Schroder Real Estate Investment Trust: What is the green premium and how can investors benefit from it?
Demand for greener buildings is rising, but supply has remained constrained
With the real estate industry accounting for around 40% of all global greenhouse gas emissions, property asset owners have a responsibility to take a lead on tackling climate change. More than three-quarters of UK buildings that are expected to be occupied in 2050 already exist, meaning decarbonising existing property is a major priority. Only by transforming less sustainable buildings into modern, efficient, future-proofed assets will the sector successfully deliver against existing Net Zero Carbon commitments.
Already, we see evidence of a ‘green premium’ in global real estate markets, where environmentally efficient buildings are commanding a higher rental income from tenants than properties with a larger carbon footprint. Here we explore what we mean by the green premium and explain how investors can potentially benefit from it through the Schroder Real Estate Investment Trust.
What is the green premium?
The term ‘green premium’ describes the additional rental income and capital value that can be realised by environmentally efficient buildings compared to traditional ‘brown’ properties that have a much larger carbon footprint.
Research in the real estate industry has been consistently demonstrating the existence of this green premium in recent years. In 2021, the world’s leading independent real estate research consultancy, Property Market Analysis (PMA), conducted an analysis of 18 separate research studies conducted since 2008, which found that green offices in London and the US could on average command an almost 20% price premium and a nearly 10% rental premium, when compared to traditional office space.
Meanwhile, Knight Frank analysed data on more than 2,700 London office transactions between 2010 and 2021, finding that favourable BREEAM1 certifications had an increasingly positive impact on rental premiums as outlined below.
Source: Knight Frank, 2021. The Sustainability Series Report.
Why does the green premium exist?
The green premium reflects the growing interest in the sustainability and energy efficiency of global property. Alongside many other countries, the UK has adopted ambitious environmental regulations and targets, including a commitment to achieve Net Zero Carbon emissions by 2050 which was enshrined in law in 2019 through the Climate Change Act 2008 (2050 Target Amendment) Order 2019, which made the UK the first major economy to pass net zero emissions law. Consequently, property buyers and tenants are increasingly seeking properties that align with these goals, driving additional demand for greener buildings. As the chart below illustrates, Net Zero Carbon ranks as the most important issue currently facing real estate investors, with other ESG issues running a close second.
Source: PMA, Net Zero Carbon Survey of Investors
It is also likely that environmentally efficient properties will benefit from lower long-term operating costs, which adds to their appeal. Ultimately, however, although demand for greener buildings is clearly rising, the supply of them has remained constrained. London provides a useful example of this structural market imbalance. A study of almost 700 London office occupiers that have signed up to Science Based Targets, suggests that demand for Net Zero Carbon buildings will increase by 1.8 million square metres between now and 2030 in that city alone. The supply of such buildings in London, however, is currently just 0.74 million square metres. That’s a shortfall equivalent to approximately 150 football pitches laid side by side. This structural imbalance between the supply of and demand for green buildings is not just confined to the UK’s capital. It is evident in most large cities in the UK and indeed across Europe and beyond.
Importantly, when such a significant disparity between the supply and demand of a product exists, the simple rules of economics suggest that prices will adjust to maintain a balanced market. And that is precisely why the green premium exists. Demand for green buildings has risen, but their supply has been constrained. The main mechanism through which demand and supply can be balanced is price. This means higher rents for environmentally efficient buildings as well as higher capital values.
Conversely, properties that do not see improvements to environmental performance are expected to be penalised by the market in the form of a “brown discount”, resulting in lower rental income. These buildings may also suffer from reputational and secondary risk considerations, such as difficulties in finding insurance. How can investors benefit from it?
Over time, we should expect market forces to address this structural imbalance. The supply of more sustainable buildings should gradually increase to meet the demand. The presence of higher returns will encourage this, with property developers and investors keen to capture the premium yields on offer. This will likely take the form of new building stock, but it will also involve the ‘greening’ of older, brown properties, converting them into more sustainable, energy efficient buildings over time.
Nevertheless, the availability of additional green building stock cannot be delivered overnight. The process of building new and developing older property takes time, which suggests the gap between supply and demand may take time to narrow. Indeed, although the demand for green buildings is already high, we should expect it to continue to increase as the UK progresses towards Net Zero by 2050.
The green premium, therefore, represents an interesting long-term opportunity for real estate investors to pursue. The Schroder Real Estate Investment Trust is an attractive option for those investors looking to do so. For several years, the company has been keenly focused on the environmental profile of its portfolio, but it has recently introduced a new, innovative ‘brown-to-green’ investment strategy. This aims to meet the growing demand for more sustainable buildings by positively transforming the holistic sustainability performance of every eligible asset in the portfolio over time. This should allow shareholders to fully capture the rental and valuation premium that buildings with genuine green credentials can command, while also providing significant opportunities for sustainable income and long-term capital growth.
The company is managed by Schroders Capital, a highly experienced global real estate investor with a strong sustainability track record. Its proprietary and independently validated methodology for monitoring and reporting on sustainability performance allows investors to monitor the portfolio’s progress against clear, portfolio- and asset-specific sustainability objectives. In addition to energy and carbon efficiency related opportunities, wider environmental, social and governance considerations will also be taken into account, including physical climate risks, access to green space and community facilities, building certifications and tenant profile, when looking for ways to achieve meaningful improvements to the sustainability profile of real estate assets. In formalising its sustainability proposition and commitments, the Schroder Real Estate Investment Trust is leading the market and pre-empting future regulatory change with a forward-thinking strategy that will remain appealingly relevant to investors in the decade ahead.
Conclusion
The green premium in UK real estate offers an exciting opportunity for investors to align their financial goals with their sustainability values. It exists because buyers and tenants are increasingly willing to pay more for properties that minimise negative environmental impacts, reduce running costs and contribute positively to their locality and overall community vibrancy.
With its innovative brown-to-green investment strategy, the Schroder Real Estate Investment Trust provides UK investors with a unique opportunity to harness this green premium whilst also supporting the green economy transition. By positioning its portfolio towards greener buildings and investing in existing assets to improve their environmental performance, the fund can allow its shareholders to benefit from a higher, more sustainable income along with significant opportunities for long-term capital growth.
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Fund risk considerations - Schroder Real Estate Investment Trust
Credit risk: A decline in the financial health of an issuer could cause the value of its bonds, loans or other debt instruments to fall or become worthless.
Currency risk: The fund may lose value as a result of movements in foreign exchange rates.
Interest rate risk: The fund may lose value as a direct result of interest rate changes.
Liquidity risk: The fund is investing in illiquid instruments. Illiquidity increases the risks that the fund will be unable to sell its holdings in a timely manner in order to meet his financial obligations at a given point in time. It may also mean that there could be delays in investing committed capital into the asset class.
Market risk: The value of investments can go up and down and an investor may not get back the amount initially invested.
Operational risk: Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the fund.
Performance Risk: Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.
Property development risk: The Fund may invest in property development which may be subject to risks including, risks relating to planning and other regulatory approvals, the cost and timely completion of construction, general market and letting risk, and the availability of both construction and permanent financing on favourable terms.
Real estate and property risk: Real estate investments are subject to a variety of risk conditions such as economic conditions, changes in laws (e.g. environmental and zoning) and other influences on the market.
Concentration risk: The company may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the company, both up or down, which may adversely impact the performance of the company.
Gearing risk: The company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that investment could be lost, which would result in losses to the fund.
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