Retail investment: green premium or brown discount?

HOW ARE ESG MATTERS AFFECTING THE INVESTMENT MARKET AND HOW DOES THIS TIE IN WITH THE REPURPOSING AGENDA?

WHAT’S SHAPING RETAIL INVESTMENT?

After a challenging few years, two things are clear: shopping centre investment is getting back on track and existing trends have been accelerated. 2021 saw 74 deals, followed by similarly anticipated levels of activity in 2022. Meanwhile, the green agenda appears to be top of mind, with ESG permeating our daily conversations with investors.

However, despite this apparent enthusiasm, it remains difficult to isolate the specific benefits of green schemes from other factors that distinguish the cream of the crop. Instead, we see several investors focusing on prime regional schemes at rebased rents, or convenience-focussed open-air schemes.

It is encouraging, therefore, to see more and more investors starting to discuss the benefits of green schemes. For instance, in their ESG policy, M&G Real Estate Limited state that sustainable assets are better performing assets. Mitiska REIM estimate an 8% premium on the schemes in their European retail park portfolio with the greenest credentials.

But, is premium just premium irrespective of whether it is green and is the issue more about lack of action and the so-called ‘brown discount’?

DEFINING A PREMIUM

What is the green premium? The debate has occupied the office sector for some time. One side argues that the highest performing BREEAM rated buildings make the best investments. The other side contend that the greenest developments are, usually, also the newest shiniest buildings in the best locations with the trendiest office configurations. So, the argument goes, the green element is part of a wider package of benefits that make the development so appealing to occupiers and investors—it’s a product of the times, of trends, and doesn’t command a premium by itself.

There is a key difference between standing and new stock. The office and shed markets have been pumping out new developments over the last decade; each greener than the last using the latest environmental technology available. Building standards are evolving rapidly and there are stringent planning requirements regarding sustainability that all new buildings must adhere to.

But, during the same period, no more than a handful of new shopping destinations have been built and it proves difficult to measure the retail market using the same metrics.

For retail, creating greener stock must come almost entirely from the retrofitting of existing stock. As a result, there is a drift towards BREEAM In-use—that is, allowing an assessment to be carried out on a buildings built form and service— with a handful of the biggest shopping centres across the UK now registering this certification by demonstrating

environmental and operational efficiencies and capability. However, this requires investment, which invariably means it’s received by the best; blurring the distinction of what defines a premium.

In the world of real estate investment, we often talk about the Flight to Prime to describe the increased polarisation between demand for the best space versus the worst. It’s an ever-present trait of the retail sector, particularly where the overall need for retail floorspace is reduced.

Recent research by Savills has explored how ‘prime’ retail isn’t just about luxury malls, but differs in perspective depending on who you are and what you sell. A prime site for a Co-op convenience store may be a very different proposition to the prime site for a major brand like Apple where it’s all about identity, marketing and showrooming, or Lane7 which is tied to the night-time economy. That’s why we continue to see the best investment demand for community and core city centre and regional mall assets.

Retail has had a perfect storm in recent years: from ecommerce,

the global pandemic, geopolitical tensions and cost of living crisis. Like it or not, a wide array of factors are affecting retail performance, a brand’s ability to pay its rent, and consequent impacts on asset valuation and investment premiums. That’s before we even start considering the environmental performance or social benefits of the building. When, recently, several shopping centre’s assets recorded an 80% loss of value, this had nothing to do with their carbon footprints or build quality.

However, there is a sea of change and advancing legislation that is likely to flip things on its head in the next few years. ESG is driving major institutions to rethink their approach to how they manage and operate their schemes. Increasingly, there’s a school of thought that schemes that operate in line with environmental and social policies in particular will prove more favourable, by garnering support from tenants due to operational efficiency and from customers through community engagement.

Indeed, recent news announced Aviva Investors’ £227 million sustainabilitylinked refinancing to London investor and developer Romulus, who acquired the Centre Court shopping centre in 2021. The 10-year, fixed-rate loan secured against a number of assets including office, hotel and retail sectors follows Aviva’s commitment to originating £1 billion in sustainable transition real estate debt by 2025.

With the full value of the loan linked to sustainability key performance indicators, favourable borrowing rates can be secured by achieving measurable environmental improvements. A lower cost of capital is clearly consistent with the idea of a ‘green premium’, albeit more indirectly than a growth in capital value.

Invariably, the better trading locations can be greener because they attract more inward investment, are usually subject to positive asset management, and are aligned with occupational demand. Which brings us neatly back around to the question: what do we mean by ‘premium’? Or is the issue around green pricing more about evolving an asset rather than seeing it in decline?

THE LOST MIDDLE

According to research from Deepki, 79% of 250 European pension fund managers surveyed expect commercial real estate with good ESG credentials to provide better returns or ‘green value’ over the next five years. However, real estate that falls short will suffer significant value depreciation as a result of ‘brown discounting’. Two thirds of European pension funds believe the impact of brown discounting is set to increase significantly over the next three years.

If past performance is any indicator of the future, their predictions are unsurprising. The study showed that over the past 12 months, 40% of pension funds said they had seen depreciation of 21%-30% due to brown discounting. Furthermore, returns on buildings with poor environmental credentials are restricted by CAPEX requirements,

which investors are increasingly factoring into their cashflows, as changes in legislation are implemented over assumed hold periods.

Essentially the ‘brown discount’ is a direct result of the do-nothing scenario, which is considered to have more severe negative implications for property values than the positive implications of a green premium. The problem is one of inactivity and while this might sound like the result of apathy it could also be because of a lack of opportunity to change.

The ‘lost middle’ has often been used to refer to retail brands that, due to a lack of investment or a distinctive offer, have lost relevance with their customers,

with inevitable consequences. The flurry of compulsory voluntary arrangements (CVAs) in 2018-2020, during which 16,000 shops were impacted, speaks for itself. However, the lost middle is just as relevant a concept for shopping centres and high streets that lack a point of difference and, therefore, struggle to compete with ecommerce or a congested retail presence.

Nationally, much of the most challenged retail stock, and those with the highest occupational voids, is in the ‘lost middle’ category; either isolated schemes or marginalised high streets at the periphery of town centres. The investment values of these assets will remain challenged, but given that there is a correlation between the best occupationally performing stock and the level of additional funding available, it’s hard to see how some of these places will adapt without major investment.

“The cost of inactivity seems clear; if bringing down emissions and aligning with ESG principals is not part of the strategy there is an elevated risk that the market will punish the worst assets and devaluation will occur.”

Who’ll upgrade the poorest quality stock- either occupationally or environmentally- given either a lack of funding or, more often, viability? Given the potential for heavy brown discounting, or indeed the MEES EPC regulations, will some of these properties retain any value at all? The impact of a non-compliant EPC could have a significant impact on yield, values and lettability, as many of the costs required to enhance ESG credentials remain unknown.

The brown discount can’t be disaggregated from lower occupational value; the two are invariably entwined. Occupation brings investment and investment (theoretically) improves occupation.

But, hope is not lost! There’s an alternative future and one that we’ve been commentating for a while now. Where there is no longer, occupational demand for the retail that’s in situ, there is an opportunity to adapt through repurposing. Active repurposing provides an opportunity to improve the green credentials of a building and, thereby, improve its investment credentials.

ESG LED REPURPOSING

Where does this sit with the wider repurposing agenda and what will we see in the next decade?

Repurposing/regeneration on a large scale may prove the only solution for a sizeable proportion of lower quality stock. But, where ownership is out of the control of major landlords, repurposing will rapidly become a local authority issue, with the latter’s ownership or partnership instrumental.

ESG will provide the carrot for institutionally-funded assets, but other ownerships may need more of a policy stick or financial support. Access to debt will play an important role with lenders increasingly seeking green credentials and planning authorities stipulating more sustainability requirements.

A further challenge to the market might be the inevitable rise of embodied carbon measurement and costing. Over the next decade it will become harder for developers to justify demolition and new construction, both in terms of their own ESG commitments, and through new planning policy. However, until an industry standard measure for the amortisation of embodied carbon has emerged, it will be equally hard for investors to justify holding older stock instead of redeveloping it.

This is partly driven by the building age of many shopping centres and the range of differing brands and stakeholders that underpin the shopping offer. This further reinforces the requirement for a long-term environmental strategy, being created by a pro-active asset management role, to create wise investment decisions that can challenge and lead to improved retail values.

LEADING THE WAY

So, can we directly and definitively prove the ‘green premium’? In such an occupationally demanding market, not yet. On the other hand, the cost of inactivity seems clear. If bringing down emissions and aligning with ESG principals is not part of the strategy there is, if nothing else, an elevated risk that the market will punish the worst assets and devaluation will occur.

Fortunately, however, we’re pleased to see that more and more of the schemes we deal with have a green edge or are undergoing ESG initiatives that will improve the grade of the stock. For the best examples, as ever, this will produce an investment premium.