How do ESG requirements impact REITs financially? Interview with Elite Commercial REIT (Part 2)
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,