrich, Global Chief Executive Officer and President at JLL.
Today, 97% of commercial buildings will not support the transition to net zero in their current form. For an industry that’s generally slow to adopt new practices and standards, it will take a combination of incentives and penalties to move the real estate industry toward greater sustainability. And, if green premiums are the carrot, then brown discounts are the stick.
Properties that are less energy efficient or sustainable may depreciate, sometimes up to 30%, due to the growing demand for "green" buildings. This decrease in value is known as a "brown discount."
If green premiums are the carrot, then brown discounts are the stick.
How much is a brown discount worth? It’s difficult to calculate and will almost certainly accelerate over time. But the European market is already seeing signs that the brown discount negatively impacts property values. A survey of 4,000 real estate professionals by the Royal Institution of Chartered Surveyors (RICS) found that the discount is likely to be up to 10%, although a quarter of respondents believed it was even higher.
To help quantify it more specifically, Fidelity International offers this model comparing the green premium vs. the brown discount that makes some conservative assumptions, including that rental growth for brown buildings will be zero in a best-case scenario.
“Assuming the same rent and asset value at the start of the period, and that new occupiers will need to be found in year 5 of the tenancy when the current lease expires, these hypothetical assets produce an internal rate of return of 5.7 percent in the green scenario over 10 years. This compares to just 3.5 percent in the brown scenario,” they wrote.
This analysis accounts for key factors which contribute to the financial impact of brown discounts including higher vacancy rates, but there are other costs to leasing and owning buildings that are not retrofitted or built to be energy-efficient. A UK-based law firm noted that brown buildings will face higher operational costs and capital depreciation as a result of ESG-focused regulatory and legislative changes.
The concept of a green premium was popularized by Bill Gates and, as applied to real estate, describes the power of energy-efficient buildings to command higher rents, better leasing opportunities, and better overall performance.
Green premiums are already playing out in the market: tenants are demonstrating a willingness to pay more for space in climate-friendly buildings. According to a JLL report, green certifications result in a rent premium of 6% and a sales premium of 8%. Cushman & Wakefield found that LEED-certified buildings command a whopping 21.4% higher price-per-square-foot than less sustainable comparable properties.
As the real estate market moves toward more sustainable building practices, green buildings will become the norm while those which don't improve will be left behind.
However, as the real estate market moves toward more sustainable building practices, the green premium may actually diminish in importance. Sustainability will become the norm rather than the exception as lower-carbon buildings become more widespread. Tenants and developers will not be willing to pay a green premium; instead, they will expect to pay less for buildings below the new green standard. In other words, over the longer term expect the “green premium” bump to fade and the brown discount to get even steeper.
This shift will make the brown discount a more powerful, motivating market force for the building industry.
Fidelity International provides a good guide for building owners to avoid losing revenue through stagnation. According to the firm’s research, market expectations are guided by the Building Research Establishment Environmental Assessment Method (BREEAM) score of at least Very Good, or a LEED Silver rating. For property developers and owners, bringing older buildings up to similar standards can help mitigate the brown discount.
Upcoming regulations will also dictate sustainability standards and influence demand for green buildings. The Inflation Reduction Act and other regulatory actions on greenhouse gas emissions will put pressure on the industry to improve carbon emissions. These actions also clarify to tenants and property owners what their expectations should be—driving the brown discount to reflect the true value of the property.
Building developers should take action now to bring their portfolios up to green standards. Moving ahead of this market shift enables property owners to capture more of the green premium while counterbalancing the negative effects of a brown discount. Capitalize on the ability to command higher revenue now, and avoid the cost of doing nothing in the future.
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