RICS Draft Guidance Note: Sustainability and ESG in commercial property valuation and strategic advice, 3rd edition

Sustainability and ESG in commercial property valuation and strategic advice 3rd ed

10 Sustainability characteristics, considerations and risks

Reflecting sustainability and ESG in commercial property valuation means reviewing and weighting a range of property characteristics, market considerations and risks. The most common of these are set out below; their weight and relevance are subject to th

10.1 Carbon emissions, net zero and energy efficiency

One of the most prominent factors in the minds of most industry stakeholders is decarbonisation and an aspiration towards 'net zero'. Further to this, regulatory, statutory and investment criteria drive requirements around decarbonisation, of which energy efficiency can form a substantial part.

Carbon efficiency improvements can require substantial capital expenditure (see section 10.2). Improvements undertaken to reduce carbon emissions may result in more economical operational performance, but in some circumstances, this may not be in excess of the required development or refurbishment costs. Valuation that explicitly considers medium- to long-term performance is better placed to factor in carbon emission performance. Regulatory, statutory and investment criteria (where they exist), may be a more substantial lever in respect of value than predicted operational savings.

Energy prices and the regulation of energy efficiency may vary across different jurisdictions and markets. Valuers should be aware that in high-value areas the cost of energy is likely to form a very small proportion of overall occupancy costs. It should be further noted that excess energy generated by sustainability measures such as photovoltaics can, in some locations, generate a measurable income that can be factored into valuation.

Valuation at the individual asset level is likely to focus on the impact of scope 1 emissions but the valuers should also be aware of scope 2 and scope 3 implications, particularly where providing strategic advice or valuation in respect of a portfolio of assets.

10.2 Capital expenditure

While a building survey or environmental assessment may not always be undertaken as part of a valuation, matters relevant to this may need to be recorded and considered - including in respect of reasonable judgements around likely capital expenditure requirements to meet market and regulatory needs. These might include but are not limited to:

  • the servicing and replacement of construction materials
  • services such as air-conditioning and heating installations
  • energy efficiency and carbon emission reduction
  • water efficiency
  • waste management provision.

The suitability of certain construction materials or services can vary between property type, age, use and location. The ability and cost for a property to be upgraded to particular sustainability and ESG requirements can also vary. Valuers are therefore advised to familiarise themselves with valuation impacting characteristics relevant to the particular market.

Valuers may need to assess the use of technology intended to improve sustainability and consider them within the context of the local market. Technology can make substantial efficiency improvements with resultant benefits but may also become obsolete. As a result, valuers should be aware of the differences in the technology available, as well as any financial incentives or grants associated with the technology.

It is accepted that valuers may need to make judgements around capital expenditure cost estimates and in some cases seek specialist advice. Explicit valuation models such as DCF are often best suited to modelling cost implications relative to value over time. Any limitations on cost assumptions need to be agreed with the client in advance.

Given the embedded crossover with cost development and management disciplines, valuers should reflect on competence in this area and whether additional advice or expertise is required. Specialist advice may be from, for example, a sustainability assessor, cost consultant, building surveyor or building services engineer. The need for additional specialist advice should be agreed with the client in instructions.

10.3 Environmental risks

Environmental risks and global real estate, 1st edition, RICS guidance note, sets out in detail the many environmental risks that may affect property. Governments may also legislate to mitigate, where possible, against climate change implications, presenting a changing regulatory framework within which valuations take place.

It is not just the physical impact of climate change that presents environmental risk. For example, soil and air pollution, and waste materials all present risks that require management, with consequent implications for values in some circumstances. Valuers should ensure that, as far as reasonably possible, up-to-date information on environmental risks is gathered and considered when comparing the subject property to others used as part of the evidence base. Environmental risks and global real estate, 1st edition, includes checklists to assist with this process., including the example for commercial and industrial property reproduced in Appendix B.

The inability of some assets to perform against contemporary sustainability standards or to physically withstand the impact of, for example, rising temperatures, flood, severe storms and wildfire, presents additional risks to the property owner and/or occupier. These may impact usability and interrupt business. Red Book Global Standards recognises 'resilience to climate change' (VPGA 8, section 2.6 (c) (iii)) as a key issue. Such risks can cause challenges with insurance, but in certain cases are insurable, which valuers should reference where appropriate.

Subject to the purpose of the valuation, and recognising that the manifestation of environmental risk may impact value over the immediate or longer term, valuers should consider the extent to which such risks will be expected to present an immediate or transitionary risk to value. For valuations provided for purposes connected with certain investment decisions, such as transaction due diligence and secured lending it may be appropriate for the valuer to provide qualitative and/or quantitative observations with regard to the potential or likelihood of environmental risks impacting value over reasonable time horizons.

10.4 Secondary property

For secondary property, the diverse nature of market participants may mute the explicit impact on valuation of near-term environmental factors.  Nonetheless, valuers should be aware of the continued escalation of regulatory reform leading to tightening minimum standards of compliance, coupled with the broadening range of stakeholders expressing heightening expectations and demands linked to ESG and sustainability.  It is the responsibility of valuers to understand the market in which they are engaged and to be able to determine with confidence the extent to which such matters are impacting on the behaviour and actions of market participants. 

10.5 Fiscal and legislative considerations

The exact type and focus of fiscal and legislative measures can vary between countries and might focus on particular aspects of sustainability such as the environmental risks described in Environmental risks and global real estate, 1st edition, RICS guidance note. Valuers should be aware of public information relating to existing measures and potential future measures, subject to the purpose and basis of value.

Making progress towards sustainable development goals is a high government priority in a number of countries, and in some cases specific goals are linked to fiscal initiatives including tax breaks and incentives in respect of improvements, renovation and retrofit, construction or use. Non-compliant assets may be at risk of penalties and, in some cases, depreciation in value. Taxes levied on emissions or unsustainable aspects of properties may also detract from value. Credits from validated and (usually) registered schemes such as in relation to carbon emissions could also potentially affect value.

10.6 Certification, rating and other benchmarking

Developers, owners, governments and regulatory authorities may seek to certify the sustainability and ESG credentials of property using a range of rating systems, codes and schemes.

Examples of rating schemes for real assets include Leadership in Energy and Environmental Design (LEED), Building Research Establishment's Environmental Assessment Method (BREEAM), Global Real Estate Sustainability Benchmark (GRESB) and the National Australian Built Environment Rating System (NABERS). While some of these were originally designed for use with new buildings, they have evolved and are increasingly applied to existing stock.

In some jurisdictions there are government and regulatory codes that may apply, such as the Energy Conservation Building Code for new buildings in India. Such regulations may also apply to existing buildings in some locations. Examples include the European Energy Performance of Buildings Directive and Minimum Energy Efficiency Standards in the UK.

Many schemes and regulatory codes are multi-criteria, which makes comparison between buildings complex. These schemes and codes are often updated regularly, so a past rating may not accurately indicate the current rating at the date of valuation. Voluntary certification schemes may be less transparent or well understood, but, where properly instigated and managed, they can help inform property performance.

The criteria used and details recorded in order to achieve ESG and sustainability accreditation may contain useful information about the sustainability features of an asset and therefore be of assistance to the valuer. However, these should not be the sole determinative of a property's weight as a comparable or any adjustment to the valuation. Credentials and expectations also change over time. Additionally, schemes do not usually provide quantifiable cost reduction metrics.

Some companies and other organisations use accreditation and rating data to make occupational and ownership decisions. Where such occupiers are the most likely bidders for the property, rental and capital value may be impacted. Certain investors and lenders may also have minimum requirements in order to transact - impacting bidding trends.

The absence or presence of certification, ESG reporting or benchmarking detail relating to a property is not an absolute measure of its sustainability. Valuers should understand the measures used, seek to establish the age of any certificate or rating and take this into account when assessing overall characteristics, in order to provide more accurate valuation.

Where the client is explicitly seeking the certification or rating of a property/portfolio as a factor in a valuation or strategic advice, the valuer should appropriately reflect on the impact of the valuation basis and other relevant terms. Valuation undertaken in accordance with particular client needs around certification and rating may either require special assumptions to reflect this or, in some circumstances, more appropriately reflect investment value (worth) rather than market value, but note their needs may be reflective of the wider market.

In addition to the property certification listed above, valuers should be aware of other international benchmarking and performance measurement schemes that enable companies to consider ESG. These range from high level overarching standards such as the UN Sustainable Development Goals to technical standards such as ISO 14001, which measures a company's progress towards more sustainable management. These standards can be useful in valuation but may not be specifically designed for this purpose, particularly in respect of application at an individual asset level.

Included in Appendix A is a list of accreditation and rating schemes, the relevance or applicability of which will need to be judged by the individual valuer.

10.7 Planning, zoning and development considerations

Most jurisdictions have statutory land use or spatial planning frameworks within which development takes place. Additionally, in 2015 the UN set out an agenda for 2030 including 17 sustainable development goals.

The above can be translated into planning and zoning policies and regulations, so the valuation of commercial properties with development potential may be impacted by the need for such redevelopment or refurbishment to be delivered to sustainability standards. Valuers should consider whether such standards have an impact on sustainability and commercial property valuation, and the likely costs of development/refurbishment on the potential rental or capital value realised upon development. It should be noted that RICS produces standalone guidance related to development both in relation to valuation for development purposes and development costing. IVS also specifically defines and provides commentary on residual valuation where this may be appropriate. Valuation or other consultancy for the purpose of development is a specialist area and may require expertise outside the valuer's knowledge such as cost and planning advice.

10.8 Asset management

Similar to the development considerations above, management and leasing is a specialist area of surveying and the guidance below is not intended to comprehensively cover this subject.

Different property owners and occupiers may have a range of perspectives around sustainability and ESG, which valuers may need to consider. Occupiers are likely to focus on their operational needs. Investment property owners are also interested in the capital value of property and may take steps that prioritise the resilience and growth of this - through a variety of strategies. Where a saving is only attractive to a particular operator or owner it may not be reflected in market pricing (but could be a factor in investment value/worth).

When seeking to improve a property's inherent sustainability performance, owners or occupiers may look towards management strategies, improvements to fixtures, fittings and services and ultimately, in some cases, specific ESG and sustainability-orientated retrofit or reconstruction of the property itself. If a property is inappropriately managed it may not perform to its specification standards or its full potential.

10.8.1 ESG in leasing and finance

Within the investment sector, some stakeholders make arrangements that encourage, or even contractually impose, standards of sustainable asset management and ongoing sustainable performance on either or both the landlord and the tenant. These contracts (leases, licenses, management agreements) aim to address the inequities of investment and return inherent in traditional leases, in which the landlord has responsibility for capital investment, but the beneficiary is the tenant. A common version of these agreements are so-called 'green leases'. The concept is to share the tenant's savings with the landlord so that both benefit and there is an incentive for the landlord to undertake investment to improve the sustainable performance of the asset. Some leases may place the tenant under potentially onerous liabilities in relation to repair, including specification of materials and hand-back clauses. In all cases where contractual arrangements exist relating to sustainability performance, valuers should assess whether they may have an impact (positive or negative) on value.

The use of leases containing specific sustainability criteria is a feature of some markets and jurisdictions. Such leases contain clauses within the lease, or the addition of a memorandum of understanding attached to the lease, that place additional responsibilities and potentially additional costs on the tenant. While these clauses are not necessarily punitive, some are. If they involve the tenant in actual or potential additional costs they could result in a lesser rental bid. Alternatively, some tenants could regard the acceptance of a 'green lease' as fulfilment of their ESG requirements. As with all matters of lease interpretation, valuers should take care to analyse the inter-relationship of clauses against each other, and between the subject property and those of comparable properties.

In some markets, such as the US with its 'C-pace' system, finance is available to fund retrofitting which then involves a subsequent charge against the property. Other forms of finance and secured lending based on sustainability and ESG criteria are also available.

10.9 Utility

Valuers are capable of assessing the utility of a property, which can be improved by its design and configuration. This utility may have direct economic impacts such as increased capacity in a hotel or office, but may also have more intangible factors such as the wellbeing of occupants. Capturing relevant utility characteristics of the assets being valued and relevant comparables is helpful to the valuation process. There may also be specific metrics relevant to utility that may be of interest to the valuer. Levels of utility can be used as a measure of an asset's overall quality, but it is appreciated that this is subjective and may require the application of professional judgement.

The design and subsequent utility of a property may influence its sustainability and ESG such as by achieving a longer lifecycle.

Flexibility can have a key impact on the utility of a property. Property design is not something that can normally be altered without largescale capital expenditure. However, even when occupiers hold only short-term legal interests, they may need to make changes to the way they use space during the period of possession. If a property does not accommodate this, it may be less attractive to occupiers who require flexibility in how they use space. Even when the period of occupation is anticipated to be lengthy, flexibility may be important: rapidly evolving work patterns mean that inflexible properties will require capital expenditure and may exacerbate waste problems as adaptation takes place.

10.10 Accessibility by transport

In order for the valuer to consider the impact of accessibility on a property, records should be taken at the inspection and investigation stage of the available modes of transport capable of facilitating access and their corresponding capacity. For example, the amount of private parking, bicycle storage and proximity to public transport hubs. Dependent on the basis of valuation these records will then need to be compared to the requirements of the relevant stakeholder or market. Assumptions should not be made about the impact of sustainable transport offerings upon value unless these can be evidenced. A further important aspect of accessibility relates to provision of facilities for the disabled, which should be recorded with reference to the requirements of the relevant jurisdiction or market.

10.11 Social and wellbeing considerations

Sustainability is not purely about environmental issues, as demonstrated in the definition in the glossary. Within the commercial valuation context, for example, considerations such as the 'social' element of ESG and the health and well-being of employees (for example ventilation in offices) can be important in property decision-making. The Red Book Global Standards Glossary definition of sustainability refers to 'health and well-being and corporate responsibility'.

In relation to workplaces as an example of service provision, factors considered in relation to sustainability include fit out and design that assists with productivity, mental and physical well-being, and subsequent employee recruitment and retention. This can include access to social space, natural lighting and individual temperature control, and facilities such as showers, creches and refreshment concessions.

Where valuers believe that such considerations will be material, they should be noted and accounted for within the valuation, including an understanding of whether they are provided by the occupier, owner or management company.

10.11.1 Social value

In common with 'sustainability', there is no universally agreed definition of social value. It is defined in the IVSC perspectives paper: Defining and Estimating 'Social Value' as including 'the social benefits that flow to asset users (social investment) and the wider financial and non-financial impacts including the wellbeing of individuals and communities, social capital and the environment, that flow to non asset users'.

The financial implications of social value should be implicit to the valuation. The need to reflect non-financial impacts and all impacts to other stakeholders (including public impacts) will depend on the nature of the instruction, valuation purpose and basis. In some jurisdictions and for some purposes such as development there may be specific requirements to take account of financial and non-financial elements of social value.