Thursday, 1 May 2014

Performance Challenge

This article origionally appeared in the May/June edition of RICS Building Surveying Journal. You can access the magazine by clicking here.



Written by Graeme Murray
Head of Sustainable Engineering, CBRE Building Consultancy

The impact of The Energy Act 2011 will hit the property sector hard from April 2018, when in most cases it will become illegal to lease a commercial or residential property where a minimum energy efficiency standard has not been achieved. This is believed likely to be an Energy Performance Certificate (EPC) rating of E, meaning that many properties falling beneath this level will be unlettable, or ‘obsolete’.

Surveyors should also be aware that in the case of domestic properties, the Act introduces a right for tenants to request energy-efficiency improvements that a landlord will be unable to unreasonably refuse, by the earlier date of 1 April 2016.

As leases of obsolete buildings potentially become void, the ensuing results can include a fall (or considerably slower rise) in values, a less secure asset or ultimately the withdrawal of funding. But while the impact can appear extreme, there is much that the building surveyor can do now to reduce the client’s risk.

 
Upgrade costs

With an estimated 18% of commercial property currently failing to meet an EPC rating of E or above, values of less energy-efficient properties will be – and in some cases are already – affected due to the seemingly unrealistic cost of upgrades and the threat of obsolescence. At CBRE, we are already seeing major commercial landlords and institutional investors responding by conducting reviews of property assets and putting in place material changes. In London and other regions where values are high, this response is not only a legal necessity but a worthwhile investment. It is in the areas and sectors where capital expenditure costs potentially exceed revenue, that the Act can pose a real threat.
 
Approximately two-thirds of the UK commercial property market is leased, with the majority of let buildings having several occupiers. Although the legislation does not come into effect for four years, owners of such buildings should imminently consult leases (many of which run beyond 2018), to determine where responsibilities lie and ensure that buildings meet requirements. Consideration should also take into account whether a statutory compliance covenant exists, which could oblige the tenant to carry out the necessary improvements. Green leases are gradually emerging as a means of contractually agreeing (rather than imposing) standards of  sustainable asset management on the landlord and/or the tenant. Such leases can address inequities of investment and return in which the landlord has responsibility for capital investment but the tenant benefits. While the objective of sharing the tenant’s savings creates an incentive for the landlord to undertake sustainable investment, there is a risk that the tenant is placed under onerous liabilities in relation to repair. Therefore, it falls to the surveyor to determine the impact of such clauses on the value or yield.
 
Accuracy issues

Surveyors should be aware that EPCs are being reviewed and challenged during the Technical Due Diligence process. In CBRE’s experience, smart clients are no longer taking EPCs at face value or treating the process as a tick-box exercise, which has highlighted that a significant number of historic EPCs are inaccurate. The process of completing an EPC for a commercial building requires information to be collected and assessed using approved software. All data fields should be completed as accurately as possible, because if an element is not known the software reverts to a ‘worst case’ scenario. As such, many EPCs have been compiled with scant information by inexperienced assessors or simply undertaken cheaply, often resulting in a rating below what could have been achieved. Consequently, many properties that appear to fall below the minimum standard may actually comply: they are simply misrepresented.
 
The impact can be significant, causing either price chipping or the collapse of deals. CBRE was recently asked to look at a transaction that was near collapse due to a poor EPC rating. Following the intervention of our Sustainable Engineering team, the EPC was improved from an F to a D simply by running a more thorough thermal model and the deal was rescued, saving the client a substantial sum.
Our case study of four retail units in London’s Covent Garden exemplifies this: originally rated as F and G, the units were recertified as C and D following a review on behalf of the vendor despite the only major change being the way the lighting had been assessed.
 
EPCs were first issued in 2008 and expire after 10 years. It is worth bearing in mind that any transaction today may have an EPC dating back to 2008, and therefore will need to be recertified shortly after the 2018 deadline.
 
Due to changes in Building Regulations, it is quite possible that a building with a good rating achieved pre 2010 may be at risk of obsolescence by 2018: already we are seeing buildings previously rated D now being given an E rating due to the more stringent benchmarks, and after the changes in regulations in April this year and again in 2016 that same building could potentially fall to an F when recertified.
 
With such potential variation and scope for inaccuracy, it is unsurprising that ratings of C and D are also being questioned to ensure that purchasers are not exposing themselves to significant financial risk should the ‘good’ rating actually turn out to be ‘bad’ post 2018.
 
Dilapidation settlements are likely to be affected by the change as landlords look to pass EPC risk onto tenants. As already mentioned, we are likely to see an increase in green leases as a result, with clauses requiring improvements to be carried out and EPC ratings maintained. Similarly, tenant fit-out guides will become more common and more rigorous. Some landlords will need to achieve a high EPC rating to allow for the possibility that some factors under the control of their tenant – such as the choice of lighting – will bring down the rating and potentially lead to obsolescence.
Sources of information
 
In 2012, the Investment Property Databank (IPD) launched Eco-Portfolio Analysis Service (EcoPAS), a benchmarking service that identifies and highlights the potential environmental risks in a real estate investment portfolio. It has the support of RICS, which recommends that the sustainability inspection checklists are used in standard valuation practice. Because all future valuations should take the requirements of the Act into account, the RICS guidance note Sustainability and commercial property valuation is an extremely useful document.
 
This states that in order to respond appropriately as markets change, valuers should continuously seek to enhance their knowledge of sustainability. It summarises ‘sustainable buildings’ as having been designed or refurbished to achieve longer life cycles, featuring different resource use or ecological footprints or having design features that impact on factors such as the heat island effect, internal natural light distribution, natural ventilation, water and storm water management.

To help surveyors translate these aspirational objectives, specifically in relation to energy and water efficiency, the RICS Building Surveying Professional Group recently published the RICS professional guidance note Sustainability: improving performance in existing buildings. Rather than recycling the wealth of data already available, this document seeks to integrate sustainability into the design and construction process in a way that will be familiar to the building surveyor. It includes a simple road map to highlight key issues at each stage of the process and a checklist based on individual building elements with an initial indication as to whether the work might have a short or longer ‘payback’ period.
 
While much of the talk about the Act can be alarming to property owners, few buildings are genuinely obsolete: there is nothing to prevent an older building achieving a good rating assuming that it has been carefully reviewed, and where necessary, adapted, with energy efficiency in mind.

I would recommend that building surveyors remain continually on the lookout for confirmation and clarity surrounding the Act. Although we expect the legislation to go ahead in 2018, ‘green’ politics is not devoid of U-turns and just as the proposed change could be reversed, it could also be intensified. Remaining well informed, planning for change and responding positively should be high on building surveyors’ agendas over the next four years.
 
Steps to managing EPC risk
 
1. Portfolio analysis to allow fund managers to identify high-risk assets and develop an action plan to either dispose or improve the property in a structured manner.
 
2. Desktop reviews of existing EPCs and assessments of uncertified assets to ensure that any capital available is invested effectively to minimise the risk.
 
3. EPC risk assessment to be carried out in conjunction with other asset management tools such as life cycle replacement plans, planned preventative maintenance and air conditioning inspections.
 
4. Consider funding options such as:
  • Enhanced Capital Allowances: a scheme that enables businesses to claim a 100% first year capital allowance on investments on certain energy saving equipment, against the taxable profits of the period of investment. Allowances are typically aimed at commercial property.
  • Renewable Heat Incentive: a payment for generating heat from renewable sources. Systems installed since July 2009 will be able to claim tariffs from the appropriate registration date. It is anticipated that the scheme for residential property will be launched in spring 2014.
  • Feed in Tariffs: energy generated from a renewable or low-carbon source such as solar photovoltaic or wind turbine is paid for by the energy supplier, even if already used.
5. Improvement programmes can be carried out while tenants are in occupation although this can be costly, disruptive and involve compromises in the end product. If lease events allow, it is more effective to carry out the works on a vacant property as part of a general refurbishment project
 

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