Property funds: it’s getting hot in here

Fund managers of property portfolios are becoming increasingly aware of the financial risk inherent in the management, development, acquisition and redevelopment of property assets to higher sustainability standards, but the financial implications are yet to be fully integrated into all Australian asset management strategies.

The Australian commercial real estate industry is being driven towards more stringent environmentally sustainable practices by a convergence of drivers, including shortages in peak energy capacity, diminishing water availability and higher waste and transport costs. Momentum is being compounded by increasing demands from occupiers and investors, a focus on corporate social responsibility (CSR) imperatives globally, environmental rating tools gaining traction in the industry and a changing political and legislative climate.

But the funds management industry is yet to fully understand the financial risks and opportunities inherent in incorporating sustainability as part of an asset management strategy.

Regulatory impact

As recently as July 1, 2006, the Energy Efficiencies Opportunities Act 2006 took effect locally.

This new Act requires large energy using businesses to undertake an assessment of their energy efficiency opportunities to ensure they are identified and evaluated, and to report publicly on the outcomes of that assessment in order to demonstrate to the community that those businesses are effectively managing their energy.

In New South Wales, businesses using more than 10 gigawatt-hours per year at a site are now required to prepare an Energy Savings Action Plan.

Only recently, the British Government launched a major new initiative in setting carbon targets for the nation, leading some to speculate that it will prompt a domino effect around the globe, resulting in the establishment of an emission trading system in Australia.

Certainly, as government regulations tighten, all those involved in the industry will be required to report on their carbon footprint and will be required to monitor, manage and report on performance.

As carbon evolves into a global currency, the funds management industry will be closely scrutinising the way it monitors and reports the issue to shareholders.

Industry driving change

The barriers toward change are already starting to break down, most notably in the preparedness to invest in sustainable practices.

Recent Jones Lang LaSalle Research reveals that 28 per cent of Australian investors in commercial property assets are now prepared to pay more for their investment in a building with sustainability potential in 2007. An additional 58 per cent of respondents agree that if all other things are equal, sustainability can sway their choice between alternative investments.

Investors are looking to sustainability to achieve reduced operating costs, increase market share, improve productivity and quality, enhance brand profile and mitigate future regulatory impacts. Some investors are bottom line driven, some are brand driven, some see it as part of their CSR, and still others see it as part of a risk mitigation strategy. The one common theme is that most want lower variable outgoings (VO) and improved market appeal for their asset.

In the next 12 months, the percentage of Australian investors who will consider the existing or future sustainability performance of an asset before acquisition or disposal is likely to increase further.

Jones Lang LaSalle Research shows 24 per cent of investors believe sustainability will become a critical issue for their organisation in the next 12 months. A further 76 per cent of respondents believe that it may take a little longer, perhaps within the next five years.

Since the inception of the Australian Building Greenhouse Rating (ABGR) and Greenstar for rating environmental performance the property world has changed significantly in terms of its attitude to performance delivery. Sustainability performance is now one of the key metrics that the industry is measured by; however, the financial implications are yet to be fully integrated into asset management strategies.

Six main risks

Whether for holding, disposal or acquisition, there are six main areas of risk that fund managers of commercial property assets will face if they do not address sustainability as part of their asset management strategy:

~ insurance — global insurers are beginning to assess the sustainability performance of their clients before issuing insurance, particularly in light of increased threats of natural disaster due to climate change;

~ finance — some financiers are now considering whether they will provide financial support to those whose activities are not sustainable;

~ brand — sustainability presents an opportunity for investors to position themselves positively in the marketplace around CSR — at the same time, it is a risk and if not addressed it can do damage to the brand in the eyes of stakeholders;

~ obsolescence — as new buildings come on to the market and an increasing number of existing buildings are refurbished, buildings that do not meet sustainability performance criteria will be at risk of becoming obsolete. Non-sustainable buildings may find themselves subject to a non-sustainability ‘discount’ as investors and tenants come to expect sustainability as standard;

~ attraction and retention of tenants — similarly, as CSR climbs up the corporate agenda, buildings that are not well positioned around their sustainability offering may have trouble attracting tenants and may face longer letting up periods, with significant impacts on building value and return to shareholders; and

~ future legislative implications — with an increasing government focus on sustainability, there is little doubt that legislative implications will increase steadily over the coming years. Those asset managers that are not starting the journey early will find themselves behind the mark and at risk of non-compliance in the near future.

Sustainability to enhance portfolio value

The amount of existing building stock in Australia makes refurbishment a good option, and some informed clients target buildings that are ripe for refurbishment and repositioning as a key investment market.

Investors also need to enhance the value of their existing portfolios in Australia in order to deliver returns to shareholders, because the opportunity to add new assets to the portfolio is becoming scarcer and more expensive.

Sustainability as a mechanism to maximise shareholder value obviously depends on a particular grade of assets, target markets and holding strategies.

When reviewing an asset for its sustainability potential through refurbishment, the building should initially be reviewed by considering key attributes such as location, structural system and integrity, facade, floor-to-floor heights, core flexibility and primary service capacity and quality. Other key factors for assessment include how much it will cost to bring it up to standard, how long the project will take, what the projected performance uplifts are and what impact it is likely to have on valuation and letting-up periods.

In a hypothetical example of a 30,000 square metre, single tenanted, A grade Sydney CBD property prepared by Jones Lang LaSalle, it was determined that a series of commonly implemented sustainability initiatives could result in a one star ABGR improvement, with payback in approximately 3.2 years. However, many asset managers have found that a building’s sustainability performance can be enhanced by relatively low cost modifications to existing services and improved operating strategies, rather than a complete upgrade.

Reduced operating costs offset

Running cost savings per annum for this particular example cited above would be around $99,704 per annum. However, such an upgrade would cost around $320,115 and add approximately $3 million to capital value, or 10 times the initial investment.

Sustainability performance will also obviously impact disposals or acquisitions. Some considerations include how the asset currently performs against established criteria, the pedigree of the building and the track record of the owners or developers and if the property can meet current and future tenant requirements. Most asset managers will be considering where the asset fits within an existing portfolio and what impact the asset may have on the overall performance of the portfolio. This will help decide if the building should be marketed on its inherent sustainability potential.

Prior to acquisition or disposal, asset managers should determine whether there is any performance or ratings data that can help position or assess the asset and the liabilities if the building does not deliver on its sustainability promise.

Tips towards implementing a sustainability strategy

Sustainability performance is not an add-on — it is part of an integrated delivery process.

Waiting to integrate sustainability at the end of the project has proven to be costly, and is almost certain to deliver sub-standard performance. Most developers, builders, consultants and contractors are yet to make the change, as it is a specialised field and most generalists do not have the necessary focus.

There are various ways to hedge an investment in sustainable initiatives. Consider the importance of having a ‘certified’ building. Investing the money to get an official industry rating provides market recognition that your building has reached a certain standard. Always keep in mind how you are going to monitor and review for continual improvement, reporting and re-rating purposes.

Investment in appropriate benchmarking, measurement and reporting mechanisms during the planning phase will minimise the risk of underperformance.

Investing in the right people and the right training will ensure your high-performance building is running to optimum performance.

Similarly, creating a project charter and developing a knowledge retention process will ensure new participants can quickly become ‘project aware’ and maintain the non-negotiable aspects of building performance to ensure the required sustainability performance is not compromised.

The outcome should be a building with shorter letting up periods and longer lease terms to quality tenants. The building should run more efficiently and with lower operating costs.

There is mounting evidence that sustainability has a positive impact on building values, as outlined in our 2006 white paper “Assessing the Value of Sustainability”. In addition, an asset that has addressed sustainability issues will be ready to stand up to future legislative and regulatory changes.

If the appropriate risk management process has been followed, ongoing sustainability performance will be secured and will therefore be a vital part of a dynamic property portfolio that will continue to deliver positive returns to shareholders over the long term.

Peter Hilderson is head of engineering and operations at Jones Lang LaSalle, Asia Pacific.