The current uncertain economic conditions are affecting all market segments, and the real-estate sector is no exception. The economic downturn, rising interest rates and regulatory inflation are just some of the challenges facing investors and tenants today. Green leases are becoming a strategic tool for investors, helping to secure the value of real estate as an investment asset, and responding to the EU’s growing ESG expectations.
Lease: the heart of commercial real estate
The real value of commercial real estate often lies in the lease: it is the lease that makes an office building or warehouse a financial vehicle that generates regular income the value of which exceeds the cost of maintaining the facility. As a result, a typical valuation of commercial real estate by a bank or investment fund takes into account not so much the architecture or other features of the building, but rather the content of the lease agreement.
The concept of a commercial lease is highly standardised. The contract must have several safeguards to be suitable as an investment product. For example, it must be permanent (non-terminable before the end of its term). It must also guarantee the lessor a set margin over the assumed period. Hence, the annual rent is usually indexed by the inflation rate or the assumption that the rent is the lessor’s income, while the costs of operating the facility are covered by the lessee.
There are many such safeguards. The Civil Code does not regulate them in a way that is specific to the financial markets, so the parties themselves must do so in the contract. And this is done prospectively, as a typical commercial lease lasts a minimum of five years. This is why a commercial lease can be longer than a contract for the sale of the entire property. A lease that is not thought through in terms of potential risks is a major financial risk.
The real estate market landscape is changing
The socio-economic reality of the real estate market has changed surprisingly over the most recent years. This raises questions about the need to adapt existing operating standards to new challenges.
After the difficulties caused by the pandemic, the real estate market is facing inflation and rising interest rates. The recession is causing an outflow of foreign capital, which has traditionally dominated the Polish market. Macroeconomic indicators are also affected by armed conflicts, with future prospects that are ambiguous.
Although there is no shortage of challenges, the European legislator has made a surprise move with its legislative initiative on environmental, social and corporate governance (ESG) issues. Underpinning the pressure towards sustainability is the EU’s commitment to reduce greenhouse gas emissions by at least 55% in 2030 compared to 1990, and to achieve climate neutrality by 2050 (the Fit for 55 package and the European Green Deal).
Real estate and construction in the EU’s sights
ESG transition particularly affects the real estate and construction sectors, as these account for almost 40% of global greenhouse gas emissions. The same industry also accounts for 40% of global electricity and natural resource consumption.
Achieving environmental targets must therefore mean radical change. Hence the EU regulator’s expectation that from 2030 all new buildings will be energy efficient and zero-carbon during operation—and from 2050 carbon neutrality—will apply to all facilities. For the overwhelming majority of buildings currently in operation, this means that major modernisation is required.
McKinsey experts have estimated that the value of investments to achieve a net zero-carbon economy in Europe could amount to at least €1.7 trillion a year by 2030 alone. In real terms, the outlays are equivalent to 11 times the post-World War II Marshall Plan spent. The scale of this undertaking is so huge that it is impossible to fund it from public funds alone.
The EU regulator has therefore assumed the involvement of private capital. To this end, it has set up a public disclosure system aimed at redirecting financial flows towards sustainable investments. It is a question here of taxonomy and the new corporate reporting rules. While they do not provide for a prohibition on investment in unsustainable assets, they do impose the ESG disclosure of capital placement.
Green revolution in the real estate market
This mechanism is already working. Real estate that does not qualify as “green” is seen as less attractive and investing in it as riskier. Sustainable facilities, on the other hand, are more popular with lessees, which better positions them in the market and is generally positively reflected in the rent rate.
The Emerging Trends in Real Estate® Europe 2024 study, carried out by PwC and the Urban Land Institute indicates that the pace and scale of the ESG transformation challenge will increase over the next five years. Nearly 80% of institutional investors agreed that ESG criteria will have a significant impact on asset valuations in the next 12-18 months, while noting that the current state of these valuations is not fully reliable. In the near future, therefore, it is to be expected that valuations will become more realistic, which is likely to involve an unexpected reduction in the value of some assets.
Faced with these circumstances, market players are looking for ways to hedge the value of their portfolios. One of the keys to preserving the investment potential of commercial real estate is to apply green lease principles.
Green lease the answer to safeguarding the value of assets
A green lease is a commercial lease adapted to a changing reality. It responds to contemporary market challenges, such as ESG reporting obligations, carbon neutrality requirements, the spectre of building retrofits, rising electricity costs, and user expectations.
The green lease concept is based on three pillars:
- Optimisation of emissions and utility consumption
- Issues relating to the construction and modernisation of properties (including retrofitting)
- Sustainable management and use of real estate
The first category is related to the operation of the facility and the second is traditionally associated with capital expenditure. However, all three aspects are closely linked. For example, investing in technology at the construction or retrofit stage of a facility usually improves energy efficiency and translates into lower operating costs.
Statistically, over the entire life cycle of a building, it is the operation phase that weighs most heavily, both in terms of emissions and consumption of utilities, and the costs generated. Naturally, a common goal for the lessor and the lessee is therefore to reduce both these indicators. This stimulates cooperation between the parties in a way that is difficult to achieve in an ordinary contract and encourages lessees to share responsibility for the property.
The implementation of a green lease involves specific tools at the contractual level. For example, it could be about monitoring emissions and consumption of utilities and collecting data, sharing them with each other (including ESG reporting), setting up procedures for cooperation (e.g. a “dialogue forum”) between parties, and renewable energy supply. There are many such aspects and they need to be selected on a case-by-case basis.
It is worth considering this before entering into a contract because, because if you contrast this with the fixed-term of a typical commercial lease agreement, the next opportunity will be in five years at the earliest.
