Built Environment: Outlook for 2023 - Real Estate

Alison Murrin:

Hi everyone, my name is Alison Murrin and I'm delighted to be joined by Richard Vernon, a partner in our real estate team to share his views on the real estate outlook for 2023. Richard, it's probably stating the obvious that the economic outlook is challenging at the moment. We've got inflation running at a 40-year-high. Interest rates are rising, energy costs are surging, and with these high energy prices and a recession, we're probably going to see occupancies and rents falling even in those sectors, which were previously fairly robust in real estate.

So it's fair to say 2023 is looking like it'll be a tough year and some industry leaders are predicting that recovery may not emerge until early 2024. So we've got increasingly expensive debt, which is going to cause a change in valuations. And pending that correction, I think market participants are definitely going to be more cautious. However, as we've seen in past downturns, there's also opportunity for those that have got access to capital. And once inflation and interest rates come down it's likely that we're going to see confidence in investment returning to real estate. But bearing in mind these headwinds that are facing the real estate sector, can I ask you what you think is the biggest challenge facing real estate at the moment?

Richard Vernon:

Thanks, Ali. Confidence, as you say is the key word and the current challenge. And we really need a period of stability both politically and economically. The market needs that confidence to make a call on valuations today without worrying what it's going to be worth tomorrow. And otherwise we'll just continue in that cautious market you refer to where the safest option is to sit on our hands and pause. But as we know from previous experience, the market will come back.

You ask about the biggest challenge and for me, as we've just seen highlighted from COP 27, climate risk remains the biggest challenge facing real estate at the moment. This time last year, we were all really excited by the first ever built environment day at a COP conference to highlight what needs to be done. But a year on have we seen that huge shift in the industry that needs to happen.

The built environment, as we know, contributes around 40% of global carbon emissions. And so it's impossible to mention real estate without referencing ESG and decarbonization. The government's target is to reach net zero by 2050, but 80% of buildings that will be standing in 2050 exist today and the vast majority do not meet the required environmental standards.

And whilst the sector is responding to changing regulation and occupier trends that's unlikely to turn the dial in any meaningful way. There really needs to be an increasing focus on action on the ground that will make a real difference, such as retrofitting those existing buildings to meet climate goals.

Property owners should be pricing in the cost of transitioning towards net zero now and be concentrating on how to finance and deliver the retrofits of existing buildings, which will also help protect a hit to values in the future. Getting these buildings to net zero while also seeking to demonstrate greater social conscience and continuing to thrive in a more challenging environment is a huge test for the real estate sector. However, at the risk of stating the obvious inaction now will give rise to a greater financial and environmental burden in the future.

Alison:

Thanks Richard. I think that that leads me nicely onto my next question actually, which is whether we need to be factoring in increasing regulation as we transition towards net zero.

Richard:

Well currently in line with the minimum energy efficiency standard regulations or MEES as they're called, since 2018 owners of buildings have had to ensure that their property meets a minimum EPC rating of E before they can grant a lease at the property. And from the 1st of April 2023, landlords will be prevented from continuing to let, unless the EPC rating is E or above, even if the lease was granted prior to MEES coming into force in 2018. So one question is whether landlords and funders fully understand the EPC rating status for those buildings that were already let prior to 2018. Of course, MEES only apply to properties that are required to have an EPC. So property which does not require an EPC is not affected. There are common misunderstandings about trigger events for an EPC and its relationship with MEES.

So it's important to take advice if you are uncertain as to whether an EPC is needed to avoid inadvertently also triggering a MEES liability. And although they have not yet been made law, the government as we've seen, has already consulted on a number of significant changes including raising the minimum standard to an EPC rating of B by the 1st of April 2030. An obligation to maintain a valid EPC at all times is also under consideration rather than just at the point of granting a lease, capturing many properties that may have otherwise escaped a MEES liability by virtue of EPCs having expired. And if this does become law, then this means a large proportion of existing buildings will need to be upgraded in a very short time. Landlords, investors and lenders will need to take action now. Seven years for the likely works involved is not long when you have funders, landlords and tenants and potentially planning permission in the mix.

And the cost of inaction is likely to be significant. But of course sustainability presents an opportunity for investors to differentiate themselves among their peers where sustainable buildings are likely to be considered the new prime with a so-called 'greenium'. Any asset that is deemed not sustainable is more likely to be at risk of a brown discount with talk of so-called stranded assets. And will we see a two-tier market with the flight to prime ensuring resilience? But of course delivering and scaling a sustainable strategy is not going to be easy with challenges such as data collection, capital allocations for transitioning assets and also monitoring that compliance.

Alison:

Thanks Richard. It's really interesting what you're saying about MEES and it does seem to be the focus at the moment. We're seeing the government just trying to improve the effectiveness of MEES, but I suspect there are probably other regulatory changes in the pipeline as we transition towards net zero. And I wondered if you could just highlight some of the key forthcoming changes for our listeners.

Richard:

Yes, of course. I mean obviously MEES and EPC is just part of the story. I think the next on the agenda will be how to deal with embedded carbon. So that's emissions associated with materials and construction, maintenance, repair, demolition, and also the disposal of a building. And that whole area is largely unregulated at the moment, noting that it's estimated that around 35% of the lifecycle carbon found in a typical building is emitted before it's even open.

The Environmental Audits Committee report in May this year recommended the introduction of mandatory whole life carbon assessments for new developments above a certain size threshold.

And it's great news that the government's response endorsed this recommendation and indicated that it will review the national planning policy framework to ensure it contributes to climate mitigation, which will include a consideration of incentives for retrofits and also the role of circular economy statements. However, the regulatory framework needs improvement. We really need a universal definition for a net zero carbon building. We need a minimum energy efficiency standard based on operational performance and that obligation to have a whole life carbon assessment. So clear and effective policy and regulation will allow property owners, investors, and funders to make proper long-term decisions for the good of the sector. But of course, time is against us with 2050 on the horizon.

Alison:

Yes, I think it's clear from what you're saying that the direction of travel is clearly we need a better regulatory framework if we're going to complete our net zero journey in the built environment.

And I think the other side of that coin is green washing and I'd really like to hear your thoughts on how the government intends to tackle that issue of green washing.

Richard:

Yeah, it's a real concern because I mean, in recent years there's been a growing talk around green washing and the possibility that investors are being misled about the true sustainability credentials of their investments. And to tackle this, the UK Green Taxonomy aims to create a sort of consistent benchmark which provides clarity for those investors and therefore reduces the risk of green washing. And as well as the UK Green Taxonomy, there are proposals for the introduction of sustainable disclosure requirements known as SDRs, and those require sustainable disclosures at both corporate but are also asset level.

And the government is really committed to focusing on net zero in the UK context, which builds on international taxonomies and taking the scientific metrics in the EU taxonomy as its basis. And it's clear that an agreed international definition of a net zero building would really help level the playing field. So with the introduction of the SDRs and the UK Green Taxonomy, it will mean more regulation for large companies, asset managers and asset owners. This means that there is a greater compliance burden, but regulation has made the real estate market more transparent around climate and carbon risk, which is obviously a good thing and it helps to assess and determine the response to risk. It helps to satisfy the need for evidence of a sustainability strategy in practice for the regulators, investors, clients, but also society at large.

Alison:

Thanks, Richard. And I think that means when you think about the increased regulatory landscape, it suggests that parties who are entering into contracts will really need to think about how they future proof those contracts and the assets that those contracts concern. And much has been said about green lease clauses and I wanted to ask you what your experience is of how green lease clauses are used in the market.

Richard:

Well, as you say, there's been a lot of talk about green leases for a long time now. But from a landlord and tenant perspective, the use of green leases certainly in England remains far from widespread. But there's a renewed push for the property industry to become more energy and environmentally efficient because of the increasing transition risk to net zero. And so parties are looking at green lease clauses as a means of future proofing.

A green lease will often include additional clauses for say, the management and improvement of the environmental performance of a building. It can address wider sustainability issues such as water and waste management and the use of sustainable materials for buildings. But the extent to which green clauses are adopted depends on how green the parties wish to be and the circumstances of the relevant transaction. For example, the age and nature of the building. Leases can vary from light green to dark green depending on the extent of the obligations and how onerous they are.

On the light green side leases may simply contain a general obligation on the parties to work to improve the environmental performance of the property or the building. Darker green leases will set out specific objectives to reduce greenhouse gas emissions, reduce the carbon footprint of the building, offset residual emissions, protect and enhance existing ecological features in the building, minimise pollution and minimise water usage. And more specifically, landlords may require any tenant alterations to be carried out using sustainable materials and avoiding materials that increase the embedded carbon. And tenants are not being required to reinstate any tenants alterations, which would adversely affect the environmental performance of the property. And this means there is less wastage of materials. Of course, in order to monitor the energy performance of the buildings, the landlord will want the tenant to share information and monitor the energy and other resource consumption at the property on a regular basis.

And there will often be specific policies and regulations for the particular building around water management, waste management, and measures to ensure the workforce travelling to and from the building do so in a sustainable way. For example, with the inclusion of vehicle charging points, cycle racks and showers for example.

The negotiation and acceptance of green leas provisions is still a work in progress. We do not have a settled market position on the balance of liability between landlords and tenants on who should pay for green improvements. It's all going to be about collaboration.

At present it depends on the ESG priorities of the parties and the type of building. And unlike other clauses in leases, the adoption of green lease provisions and sustainability wording has the real potential to transform the real estate landscape. However, with so many shades of green still in the market, what is reasonable is difficult to determine. Ashurst works closely with the Chancery Lane project, which is a not-for-profit organisation, which partners with international legal and industry professionals to create climate contract clauses. And their built environment hub has a bank of suggested green clauses for use in leases and other real estate contracts. And that's well worth a look.

Alison:

Thanks Richard. There's a lot that you've said there in talking about climate change, regulatory risk and contract protections to future-proof real estate. And I just wanted to round off our podcast by talking about maybe some of the other challenges or risks that are on the horizon that we should watch out for in 2023.

Richard:

Well, thanks, Ali. I think firstly it's worth mentioning the Building Safety Act 2022. Although that's enforced, there are various provisions which are yet to come into force and are likely to come through next year, which both landlords and developers will need to plan for. For example, for owners of residential buildings over 18 meters, the ACT requires there to be an accountable person and that is the person who's responsible for the repair of the structure on common parts of the building. And the accountable person will have various duties to manage building safety risks and provide information to the regulator. The ACT also will introduce the concept of the golden thread, and that's designed to ensure that all the information gathered during the planning, construction and occupation of the building is maintained and can be provided to third parties in the future on request. And furthermore, in order to recover service charge from the residential leaseholders, the landlord will need to include certain prescribed building safety information in the rent demands.

And of course, all that comes on top of the restrictions on the recovery of service charge for remediation of historical building safety defects, but also the new liabilities that can be imposed by the first tier tribunal against current and previous building owners to remedy such defects by virtue of a remediation order or a remediation contribution order. And importantly, it's worth noting that those orders can extend to group companies, associated partnerships, majority shareholders, even corporate directors of the party responsible, so very wide reaching. Finally, the ACT also gives the Secretary of State the power to set up a building industry scheme, which is interesting because developers and contractors who agree to undertake or fund the cost of remedial works to their buildings will be able to become members of that scheme. The Secretary of State will then have the ability to prohibit non-members from undertaking development work if it considers necessary to ensure building safety or building standards are met.

We then have the 31st January 2023 deadline, which is fast approaching for overseas entities that own UK real estate to apply to Companies House for registration on the overseas entities register. Now at this point we reckon only about 5,000 of the approximate 31,000 affected companies or entities have successfully registered at Companies House. So I think there's going to be a last minute rush there. Overseas entities also need to be aware that even if they no longer hold any land in the UK as at the 31st of January, they will still be committing a criminal offence if they have not provided Companies House with details of all their land disposals since 28th, February 2022. With regards to the register, it's also worth flagging there is an annual update requirement, which needs to be complied with going forward. And failure to update is a criminal offence committed by the overseas entity and by every officer of the entity who is in default, punishable by a fine or imprisonment.

We then have the product security and telecommunications infrastructure bill that's likely to continue its progress towards Royal Ascent next year. This bill seeks to amend the existing electronic communications code to rectify some of the issues which have emerged as a result of some of the cases that have been decided since the code came into force in 2017. This will mean that an occupying operator will be able to seek new code rights by statutory disregarding its occupation and the 1954 ACT will be amended to align its rental valuation provisions for telecommunications leases with the operator friendly site payment provisions under the code. And the bill also seeks to extend upgrading and sharing rights to equipment installed before the code came into force and streamlined the renewal of code agreements.

And I think the only other bill might be of interest is the Renter's Reform Bill, worth mentioning. Michael Gove has indicated that this will progress next year and amongst other things it will scrap Section 21, no fault evictions under the Housing Act 1988. Section 21 is a reassuring safety net for a landlord who can be safe in the knowledge that aside from the relevant notice period, they are virtually guaranteed a possession order. So the bill promises to strengthen the landlord's rights of possession to ensure properties can be returned when necessary. So all in all, Ali, 2023 is shaping up to be an interesting year.

Alison:

I think I can wholeheartedly agree with you there. Thanks so much, Richard. That's been really interesting and obviously we haven't been able to cover all of the developments that will no doubt occur in 2023, but hopefully we've shared some highlights.

Thank you so much, Richard, for your insights and thanks to our audience for listening.

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