There’s no escaping the importance of sustainability in any investment sector. Globally, Environmental, Social and Governance (ESG) investing is worth $30 trillion in assets under management each year, around a quarter of all professionally-managed assets. It is more relevant than ever as the ‘high impact, low probability’ shock imposed by Covid-19 has strengthened the case for prioritising people and planet alongside profits, and illustrated the power of collective action to tackle global problems.
Many investors are unaware how significant this trend will be. If you are an investor, you need to consider why sustainability will be important, what sustainable property investing actually means, and what the major issues and opportunities are, as these will affect your risks and returns.
Why is sustainability so important for investors?
The UK’s legally-binding commitment to achieve net carbon zero by 2050 means that sustainability is no longer a ‘nice to have’. Our legal obligation is showing up in the form of new rules, regulations and best practices affecting all sectors that contribute to emissions.
40 per cent of UK emissions come from households, which makes the chance of more regulations and policies around the environmental performance of property more likely than not. These regulations will not only affect your ability to operate in a way that is compliant, but fundamentally change the value, performance and risk associated with your investments.
What is sustainable residential property investing?
Sustainable property investing is, at its core, about making profit – buying, building and improving bricks and mortar assets – with positive ESG impacts (or at least without negative impacts). Unlike charity, it’s not about sacrificing profits. Unlike ‘traditional’ investing, it’s not purely focused on profit.
Instead, it focuses on creating competitive long-term financial returns with positive, measurable externalities. These impacts can range from improving the affordability of housing for local key workers to reduced emissions associated with heating or cooling homes.
The major issues and risks
Residential property is dominated by individual investors or small private companies: 94 per cent of property investors in 2018 were individuals and in 2016, 93 per cent of residential property investors owned four or fewer properties.
Further, over 75 per cent of UK housing stock was built before building regulations required insulation, so a significant proportion will need to be improved in order to align with government policies.
The fragmented nature of ownership, age and quality of housing stock and cost of change could create a major challenge for investors. The cost of ‘retrofitting’ older, less environmentally-friendly properties is high. Subsidies or grants may be available to support the transition to greener housing but until then for new acquisitions, consider the Energy Performance Certificate (EPC) up front, or factor in the cost of transition to higher-rating bands (A-C).
Since 1 April 2018, it has been illegal to grant a new tenancy on properties with an EPC rating of below E. Since 1 April 2020, it has been illegal to continue letting such property (unless exempted). This minimum standard is expected to increase over coming years, as the government strives to meet its legally-binding commitment to achieve net carbon zero. Less environmentally-friendly properties will increasingly be worth less in terms of their ability to deliver cash flow, while greener properties are increasingly worth more.
As for your existing portfolio, you need to consider how the shift to a more sustainable society could affect value, if you haven’t already. The direction of government regulations suggests that environmental performance will impact your ability to sell or rent out property.
What are the opportunities that you can use to capture value?
If you’re anything like the investors I work with, it’s likely that you want cash flow, to protect and grow wealth, and to avoid excess risk or hassle. The sustainability agenda could enhance your ability to achieve these.
Your cash flow as a property investor is rent less costs, including finance, management and maintenance. More sustainable investments can have better cash flows because, provided it is explained to them, tenants should be willing to pay higher rents for the lower heating bills that come with more environmentally-friendly properties. Further, providing quality, affordable housing to tenants who benefit most, such as young families or key workers, generally reduces void periods. Families stay longer, and key workers keep their jobs throughout market cycles.
On the cost base associated with cash flow, more sustainable investments can come up trumps (although they don’t always). With the advent of ‘green mortgages’, finance costs are becoming cheaper for investors in more sustainable properties. Maintenance costs can also be cheaper for more efficient properties, by eliminating the cost of repairing, replacing and insuring gas boilers, for instance.
Investing sustainably also encourages more people to want to work with you. Tenants want landlords, suppliers want clients, and banks want borrowers who do good.
When it comes to protecting wealth, many investors want to build or protect a legacy to pass on. Regulatorily compliant, environmentally-efficient properties that people want to live in, where they want and need to live, at a price they can afford will be more resilient through market cycles.
You can also protect wealth by minimising physical and transition risks. Avoid properties with physical risks of climate change, for example, in areas at high risk of flooding. Avoid properties with high transition risks, associated with new regulations coming in. It is very difficult to quantify the cost of transition but it is likely to be expensive.
The commercial property sector illustrates how the market can price in a ‘green premium’. Tenants and potential buyers willingly pay more for environmentally-efficient buildings, so these are worth more to investors. In the residential sector, this ‘green premium’ or ‘brown discount’ is catalysed by new minimum efficient energy standards, affecting your ability to rent the property out, and increasingly your ability to borrow from the banks. Buy green, or make your properties greener, to align with this shift and maximise your ability to grow the value of your portfolio.
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