Since 1st April 2023, MEES Regulations have made it unlawful for landlords to continue to let any commercial property that has an Energy Performance Certificate (EPC) rating of ‘F’ or ‘G’ (unless an exemption applies).
The investment this has demanded on the part of landlords has long been debated. However, for those savvy enough, or with sufficient funds to invest, creating office spaces that offer the very best amenities and the highest green credentials could present good potential yields, particularly as the drive to get workers back into the office continues.
There is an ever-increasing swathe of businesses seeking to improve their reputation and marketability by securing desirable premises that will help them to achieve greater environmental and social operational standards. They appear willing to pay higher rents for that privilege.
But what does this mean for the long-term prospects of older, poorer-quality, and less desirable office stock? If the rental demand isn’t there, especially in the current economic environment, is it even viable to commit the investment required to upgrade units to meet greener expectations? If not, will this inability to fund the necessary improvements diminish the sale value of the property should a landlord wish to sell it on?
Although the office lettings sector continues to provide opportunities for investors looking for quality properties to acquire, a divide is appearing, and there is a danger we are heading towards a two-tier market, where the more affluent or audacious landlords or investors will reap the rewards, whereas smaller landlords will struggle to compete.
The Current Market
In 2021, the Government introduced draft proposals to enhance the energy performance of domestic and non-domestic properties, aligning with the goal of achieving net zero in the UK by 2050.
The proposed two-stage approach, outlined that from 1st April 2027, all non-domestic rented properties would be required to attain a minimum EPC rating of ‘C’ (or apply for a valid exemption); then from 1st April 2030, the minimum EPC rating would be ‘B’
Earlier deadlines (1st April 2025 and 1st April 2028, respectively) were also mentioned for domestic properties.
However, on 20th September 2023, Rishi Sunak announced that the 2021 proposals had been discarded, citing concerns about property owners facing high expenses in a short period of time.
This decision was made to prevent the burden being passed onto tenants in the form of increased rents. While this news brought relief to landlords facing costly improvements, those who had already invested in expensive upgrades have found it frustrating.
Institutional landlords will have been preparing for some time for the harsher MEES regime by gradually upgrading their stock across their portfolios. However, despite any misgivings about the change in direction, those who have invested remain at a competitive advantage.
Green Premiums
The office sector has seen the emergence of a “green premium” in recent years. Buildings in London with green credentials, for example, cost 26% more than those without, according to a study by MSCI. Conversely, there is now a “brown discount” associated with older, less eco-friendly structures.
Owners of such buildings now face lower rental rates or selling prices, as well as difficulties securing investments, as a result of the increased emphasis on sustainability.
This dynamic places landlords and investors in a predicament, as they must choose between lower overheads or lower emissions. Yet, despite the increased costs, statistics show there is a willingness amongst tenants to invest in green working spaces..
According to the global JLL Future of Work Survey 2022, 74% of surveyed companies (represented by 1,095 senior corporate real estate decision-makers, from 13 countries) would pay a premium for green credentials, with 56% planning to do so by 2025.
This is because there are numerous benefits associated, including lower energy and operational costs, enhanced environmental corporate social responsibility, and improved recruitment and retention.
Occupancy
Trophy buildings will always be in demand since there are always new tenants wanting to make an impression. However, there is a shortage of both these high-end renovated or new-build properties, which will push up rentals.
This creates a bit of a catch-22. Short-term, rent from secondary-grade buildings in need of improvement will be lower, meaning landlords will have less money to spend on upgrades at a time when rising interest rates will make their mortgage burden heavier.
Some will be able to secure the finances necessary to draw in higher-paying tenants, either directly or through outside investment; however, others won’t be able to find the money or justify the expense in the current market. Their pool of possible tenants will consequently be much smaller.
This has led to an increase in vacant space that is simply not moving. According to a survey conducted in 2023, 84% of landlords stated that their occupancy was less than 70%, and 53% said that their offices were just half full. However, of those with the strongest green credentials, 56% had offices that were over 70% occupied. This situation is quickly becoming unsustainable.
The future
The demand for well-located and sustainable buildings, fuelled by the rise of hybrid working, exceeded supply in 2023 and is expected to continue in 2024.
Out of the office spaces under construction and set for completion in 2024, 37% were already leased off-plan by the end of 2023. This increased demand has depleted the development pipeline, leading to competitive tension and higher rents in the high-end market.
Some tenants may consider investing in technology for remote operations instead of leasing lower-grade premises, meaning the issue of vacant office units will remain unresolved.
As such, landlords must assess their position in the market and may need to make some investment just to stay afloat, even if they don’t want to compete in the top tier.
Karen Mason is co-founder of Newmanor Law
