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Stranded Real Estate – A Real Possibility

AUTHORs: Sally Anne Stone co-author(s): Shelley Kinsella Services: Commercial Real Estate DATE: 12/06/2023

The concept of an asset becoming 'stranded' or facing a 'stranding risk' has become a hot topic of conversation in the real estate industry in recent times – this is largely being driven by the global 'drive to net zero'.  As called for in the Paris Agreement, global emissions need to be reduced by 45% by 2030 and reach net zero by 2050. 

As the built environment accounts for a significant percentage of global carbon emissions, the real estate sector needs to significantly reduce emissions resulting from the development, ownership and management of assets.  

New legislation, currently in progress through the EU legislative process aimed at achieving this net zero goal, coupled with market demands for clean and green properties, mean that assets which do not keep up with the required pace of change are at risk of becoming obsolete or 'stranded' in the years ahead.

What is a Stranded Asset?

Stranded assets are properties that will be exposed to the risk of early obsolescence because they will not meet future regulatory efficiency standards or market expectations driven by concern with climate change and other environmental matters.  These buildings will become less marketable and may require costly refurbishment measures.

The Recast Energy Performance of Buildings Directive

One of the main factors driving stranded assets is a changing legislative context.  A key piece of European legislation requiring improvements in the energy performance of buildings, and thereby increasing the likelihood of certain properties facing a stranding risk in the near future, is the Energy Performance of Buildings Directive 2010/31/EU (amended in 2018 by Directive 2018/844/EU) (the "EPBD").  There have already been a number of regulations which have transposed various requirements of the EPBD into Irish law. 

In December 2021, the European Commission published its proposals for a revised EPBD.  The current proposals include by way of example (i) new provisions relating to Energy Performance Certificates (or BER certificates as they are commonly referred to in the Irish market) and (ii) the gradual introduction of Minimum Energy Performance Standards (MEPS).   The implications of the proposed changes are likely to be significant for secondary real estate stock.

The Commission's proposed changes to the EPBD were adopted by the European Parliament on its first reading on 14 March 2023.  It now needs to complete 'trilogue' negotiations amongst the European Parliament, European Council and European Commission before it can be enacted.  For further information on the recast EPBD, please see Energy Performance of Buildings Directive zeroes in on emission targets

Market Expectations 

Another key driver is market demand.  With ambitious ESG targets to achieve, investors and occupiers are increasingly concerned with the green credentials of real estate.  They want to invest in and occupy prime buildings that are energy efficient and sustainable.  Employees also want to work for companies who have ESG to the forefront of their agenda and to work in buildings that demonstrate this.  

This 'flight to quality' is putting further pressure on secondary assets, which are at risk of becoming obsolete if they do not keep up with market expectations. 

How to Reduce the Risk of a Stranded Asset?

Collect Data

In order for owners to identify when a building is likely to face a stranding risk, it is important to collect data regarding its energy performance.  Where the building is let, the owner may not have the required data to hand, therefore collaboration between the owner and occupier in relation to information sharing is important and is also becoming a common feature of green lease clauses in commercial leases. 

Analyse Data 

The concept of 'stranded assets' or 'stranding risk' is central to the European Union funded research project called CRREM (Carbon Risk Real Estate Monitor).  The aim of CRREM is to help reduce stranding risk exposure.  

CRREM has developed a toolkit that helps companies evaluate stranding risk based on energy and emission data and the analysis of regulatory requirements at a European and domestic level. 

The toolkit can be used by inputting technical information in relation to a particular property which will then provide a calculation as to how long the property has before it will be exposed to stranding risk. It also helps guide the user through retrofit decisions in terms of the scale of the retrofit which would be required in order to push out the amount of years by which a property is at risk of becoming a stranded asset. 

Develop a Secondary Asset Strategy 

Investors and portfolio managers then need to develop a strategy in respect of secondary assets which are at risk of becoming stranded.  

We are hearing a lot about the 'green premium' which prime buildings are attracting and conversely the 'brown discount' which is being applied to secondary stock that does not meet the sustainability criteria now expected by the market.   

It is clear that the cost of retrofitting (or indeed demolishing and rebuilding) a building will need be weighed up against the potential return on investment that those works could achieve. The carbon cost of retrofitting, demolishing and rebuilding and doing nothing must also form part of this analysis. 

Who Should Bear the Burden of Retrofitting – the Owner, Occupier or Both? 

While improving the sustainability credentials of a building is in the interests of both the owner and occupier, the answer as to who should bear the financial burden of boosting those credentials through retrofitting may not be as clear-cut.  

The occupier's repair obligations under the lease should be looked at first but in reality in most cases the extent of the required upgrade works go beyond what the occupier is liable for and for the buildings currently facing a stranding risk, few of them have leases in place that include green lease clauses that place greater obligations on tenants.

The reality is that owners of occupied buildings facing a stranding risk are going to have to engage with their tenants to agree a combined strategy to boost the green credentials. Unless there is scope for a re-gear of the lease, those owners may have to make a significant investment without an immediate return. 

Summary – Decision Time

As changing legislation and market expectations put further pressure on secondary assets to improve their green credentials, property and portfolio owners will need to decide whether to retrofit or even redevelop those properties.  While the cost of carrying out retrofit or redevelopment works could be high, the cost of doing nothing may well mean being left with a 'stranded asset'.

Should you have any questions in relation to Stranded Assets or how to develop a Secondary Asset Strategy, please do not hesitate to contact a member of our Commercial Real Estate team