The steady price appreciation enjoyed by real estate owners in an era of low interest rates has come to an end. A key way for them to receive decent returns is to try and turn their properties from “brown” to “green”, to ride on the growing trend of greater focus on sustainable assets, says Zsolt Kohalmi, global head of real estate at Pictet Alternative Advisors.
For years, a large group of real estate owners, the so-called “core funds” that buy properties to lease out and enjoy annual cash flows, were able to enjoy steady returns. This even if they let the properties remain as they were, without investing to enhance the assets. Kohalmi, who is also deputy CEO of Pictet Alternative Advisors, explains that as a result of a low funding cost environment, asset prices all around were appreciating.
“These funds had what I call an annual Christmas gift. They basically benefitted from a valuation uplift on the building without the requirement of a transformation,” says Kohalmi in an interview with The Edge Singapore. “It was very beautiful and very easy while you could have it, but obviously I believe that no longer holds.”
Now, with interest rates higher for longer, investors who were highly geared have been caught out, and this will worsen if rental income halts because of recessionary conditions.
As such, another “paradigm shift” is taking place. “We’re returning to what I call an old-school real estate. Old-school real estate is not that old, actually. It’s only pre-2008,” says Kohalmi. From his perspective, this so-called “old-school real estate” investment approach is one where owners who want to generate good returns on their properties need to make physical transformations and improvements on their assets in one way or another.
Kohalmi believes this motivation will stay. “The greatest minds in finance have not known how fast the interest rate curve would go up. I think we’re near the top and will likely go a little bit down but unlikely to go back to zero. So, in this environment, old-school real estate and value-add funds that transform one building at a time are ways I believe will achieve appreciation.”
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Tangible value
Now, the transformation is clearly not referring to just a fresh coat of paint. With ESG at the top of many agendas, designing and installing features that make buildings more sustainable is a key way such a transformation can take place. “Greenifying is one of the absolute essential ways, as that value uplift is clear and tangible now in European markets already, and will be the case globally in due course as large occupiers push for greener buildings everywhere,” says Kohalmi.
The trend is already starting in Europe, and Kohalmi, citing the recent reactions from his conversations, is convinced this same trend will be seen in Asia and the US.
Now, for starters, Europe is a more attractive real estate market for investors. For years, Europe has been suffering from a chronic under-supply in residential space, where as many as 30 potential tenants will go after the same space for let. Vacancy rate is at around 7% — just a tad above the 5% rate deemed as structural vacancy because of tenants in the process of moving around.
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New redevelopments in Europe typically face many years of regulatory hurdles at various levels. This has the effect of discouraging investors from putting in capital to meet the demand for new space, knowing that it will be many years before they start to see meaningful returns. Pictet’s new headquarters in Geneva, which is under construction, took 10 years for all the necessary permits to be assembled. A key reason is the democratic and open nature of decision-making. Europeans hold dear the idea of so-called “15-minute cities” where one lives, works and plays within this radius. “And when you try to do that, there are so many more data-points to be considered,” says Kohalmi.
Even though the Eurozone’s economy is seen to recover at a slower pace than the US, the continent’s real estate market will do better simply because it has much better supply and demand dynamics. This coming year, with tentative expectations that the economy will do better, the cumulative shortage in Europe will get much worse, says Kohalmi.
In contrast, the key reason why US real estate is in the doldrums today is that of over-building in the last 15 years when ready funding was flowing cheaply. “People got very excited and developers started cranking out even more,” says Kohalmi.
Now, even with the pandemic and companies struggling to get their workers back from home, the vacancy rate has remained stuck at 23% for offices. In New York City alone, the empty space is estimated to be equivalent to 26 Empire State Buildings.
There were some suggestions that the downtown office buildings can be converted into residential space instead. However, Kohalmi points out that too many of these office buildings are too wide and squarish, which means they have a big proportion of space in the middle with no windows and so are not suitable for such a conversion. On the other hand, workers prefer to stay at home and not endure the commutes that can easily go up to an hour or more. “Nobody quite knows how to work this out,” he says.
In contrast to their conservative European counterparts, authorities in the US are more than happy to have new developments because that means more economic activity for them to tax. “As a mayor of New York, all you want is more tax dollars. That’s my goal,” quips Kohalmi.
Thus, not fully by design, but by existential circumstances, Europe’s real estate market is more resilient today where landlords have the upper hand. He expects properties under Pictet’s portfolio to have a “really interesting” jump of between 14% and 19% in rental rates for residential assets, and an even higher increase of between 21% and 38% for the hotter logistics properties that are in higher demand because of e-commerce, depending on the country. “In such a weak environment, we are getting this kind of rent offers; imagine what happens if there’s actually an economic recovery,” he says.
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Kohalmi points out that there are of course parts of Europe suffering from really serious commercial occupancy problems: Canary Wharf in London, La Défense in Paris, and Frankfurt. “These are the three areas where we tried to copy America,” he explains.
Greenifying premium
So, how can this tactic to “greenify” a building make sense for investors? Kohalmi explains that as recently as three years back, the difference between “green” and “brown” buildings in terms of rental income premium was practically zero, which made it difficult for him to prove his case. Today, the difference has widened to 23%, he says.
Current institutional buyers of buildings — pension funds, insurers and the likes — know they need to increase the proportion of green assets. However, they do not necessarily have the internal capabilities, given their focus is on financial returns by getting income from the purchase of existing buildings.
In his role at Pictet Alternative Advisors, Kohalmi sees himself well-poised to help investors and clients profit from these trends. “Our goal and our ability is to ‘buy high and sell low’ — we buy high-emission buildings, and we sell low-emission buildings,” says Kohalmi, referring to the conventional financial adage of “buy low, sell high”.
Interestingly, profiting off greenifying buildings makes sense when contrasted with the hefty costs of redevelopment, both in financial and environmental terms. Citing Cushman & Wakefield, Kohalmi says that 76% of the European office buildings risk obsolescence, given that 90% of all European buildings were built before 1990.
Forty per cent of the emissions attributed to a building, with an assumption of a 90-year lifespan, occurs at the construction stage. Thus, the more logical and reasonable way to go green is to refurbish. “You buy ‘brown’ buildings at an interesting discount, you go through the work; and work, by the way, is different for every building. That’s the fun part,” says Kohalmi, adding that every variable plays a part, ranging from the targeted green ratings to regulatory restrictions to how and when the buyers want to exit their investments.
Of course, there is a stick too. According to Kohalmi, most European governments have already passed legislation requiring the real estate sector to “greenify” by 2030 or a few years later. What this means in practical terms is that one will not be able to lease a space — be it residential, logistics or office — in certain years, if the space no longer meets certain ratings requirements. After all, in this push for a greener environment, real estate offers the biggest opportunity, many times bigger than other sectors such as shipping, which accounts for just 2% of global emissions. “We do have the opportunity to create true emission reductions,” says Kohalmi.
Now, at the individual property level, at what level does the investment needed to turn a brown building green no longer make sense? Given the complexity and differences, there is no straight answer and of the hundreds of deals Kohalmi and his team look at every year, only a fraction is put through the greenifying process, although this will change as processes and technological capabilities improve. If so, the Christmas present from owning real estate will be enjoyed by not just the investors, but also the wider environment. “It will start to make more sense on more buildings,” says Kohalmi.
