Reimagining Real Estate Trends for 2022 Transcript

RV: Good morning and thank you for joining us today. My name is Richard Vernon and I am joined today by a fantastic panel from our real estate team – Jamie Chapman is a partner in our development team; Alison Hardy heads our real estate disputes group; Sadia McEvoy is a counsel in our construction team; Claire Dutch is co-head of Planning; and Jess Jenner is a partner in our Real Estate Finance team. For the next 45 minutes - we will ensure we keep to time - the panel will be giving their take on what real estate issues we are likely to see in 2022.

Please feel free to submit any questions you may have during the session via the chat box and we will try to answer as many of your questions as possible at the end of the discussion. The webinar is being recorded and we will circulate the recording to you after the webinar with any follow up materials.

So my take away from 2021 is that it feels like ESG and sustainability really matter and are top of everyones agenda. COP26 did not achieve everything some had hoped for. However it did change awareness of Net Zero 2050 commitment in a huge way and really felt like a call for action.

For the Real Estate sector, we had the first ever day allocated to the built environment at the conference which was so vital bearing in mind the real estate sector is responsible for around 40% of greenhouse gas emissions.

We now know the problem – for commercial real estate 80% of buildings that will be here in 2050 already exist today and the majority are not green enough. It is estimated that over 1 billion square feet of office space is below an EPC B rating.

Jamie – knowing the problem, this ultimately needs action and that action comes at a cost – so who pays? The majority of those commercial buildings are leased so it is a landlord versus tenant debate. Green Lease drafting has been around for over 20 years but what does it mean now and going forward? Are Green Leases going to move from general collaboration and data sharing to a more definitive approach to help solve part of the problem?

JC: So an easy one to start with.

You mention collaboration. Collaboration is a central theme of the roadmap launched by the UK Green Building Council at COP26.

However the problem for commercial leasing is we still do not have a market position for Green Leases which helps set that balance of liability.

In other areas of leasing that balance has been established and adjusted over many years but fixing levels of environmental performance and how we deliver environmental improvements to meet those levels are relatively new concerns. The leasing market has not yet settled on a standard position for the sharing of these costs. This has also become more difficult given the backdrop of the last couple of years where neither landlords (who have been providing rent concessions) or tenants (who may have been paying for premises they cannot fully utilise) have felt like their position has been protected. Additional costs are seen as unwelcome at this time.

However this will need to change and that collaboration will be needed in practice so that Green Leases can become an effective tool to help solve this challenge.

RV: Jess – Of course for most commercial assets there is a third person in the relationship – the funder. Do you think funders are now getting a better understanding of the impact poor energy efficiency on their portfolios, on their funding decisions and how Green finance needs to evolve?

JJ: The collaboration you mention that is needed does need to include all stakeholders including the funders. What is clear is that funders need to understand the profile of the portfolios within their loan books - what is needed for those secured assets where energy efficiency is not sufficient, what is possible in terms of improving energy efficiency and the costs involved in making those improvements.

The good news is that many funders are investing in green expertise and there has been a growth in the availability of data in this area and, where available, this data may be utilised to help financial institutions identify green projects by enabling them to compare one building's environmental credentials against other comparable buildings. We have seen a real drive from funders to push the green agenda – which will also be driven by regulatory pressure as well as investor and/or shareholder demands.

RV: Are we going to see funders refusing to lend on inefficient buildings?

JJ: We are already seeing some credit decisions based on the energy efficiency of the underlying asset and a far greater focus being placed on the energy efficiency of buildings as well as evidence of valuation outcomes being more overtly determined by the green credentials of the underlying asset. Traditionally funders would expect building owners to fund certain capex on buildings from equity, but with the cost involved we may see separate green capex lines being introduced by funders. Retrofit projects have the potential to make a substantial contribution to broader climate change mitigation efforts. For example, through innovative use of traditional building materials and design, solar technologies, low carbon heating systems; water efficiency technologies and energy management and performance technologies. Lenders have a crucial role to play in catalysing the decarbonisation of the real estate sector and encouraging activities and practices in this sector.

RV: I am guessing that green capex will come at a high cost to property owners?

JJ: We are seeing evidence in the market that competition to fund green may well drive down what would otherwise be more expensive debt. Of course as noted this question also can hits values so the defensive green capex can be seen as a way of maintaining or increasing values and necessary for funders wanting to reduce refinancing risk on their exit.

RV: We have talked so far about commercial property but Claire what about residential. Boris called for "Build Back Better" in August 2020 in the Planning White Paper. Net Zero or not, we have a housing crisis.

CD: Yes, about 18 months ago the government made a great fanfare of the Planning White Paper and said they were going to tear up the planning system! They proposed some quite radical changes looking into a type of zoning system. It generated much debate and the government received 44,000 responses – many of which were not complimentary. What's happened since? The short answer is not a lot. Everything is on hold, we have a new department – DLUCH – and a new Secretary of State. The government has said it is still committed to planning reform but is pausing to think about things. It is clear that whatever does come out will need to be closely aligned with the levelling up agenda which is obviously one of the government's main priorities.

RV: So major change is on hold – has anything actually changed?

CD: Yes the government has tinkered with the system – it obviously introduced the new broad amorphous class E for town centres giving flexibility to changes of use on the high street without needing planning permission. It has also introduced a raft of pretty extensive permitted development rights. Some of these go a long way – you can now add two stories on top of a house and demolish and rebuild a commercial building or a block of flats without needing planning permission. You can also change class E to residential. Many commentators think we will regret this kneejerk expansion of permitted development. In terms of the green agenda – does it really help? A quick and dirty development or a flip of uses without planning permission doesn’t take into account the issue of sustainability, good design, placemaking and legacy. Nor does it require affordable housing. Will we regret the impact of this in the future?

RV: Is there anything that is definitely possible for the green agenda?

CD: Yes at least the government has done something big for the environment – after a long and chequered history, the environment act was finally passed last year. It introduces new legally binding environmental targets and a new body Office for Environmental Protection. It also enshrines in law that developers must deliver at least 10% increase in biodiversity on the schemes they build which is quite a step forward.

RV: So build back better may not be around the corner and may not be better but Sadia the construction industry is already making headway. Brand new space can obviously deliver the standards we need but with the vast amount of built space to deal with and an estimated 35% of the lifecycle carbon found in a typical commercial building being emitted before the building is even opened, how are we seeing the construction industry tackle the net zero challenge?

SM: As you say, Richard, action within the construction sector has really accelerated over the last 12 months and continues to gain momentum, although it is massively challenging – and a real area of risk in terms of the UK not hitting its 2050 targets.

For new builds it's more straightforward to achieve net zero than refurbishing existing buildings. New builds can set their goals at the outset in terms of using alternative materials, decarbonised cement and steel etc. They can also prioritise from the outset ways to promote circular economy principles, for example, through mandated use of BIM; and maximise use of carbon-friendly construction processes, such as offsite manufacturing.

The bigger challenge is how to improve the carbon footprint of existing buildings. This will primarily need to be achieved through use of renewable energy sources, efficiency in building operations, and via accountability through clearer measurement of building efficiency.

RV: We are hearing about a lot about reuse rather than rebuild?

SM: Yes an area of real opportunity for developers is to maximise reusage of existing structures rather than building from scratch. This is the approach our client British Land took at 100 Liverpool Street, with their JV partner, GIC. They retained 50% of the existing 1980s structure which went a long way towards enabling them to achieve net zero on that building.

Of course, purchasing carbon credits (or offsets) is another way to reach net zero emissions. Some companies are also making commitments beyond carbon to biodiversity and water. However, we're also seeing some of our clients, such as Lendlease, committing to absolute zero, in other words, to the elimination of all emissions without the need to offset.

RV: What can the lawyers do as part of this challenge?

SM: Not everyone likes to hear it, but what we really need are contractual mechanisms that encourage the sharing of risk and improve project culture.

Collaboration is key. We're talking about this a lot today but it's essential to making the construction sector more sustainable.

Some of the best ways that construction contracts can achieve these goals – and we're seeing much more engagement from clients on these points - are:

- by providing for early contractor involvement so that the build contractor can contribute to design development and planning of the construction phase, for example enabling enough lead time to be given to consider offsite manufacturing solutions;

- by developing framework arrangements with trusted suppliers who share targets for the elimination of embodied carbon and with whom long-term relationships can be established;

- by providing for KPIs that set out a shared purpose in relation to net zero targets; and, of course,

- through shared financial incentives if green targets are met.

Such provisions, of course, go hand-in-hand with a more collaborative approach towards design and technology, and we need to be using digital solutions that work for the operational phase as well as the build phase. Using digital tools, notably BIM, has obviously been on the agenda for years but the government has renewed focus on it in the context of the new building safety regime and we're seeing more engagement with it from our clients.

RV: How we build and re-use and refurbish buildings will clearly play a vital role in achieving net zero in the industry but how we then use those buildings must not be forgotten.

We have new MEES/EPC regulations coming our way soon which means immediate action is needed, but Jamie coming back to you, where are we with EPC's and the new regulations?

JC: Since their introduction, EPC requirements have had limited teeth as if you just need to have an EPC with a low rating to lease space rather than having a challenging threshold of environmental performance which is based on proper rating criteria then there is no real impact.

The Government tells us that new reforms are "in progress" to address these criticisms. And indeed if the current consultation proposals become law as expected then needing to have a B rating from 2030 will in part provide that real impact we are currently missing, and arguably the threat of those proposals becoming law is already creating a catalyst of change.

If your building today does not achieve the B rating required to let commercial space then landlords have to start planning what needs to happen to improve their building. So that immediately brings into play the debate that has been running over who bears the cost of those necessary improvements.

RV: Can I ask – is the current EPC system flawed?

JC: The current system is arguably “not fit for purpose” because an EPC rating is based on the cost of the energy the building uses, not on the actual carbon emitted by the premises into the atmosphere. So it is a system that punishes people for installing heat pumps because they use electricity and/or liquid petroleum gas that are currently more expensive resources than natural gas – it therefore incentivises the use of mains gas over electricity or Liquid Petroleum Gas.

As the project lead for the UK Green Building Council's Net Zero Whole Life Carbon Roadmap has said: We have currently got a metric that incentivises gas because it is cheaper. If you install a heat pump, which is powered by electricity, your EPC rating may actually get worse.

In terms of reaching net zero, we need to switch as much energy demand as we can to electricity, But because the EPC system has not changed, it still incentivises property owners to do the opposite. Going ahead with new EPC targets without reforming the base criteria will not solve the problem.

So, alongside the new legislation that is proposed the Government is considering a new 'in use' rating to ensure that the EPC regime is fit for purpose. The Government is looking at consulting on a new rating system to measure and compare energy consumption performance vs actual carbon emission performance for larger commercial buildings. We will have to watch how this progresses and whether it will address the current concerns.

Going forward the proposed changes to the EPC regime are likely to have an impact in the short term. Landlords will need to review their portfolios and put in place budgets and business plans for improvements and look to refresh EPCs with a view to achieving better ratings. While occupiers will need to factor the review of green credentials of new commercial space into their decision making processes before entering into lease negotiations.

RV: Jamie and Jess you have both mentioned the question of who should cover the costs to improve these buildings but with the challenges faced over the last 2 years landlords and their funders must be looking very carefully at their tenants, the tenant mix and vacancy rates and whether the changes to permitted development rights Claire mentioned will help or hinder the situation.

Alison – For 2022 what do you see as the direction of travel for tenants as we see the protective legislation and financial support fall away and could we see a new type of distressed asset coming our way with LTV covenants being challenged not by traditional liquidity and market conditions but the energy efficiency of the asset?

AH: The government is introducing a new rent arbitration scheme to resolve outstanding ringfenced covid arrears. When launched, the government predicted this would lead to approx. 50k arbitrations, so affecting 50k properties. The estimate has recently been significantly reduced to 7.5k. Anecdotal evidence is that very few landlords unresolved rent arrears – most have reached deals with their tenants which is of course what carrot of the voluntary code, and the stick of the restrictions, were designed to achieve.

• Whilst we have seen some sectors bounce back relatively quickly, the retail and hospitality market are still struggling and we expect this will take at least another year to clear. We can, therefore, expect more distress in those sectors during 2022 and beyond. There has been much talk, including by me, of an impending wave of insolvencies.
• There are many zombie companies which have been propped up during the pandemic and this has led to a reduction in the normal churn of insolvencies. Add to that the impact of the pandemic and changed behaviour and there simply must be pent up insolvent entities. The question is when, rather than if, those insolvencies will happen. Talking of insolvencies, the new kid on the block here is the restructuring plan which has been used a handful of times. It will be interesting to see the proportion of CVAs compared to the more expensive restructuring plans.

RV: A question I am sure you get asked a lot – will the remaining restrictions be lifted at the end of March?

AH: That's what we are being told at the moment. The intention is that the new rent arbitration scheme

RV: Alison – so what does all this mean for the green agenda?

AH: In the long term, there is a real risk that the drive to net zero will lead to stranded assets and in turn to a new class of distressed asset. Those assets will require some reimagining to bring them back to life.

Thank you Alison and the rest of the panel. We have a few minutes remaining so I am now going to pick on a couple of questions that have come in

1. RV to SM:

RV - Question: One for you Sadia - Do you see building safety and sustainability as linked?

SM - Answer: Yes, absolutely. The Building Safety Bill is due to become law later this year. Its provisions will then be implemented over the subsequent 12 to 18 months. Collaboration, innovation and technology are essential to achieving both safe and sustainable buildings. I would particularly highlight the 'golden thread' which many of our listeners will know is an essential element of the new building safety regime. The aim is that information regarding an in scope building is accurate, up to date, accessible and kept in one place. This information will be equally important to monitor the sustainability credentials of a building and also to facilitate re-use. So, I would reiterate the point I made earlier which is that keeping a full digital record of the construction phase and the built asset will be essential – not just to promote safety and sustainability but also to maintain the full value of the asset.

2. RV to CD

RV - Question: Thanks Sadia – Claire – looks like another easy question for you – is the government going to go ahead with its plans to scrap CIL and s106?

CD - Answer: Good question! Short answer is who knows. In the White Paper, the government proposed this and said it would bring in a new levy called the Infrastructure Levy. Then it rowed back a bit and said it would keep s106 just for non-financial contributions and that would sit alongside the levy. The levy generated a lot of debate – it was blatant land value capture and not on the cost of the infrastructure ie the developer would pay a nationally set percentage of the GDV of the completed development before occupation of the development. Developers were quite happy with the timing of payment because it is not like CIL which needs to be paid as soon as there is a spade in the ground. Others argued that payment was too late as the LPA would not get the money until very late in the process. It was reliant on LPAs having the appetite to borrow against future levy receipts to forward fund infrastructure.

The latest news is the government is keen to bring something in. They mentioned that again in the Levelling up proposals that came out last week. Whether it will look like the proposed IL, who knows.

3. RV to JJ

RV – Question: Jess one for you – The panel has talked about lenders and assets stranded by energy inefficiency, are we going to see opportunistic funds stepping in to acquire some of these assets at a discount?

JJ – Answer: There is no doubt that there will be investors with the expertise to take on the challenges of inefficient buildings will be watching carefully as this evolves. Part of the challenge as we have said is to be able to understand the extent and cost of what improvements will be needed. At least for now the added difficulty as Jamie has said is that we have no certainty of what rating requirements will apply. We believe we know what the EPC regime will look like but if that system is to be scrapped and replaced it may be a while before there is sufficient certainty even for the opportunistic investor. Those investors may well be supported by like minded funders who may specifically choose to support that business plan based on a clear exit strategy clear costed business plan and target end value.

4. RV to JC

RV Question: Jamie – this could be a question for a whole new webinar but briefly

"How can you measure the ESG credentials of properties?"

JC – Answer: In order to measure the ESG credentials of buildings, the collection of data is key but this poses a fundamental challenge.

As we have already touched on the EPC is based on modelled data rather than a building's actual performance in terms of carbon emissions.

Of course there are a number of benchmarking schemes which property owners can sign up to which will measure energy performance. Although there are concerns that some benchmarks in the industry score members on the strength of their reporting and not on the actual data which underpins these reports.

So quantitative evidence and specific metrics need to be given greater weight.

However it is much harder to measure the social and governance performance of buildings and these additional strands are no less important. A building's effect on society, including the health and well-being of its occupiers and the impact it has on the local community are factors which are increasingly in the spotlight.

It is clear that the S and the G are just as important as the E when demonstrating ESG credentials.

RV Conclusion

We have some further questions in the chat box which we do not have time to cover now but we will include responses in the materials we will circulate with the recording of this session. If you have any further thoughts or questions please do not hesitate to contact me or any of the team.

But before we go – panel – 10 seconds each – Give us one prediction for your sector in 2022?

JC: Prolonged debates - I mean collaboration- between landlords and tenants over who pays for building upgrades.

JJ: Growth of 'retrofit capital' from both more established REF market players as well as new market entrants looking to assist with this opportunity.

AH: We'll see more distress, more insolvency processes and some therefore some opportunities in the market.

CD: Government will continue to dither about on major planning reform and will instead introduce a series of tinkering at the edges reforms which will clog up and confuse the system further!

SM: We will see more and more Framework Agreements enabling more collaboration between suppliers with a shared vision for net zero.

So for me – its going to be all about 'Collaboration'.

As the Queen said when opening COP26 – the time for words has now moved to the time for action.

Thank you very much for joining us and have a good day.