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ESG and sustainable finance – issues for real estate investors, developers and landlords

ESG and sustainable finance – issues for real estate investors, developers and landlords

Overview

ESG considerations are increasingly a priority for investors, developers, landlords and occupiers.

In terms of environmental awareness, whereas in the past passing reference may have been made to energy efficiency obligations in real estate contracts, the scale of the "Green Lease" provisions and heavily-negotiated cost apportionments seen in today's market illustrates how important environmental sustainability has become in the real estate sector.  However, the drive towards "net zero" means that environmental risks and opportunities have moved well beyond the traditional focus on energy and carbon, and have become a key factor in the processes of capital allocation and property investment decision-making.

Social impact concerns include a wide spectrum of issues ranging from placemaking concepts such as inclusive environments and wellness through to "social impact investment" through which investors can makes a positive social benefit as well as good financial returns.

In terms of governmental concerns that impact on real estate, one of the key themes in the Government's legislative agenda over the past 5 years has been the reform of the housing market and boosting the supply of new homes in England.  Its programme of reforming the residential leasehold system is part of this, as are its plans to re-introduce commonhold.  The Government is also planning to increase transparency around the beneficial ownership for foreign companies that purchase land or property in England and Wales, and around contractual arrangements used to exercise control over the buying or selling of land. 

 

Key issues for real estate

There are currently 4 main areas of current ESG focus in the real estate sector:

1. Environmental and energy efficiency measures - Early legislative action relevant to ESG was limited in scope and criticised for the excessive administrative burden it placed on companies. For example, the Carbon Reduction Commitment Energy Efficiency Scheme ("CRC"), launched in 2010 to enforce emissions trading between large businesses and public sector organisations, was abolished at the end of 2019, in part due to the disproportionate impact it was having on non-energy-intensive companies such as occupiers of office buildings. The measures brought in by successive energy performance regulations (most recently the Energy Performance of Buildings (England and Wales) Regulations 2012 (SI 2012/3118)) which regulate the energy efficiency ratings provided to buildings through energy performance certificates ("EPCs"), have been more effective and provide the framework for the more recent MEES Regulations.

The Government carried out a consultation from September 2021 to January 2021 on how best to upgrade as many private rented sector homes as possible to Energy Performance Certificate Band C by 2030, which would involve an investment of up to £10,000 per residential unit for landlords of less energy-efficient properties.  It is currently considering the feedback it received.

It is currently seeking views on its proposed framework to improve implementation and enforcement of the EPC B target by 2030 for privately rented non-domestic buildings. The consultation sets out proposals to improve the implementation of minimum energy efficiency standards, improve enforcement and ensure that the policy can be delivered in practice.

Renewable energy is an increasingly popular asset class, with occupiers, landlords and developers alike prioritising the energy efficiency of their buildings. The Government has published its Clean Growth Strategy to support businesses in reducing their energy use by at least 20% by 2030.

From a social perspective, the built environment has a major impact on its occupiers, both corporate and residential. There is increasing evidence of the importance for people's  physical and mental wellbeing of living and working in buildings which have been designed and are operated with human health and wellbeing at their centre. Tenants are therefore demanding higher standards from their landlords in relation to, for example, air quality, water quality, natural light and access to green spaces and cycling facilities, and this is driving change across the real estate industry.

In light of the pressure to tackle climate change, real estate investors and developers are having to reconsider ESG performance indicators to futureproof their investments, reflected in the emergence of ESG policies, specific benchmarks and increased reporting and performance data. 

 

2. The planning system in England and Wales balances the development and renewal of the built environment on the one hand against the protection of the natural environment on the other. The National Planning Policy Framework sets out the Government’s planning policies for England and how these should be applied. It is based on an underlying presumption in favour of sustainable development, meaning development that meets the needs of the present without compromising the ability of future generations to meet their own needs.  This is achieved via three overarching objectives:

a) economic – to help build a strong, responsive and competitive economy, by ensuring that sufficient land of the right types is available in the right places and at the right time;

b) social – to support local communities, by fostering a well-designed and safe built environment, with accessible services and open spaces; and

c) an environmental objective – to contribute to protecting and enhancing our natural, built and historic environment; including making effective use of land, helping to improve biodiversity, using natural resources prudently, minimising waste and pollution, and mitigating and adapting to climate change, including moving to a low carbon economy.

The Government has recently carried out a consultation into its proposals to reform the planning system, entitled "Planning for the future", which would radically change the planning regime to streamline and modernise the planning process, bring a new focus to design and sustainability, improve the system of developer contributions to infrastructure, and ensure more land is available for development where it is needed. Read more about these proposals. The Government is currently analysing the feedback it received. 

 

3. Transparency of land ownership and interests – in its 2017 White Paper "Fixing our Broken Housing Market", the Government promised to increase transparency around land ownership, so that it would be clear which land is available for housing and where individuals or organisations are buying land suitable for housing but not building on it, in order to increase community visibility and control over ownership and development of land in their area.

As part of this impetus, the Government proposes to establish a register of overseas entities which own property in the UK or which plan to enter into contracts with the UK Government. Click here for more details.

The Government is also considering gathering more data in order to improve the transparency of contractual arrangements—rights of pre-emption, options and conditional contracts—used to control land. If these proposals were to be implemented then developers who had negotiated options, pre-emption rights or conditional contracts with the current owners would be obliged to notify the Land Registry of their interest and give details of the terms of these rights. The consultation ended in October 2020 and the Government is currently reviewing the feedback it has received. View the consultation paper.

 

4. The reform of residential leasehold – there has been a wide-ranging review by Government of the ways in which the current system impacts on purchasers of leasehold interests. There are several strands to this process but 4 that are of key interest to investors into the sector are (1) the Government's drive to replace residential leases with commonhold, (2) the intention to prohibit the construction of new leasehold houses, (3) the proposal that residential freeholders who pay service charges in relation to shared services should benefit from the same protections as leaseholders in relation to service charges, and (4) the intention to remove a landlord's ability to terminate an assured shorthold tenancy by the service of a notice under section 21 of the Housing Act 1988, meaning that a landlord would always have to go to court to establish that it has grounds (under section 8 of the Housing Act 1988) to end the tenancy in order to obtain vacant possession of a let residential property.  If implemented, these changes will have a significant impact on the ways in which residential schemes are structured and may impact on the extent to which investors are willing to buy residential property. 

 

Back to ESG and sustainable finance

Overview of relevant law, regulation and Government publications

Risks and opportunities

Overview

Whilst the priority for real estate investors is to improve ESG performance, achieving this objective whilst protecting the return made from investing in real estate as an asset class is perhaps the greatest challenge to the industry. The short-term cost of mitigating risk to investors must be weighed against the long-term advantages.

Risks

Arguably, the greatest risk for real estate investors is that their existing portfolios are not futureproofed and, therefore, lose marketability and value in the long-term. There is also reputational risk in that investors need to show they are socially and environmentally responsible.

Best practice

For all real estate stakeholders, the key priority is to develop and implement efficient ESG policies and benchmarks which are monitored and updated regularly. On a practical level:

  • Investors should pay closer attention to these ESG policies and benchmarks in preparing for sale and carrying out due diligence for acquisitions

  • Developers need to factor in more responsible construction practices into work specifications and be prepared to provide deliverables on practical completion of buildings which evidence compliance with their ESG policies and those of their client and relevant ESG-related legislation

  • Landlords should ensure their leases include adequate landlord access rights for making the relevant properties compliant with MEES Regulations, restrictions on permissible alterations by the tenant where they impact the energy performance of the property. Further, landlords should carefully review the services they are expected to provide as part of the service charge regime and ensure that those services comply with their ESG policies and those of their tenants

  • Tenants should consider whether the costs of services can be lowered if more energy-efficient measures are introduced by landlords and whether traditional yielding-up obligations can be negotiated so that premises do not need to be yielded up with vacant possession and/or fully reinstated on the basis the tenant's previous fit-out can be recycled

Our work

Examples of our work in this area include advice on

Contacts and further reading

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