While ESG requirements are slowly legislated into countries around the world including Singapore, we take a look at how they could impact REITs financially. In this 2nd part of a 2-part series (Read Part 1 here), we interview Elite Commercial REIT on the aspect of ESG, ESG requirements in its area of operations (United Kingdom), how Elite Commercial REIT intends to meet these requirements and the financial impact ESG requirements may cause to their operations.

ESG Requirements in the United Kingdom

Kenny: In some countries, there are laws stating that buildings that are let to government agencies must meet certain environmental and sustainability standards. Are there any such requirements in the United Kingdom?

Shaldine: Yes, there are. In the UK, there is an EPC (Energy Performance Certificate) rating for every building. In Wales and England, there are stipulated laws where you must meet minimum EPC ratings by a certain year. In Scotland, these laws have not been legislated due to COVID, but the government has laid out plans to do so in the near future.

(Editor’s Note: Taken from here these are the required EPC ratings in the future:

• 1 April 2018 (Passed): It is unlawful for landlords to grant a new tenancy of commercial property with an EPC rating below E.
• 1 April 2023, Existing leases cannot be renewed for properties with an EPC below E.
• *1 April 2027: All commercial rented buildings must have improved the building to an EPC ≥ C, or register a valid exemption.
• *1 April 2030: All commercial rented buildings must have improved the building to an EPC ≥ B, or register a valid exemption.

*Not legislated yet. You may refer to Elite Commercial REIT’s announcement (dated 28 Feb 2022) for more information about the requirements.

The United Kingdom uses this progressive EPC modelling in order to eventually reach net-zero in 2050.

Our team is very aware of these laid-out requirements, and thus, we are working together with our tenants to ensure our properties remain relevant and meet these requirements in the longer term.

Meeting ESG Requirements

Kenny: Do you have a timeframe in terms of meeting these requirements (for example, achieve a minimum EPC rating of x within 3 years or 5 years etc.)

Jonathan: One of the challenges is that our properties that are let out to the government are under full repairing and insuring lease terms , commonly known as Triple Net Lease, (Editor’s Note: read more here) where the tenant is responsible for all the capex (repair costs, maintenance costs etc). This unfortunately limits our ability as the landlord, to do upgrading works. However, with information on EPC ratings available publicly, not only are we able to obtain information on EPC ratings, we are also able to obtain information such as the recommended works to be done to improve EPC ratings. We are collecting data across all 155 properties within our portfolio. For assets which are found to be below the regulatory requirements, our focus will be to work on them to meet the requirements. We currently have a couple of assets rated ‘F’ in Scotland and a few assets rated ‘E’, and we are working to improve the energy efficiency credentials of these assets.

Our team is very aware of these laid-out requirements, and thus, we are working together with our tenants to ensure our properties remain relevant and meet these requirements in the longer-term.

We see working on these assets to improve their EPC ratings as an opportunity. This is because several of the EPC criteria are related to energy performance. We are encouraged to make our buildings more efficient and by doing so, utility costs that the tenant has to pay reduces, thereby benefitting them as well.

We have worked with one of our banks with regard to a ‘green buildings tool’ developed by the bank, which can estimate the financial savings you get for implementing various works to improve energy ratings. Some of our works include changing glazing systems, improving lighting systems, insulation systems and heating systems. These investments are beneficial in the long-term since it reduces utility costs for the tenant.

Kenny: Therefore, does the tenant (UK Government) or Elite Commercial REIT own the EPC ratings?

Shaldine: We are the owner of the building, therefore we own the EPC ratings. However, since the lease is an FRI lease (full repairing and insuring lease), the tenants are the ones that perform the works on the building.

From what we understand, the Government has a program put in place that allocates a certain amount of capital expenditure (capex) to be used on our portfolio over the next few years. Although we are the landlord, at the moment, any capex work is not our responsibility. This may seem beneficial for our financial bottom line, but it runs the risk of the tenant delaying the required works until the end of their lease (or not even doing any work at all), which may result in properties that do not meet the EPC requirements when the lease ends. 

In addition, since our tenant is the UK government, it would be ironic for them to not perform the works required to get the buildings to meet the EPC requirements.

Therefore, to ensure a building stays relevant, we as the landlord, are willing to contribute a certain portion of the capex, so that we will be able to bring the buildings up to the required EPC standards, by the time the minimum EPC rating legislation comes into effect. In the short-term, we may take a small financial hit, but it is beneficial in the longer term.

In addition, since our tenant is the UK government, it would be ironic for them not to perform the works required to get the buildings up to minimum EPC requirements. By working together with the government, we are also able to avoid a situation where there is an imbalance of work done, where some buildings may be worked on all the time while neglecting others.

Update: In announcements dated 28 February 2022 and 11 March 2022, Elite Commercial REIT announced that it is embarking on its first sustainability collaboration with its main occupier, the Department for Work and Pensions (“DWP”). The REIT will invest an aggregate of £14.67 million to improve the energy efficiency credentials of the properties in the REIT’s portfolio that are currently occupied by the DWP. The agreed upon asset enhancement works would include the repair, replacement or upgrade of the lighting systems, heating and cooling systems, insulation and solar panels, and other initiatives that will improve the Energy Performance Certificate (“EPC”) ratings of these buildings. The Sustainability Collaboration is part of the Manager’s proactive strategy to ensure that the properties remain relevant and to enhance the long-term value of Elite Commercial REIT by integrating sustainability considerations into its overall business strategy. This innovative collaboration with Elite Commercial REIT’s primary occupier, DWP, marks a commitment by both the landlord and the occupier to achieve sustainability goals such as the UK Government’s commitment to achieve net zero carbon emissions by 2050.

Financial Impact of ‘Going Green’ and its benefits

Kenny: W.r.t performing the works required to greenify your properties, do you receive any subsidy for the capex required for it? What will be the impact of such capex on distribution yield?

Joel (CFO): Funding wise, it will be via existing or new debt and cash retained from DRP. The value that is driven from the ‘renewal’ of these properties will be the increase in the inherent value of these properties. When that is factored into consideration, banks are more willing to give more loans. Typically, banks operate on an LTV basis, so when your property value goes up, the amount the bank will be willing to loan tend to go up as well.

Secondly, if we do not take a short-term drag on our earnings, due to increased equity base (through DRP) and increased borrowing costs (through debt) to perform these works, our buildings may subsequently become non-compliant and hence irrelevant. It is much more important to put some spending in now to ensure our buildings will remain relevant.

If we do not take a short-term drag on our earnings, due to increased equity base (through DRP) and increased borrowing costs (through debt) to perform these works, our buildings may subsequently become non-compliant and hence irrelevant.

Shaldine: In terms of capex required, it is the same for other properties as well. Just because we are let to the UK Government doesn’t mean we do not need to set aside capex to perform the works. It is the job as the landlord to ensure that our properties remain relevant. We do not think that just because the lease is an FRI lease means that we can sit back and not do anything. Also, since we are also listed on the SGX, we are not just required to meet the ESG requirements of the UK Government, but also of the Monetary Authority of Singapore’s Environmental Risk Management requirement to conduct climate-related risk assessment and also SGX listing requirements to publish a Sustainability Report.

Kenny: Based on your experience, when a building is greener (meets EPC requirements), what is the rough impact on valuation and/or the NAV?

Jonathan: It is not clear yet. Investors have only recently been more interested in acquiring buildings that have better EPC certification and meet its requirements. In the past, there hasn’t been a differentiation between sustainable buildings and non‑sustainable buildings. 

However, in theory, this should increase its property valuation. Let’s say we and/or the tenant makes an investment to improve the EPC rating of a building. By doing so, the building becomes better performing. Decreasing its running costs, for example, ends up saving money for the tenant. You’ll therefore expect an increase in valuation due to the increase in demand for tenants.

Diagram showing how investment into green buildings can increase a property’s valuation.

Shaldine: Right now, there isn’t a clear answer in terms of “for every $1 of capex I put into a building, it returns me $x amount.” It definitely also depends on the works that are done using the capex, for example, I replace similar lightbulbs using the capex, it may not translate into improved building efficiencies compared to if I change the entire lighting system.

Read Part 1 here, where we touch learning more about Elite Commercial REIT, its future plans, its sponsors and how the idea for this REIT was conceived, 

On 13th January 2022, I had the opportunity to speak to Elite Commercial REIT’s Management Team, consisting of Ms Shaldine Wang (Chief Executive Officer), Mr Joel Cheah (Chief Financial Officer), Ms Chai Hung Yin (Assistance Vice President, Investor Relations) and joined by Mr Jonathan Edmunds (Chief Investment Officer) from the United Kingdom.

Through this Q&A, we got to know in-depth details about Elite Commercial REIT, including Elite’s future plans, how its United Kingdom properties are doing, the United Kingdom’s ESG building requirements, and how Elite is working towards meeting these requirements. Part 1 of this series will touch on learning more about Elite Commercial REIT, its future plans, its sponsors and how the idea for this REIT was conceived, while Part 2 will discuss the financial impacts and benefits of going green (meeting ESG requirements), and how Elite Commercial REIT intends to achieve them.

Read Part 2 here.

Elite’s Investment Mandate

Kenny: Your investment mandate is currently to invest in United Kingdom Commercial properties. Many investors are interested in United Kingdom Properties. Are there any plans to expand your mandate, for example investing in other asset classes in the UK?

Shaldine (CEO): Not at the moment. Certain requirements have to be met when we change our investment mandate. Firstly, if we do so in the first 3 years, it will require unitholders approval. Secondly, when we first listed on the SGX 2 years ago, we were expecting Brexit but not COVID. Although with COVID happening, it does make sense for our properties to have a strong focus on having the UK government as our tenant, as it gives certainty in terms of rental income. Due to this reason, we have been able to report close to 100% collection of rental income. We see this as a very safe strategy, especially with COVID happening, to be able to pay our unitholders on time. You cannot find a more creditworthy tenant than the UK Government.

In terms of considering other asset classes, we are not ruling out changing our investment mandate to encompass other United Kingdom properties (not just commercial), however, we don’t feel that it is the right time yet. When the time comes, we will evaluate which asset class types will be suitable or complementary to our current portfolio.

With COVID happening, it does make sense for our properties to have a strong focus on having the UK government as our tenant, as it gives certainty in terms of rental income.

Kenny: As an investor myself I feel that it might be too concentrated, especially because moving forward, with remote working spaces and work from home, we may not need as many office spaces in the future.

Shaldine: We feel that there is a wider potential in terms of government assets in the UK as compared to Singapore.

Jonathan (CIO): It is a concern, however with the UK’s government response to the pandemic, we have been able to see the importance of these assets to the government. One of the UK government’s responses to the pandemic was to increase the number of people working in these properties by 13,500 and have also increased the size of their property portfolio. This means there is strong demand for assets to be let to the UK government.

Tenant credit strength is a major factor due to COVID, and other asset classes (especially the hospitality and leisure sectors) have been hugely affected. These COVID impacted businesses were not able to pay their rents on time unlike our tenants, where rents were paid on time every quarter and in advance within seven days of due date.

Our properties are also very diversified across the UK and a 7 per cent yield is very attractive especially because our tenant is the UK government. In addition, our lease terms are usually in excess of 10 years. (Editor’s note: Elite Commercial REIT has 155 properties across the United Kingdom, with a WALE of 6.0 years as at 31 Dec 2021) We feel that this is the best strategy for our unitholders.

The sweet spot is beyond the S$1 billion market cap. Usually, this is the point where it’ll start to attract institutional investors.

Kenny: Do you have any target, in terms of market cap size, within the next 3-5 years?

Shaldine: The sweet spot is beyond the S$1 billion market cap. Usually, this is the point where it’ll start to attract institutional investors. In terms of acquisitions, we have a list of assets in the UK that we are already targeting, with funds coming from both the sponsors and third parties. But for us, the priority now is to remove this lease break option overhang, so that we will be able to deliver what we said we could, before going to the next stage of further growing ourselves.

Dividend Reinvestment Plans (DRP)

Kenny: Will Elite Commercial REIT continue using Dividend Reinvestment Plans to preserve cash?

Joel: Interestingly, DRP is a repeated request by investors, ever since we have listed.

Shaldine: REITs do not usually start their DRP that early, but since we were listed,  we consistently received queries about it during our results  or business updates every quarter. Hence, it made sense for us to implement the DRP. The cost increment is not large. As a pound-listed REIT, every half-yearly, we have to get CDP to send out notices for election. Surprisingly, we had many people opting to receive dividends in pounds before the DRP. This meant people were interested and coupled with the recurring questions on DRP, we decided to move ahead with it within a year of our listing. In our perspective, the DRP has been quite successful and we will continue with it.

Sponsors: Elite Partners, Ho Lee Group and Sunway

Kenny: One of the largest concerns among my clients is the sponsor of the REIT, especially since sponsors are a major factor on how a REIT will perform. Can you give us a background of your sponsors?

Shaldine: Actually, it is not just the sponsors that make decisions for the REIT. We have a large Board of Directors, one of the largest among REITs, with a good pool of independent directors. Some of our sponsors have set up REITs before and are not new to this game. 

Sunway (Editor’s Note: Wiki page | homepage) is an established real-estate developer set-up in Malaysia many years ago and are now expanding overseas with a track record of managing a REIT (Sunway REIT). They also have private funds setup to fund student accommodation portfolios etc.

Ho Lee (Editor’s Note: homepage) had sponsored Viva Industrial Trust back in the day, before the merger with ESR REIT. They are also not green in terms of sponsoring REITs.

Elite Partners Capital (Editor’s Note: homepage) is a relative newcomer in terms of sponsoring REITs, but if you look at who is behind Elite, they are not new guys in the REIT space. The team itself had worked in other REITs before such as Viva Industrial Trust.

As we cross the 2-year mark since our listing (6 Feb 2020), we believe we are no longer a new guy in the market. We have proven ourselves in the market through our track record of key milestones achieved since listing.

Joel: For example, within the 2nd year of listing, we entered into the SGX Fast Track Programme and have ranked joint 6 out of 45 REITs and Business Trusts in GIFT 2021 (Governance Index for Trusts).

How was the idea of an UK-based commercial REIT conceived?

When we acquired the UK properties, we had the intention to list it as a REIT from day one.

Shaldine: After the Viva-ESR merger, the team together with Ho Lee were looking at other investment classes, and we felt that the REIT market within Singapore was too saturated, so we decided to look into the overseas market for good opportunities. We chanced upon this, after looking at other portfolios such as a logistics portfolio in Poland in 2018. Since flying to Poland usually requires a stopover, while in the UK, we chanced upon a portfolio and realised that a portfolio in the UK seemed lucrative. A portfolio with Government tenanted assets, a geographically diversified portfolio, 10-year leases, freehold etc. 

We have intended to list Elite Commercial REIT from day one. When we saw the portfolio, we decided that it was something that we could list on SGX. It is something that is new to investors here.

Unlike in Singapore, UK transactions happen very fast. We’re talking about properties changing hands within 2-3 weeks. No one is going to wait for you to do your listing. We decided to purchase those properties under a private fund and structure it as a REIT while being in touch with SGX at the same time. If you haven’t realised, there were no acquisition fees during our IPO. We did the private fund with the intention to list it as a REIT and once that was completed, we started the necessary work with SGX. When investors came into the fund, they had already been notified and were asked if they were willing to take up the listed units when the REIT is listed. This meant that the original investors have converted their units into the listed units. We also did not try to get a big chunk in the difference between the units, hence, the listing process was very short. 

Click here to read Part 2, where we touch on how ESG requirements impact REITs financially, and how Elite Commercial REIT is working towards meeting ESG Requirements.