Property Perspectives: Conversations defining the future of real estate

How sustainable building practices impact commercial valuations

• natwest markets • Season 1 • Episode 4

Share episode

Use Left/Right to seek, Home/End to jump to start or end. Hold shift to jump forward or backward.

0:00 | 24:15

In this episode, Ashley Toy is joined by Tyrone Hodge, Global Head of Risk Advisory at JLL Inc., and Ken Mustafa, Director of Vertical Sunrooms Ltd., to explore the impact of sustainability on commercial property values. 

They discuss how green building practices influence valuations, the risks of neglecting upgrades, and the competitive advantages of investing in sustainable improvements. 

NB. This was recorded on 13 February 2025. 

Captions are automatically generated. 

Get more tips, tools, and strategies to help navigate your sustainability journey today: 

SPEAKER_00

From a values point of view, you're looking at whether there is an impact based on evidence in the market, which is quite hard to get your hands on, actually.

SPEAKER_01

The risk of doing nothing means it is able to slip from the rest of the pack. You'll certainly have a um an issue in terms of um the promise that someone is prepared to pay for that building. And and then I I think the other factor is uh um the cost of finance for buildings that don't have a clear plan as well, I think.

SPEAKER_02

Hello and welcome to another episode of Property Perspective from Matt West. I'm Ashituly, I'll be your host today. Uh I'm joined today by Ken Mustafa, an independent property investor. Yes. Uh and Tyrin Hodge, who is global head of risk advisory at Jones Lang LaSale. Thank you very much, guys. We're here to talk about um the impact of sustainability on your portfolio and and valuations. So let's get into it. Uh Ken, maybe if we could start with you, if you'd give us a brief overview of your property assets and maybe how you think about sustainability in that context, that'd be great.

SPEAKER_00

So our portfolio is uh retail with a residential mix above on some of the portfolio. And we have a mix of some industrial together with um um some out-of-town retail, which we regard more like an industrial style building. So we've got a mix of units um that we develop as well. So we design and build above them, or we we we um alter the buildings to add value. So that's our primary um the property company's primary role um through development, add value.

SPEAKER_02

Great. And when you're thinking about sustainability with those assets in mind, how how do you go about it?

SPEAKER_00

So yeah, it comes up quite a lot nowadays, and and the uh the main drive is at development, um at the point of development or a change of tenant. It's a good time to take something sustainability into account at that point because the investment's going to go in. So um from that design point of view, yeah, we're very interested. And EPC ratings, although you know they were once not particularly considered to be important, I think they're becoming more and more important. And I think the bank can see that.

SPEAKER_02

Yeah, absolutely. I mean, let's step away from the assets a sec. I mean, maybe if we go to you Tyran and talk about how um sustainability kind of integrates itself into the valuations or if it does at the moment. Yeah, sure.

SPEAKER_01

Thanks, Ash. Um, I I think it's important to to sort of separate sustainability into its impact on value, and we're not actually valuing sustainability. So from that perspective, in terms of valuation principles, nothing's really changed. So what's important for for valuation is uh tenant demand or or demand for you know product if you're selling uh individual units, for example, and the net operating income. So if you just break it down to those two components, um from a valuation perspective, uh if you've got a more marketable um proposition or property, uh so if it's retail that that is um low cost for the tenant in terms of their their operating costs, if they're paying the outgoings, that's more attractive than uh than a building that that is not. Uh from a residential perspective, um same same thing goes. If you have um a build-to-rent product where you're copying the the uh operating costs in the in the building, you in terms of the base building, you obviously want to make sure that your energy costs are uh are low. Um and you also want to ensure that that the energy is managed, for example, from the tenant perspective, because um, as Ken said, you know, EPCs are starting to become more important, and then that that impacts on your demand side. So um I think the valuation fraternity has been a little uh over overwhelmed with what does sustainability mean in terms of value, and and I would suggest that it really doesn't change anything because um we need to be making adjustments in terms of the marketability, uh the operating costs, um, and also any capex that might be coming up in order to reposition a building.

SPEAKER_02

Yeah, absolutely. I mean let's just stick on that for a second. So you're talking, Ken, about tenants um and and the demand drivers around sustainability. So what sort of things are your tenants saying to you when they're coming up for lease renewals or new lease?

SPEAKER_00

Yeah, so um not too much to be honest, actually. So we don't we we we at least renewal. So for commercial property, what we don't find is that tenants are approaching us at least renewal times and saying, well, you know, we want a more sustainable building. But I know it has an impact at rent review and at least renewal times. Um and there is an impact when it comes to service of notices, so any good surveyor that deals with rent review work will probably bring to their client's attention uh uh uh the the the the investor that maybe they have to look at sustainability, EPC ratings, etc., at the point just before those those lease renewal negotiations and rent review negotiations. Again, it comes down to market evidence, doesn't it? So um from a valuers point of view, you're looking at whether there is an impact based on evidence in the market, which is quite hard to get your hands on, actually. So I think that's that's not really there. But from a development point of view, from the point of view of taking an asset, converting that asset, you want to make it as good as you possibly can to attract the best quality tenant um in terms of whether it's residential or not, actually. Um but I think that that uh where in the last year or so we've we've spoken to covenants and covenant strength tenants, they really are interested and and they they do tell you what they want at that point in time, but not not really at that the negotiation stage whilst they're in the building.

SPEAKER_02

So is it fair to say there's a bit of a disparity between larger, more complex tenants who maybe have other external drivers around sustainability and smaller tenants who are maybe driven by more kind of economics?

SPEAKER_00

Yeah, I mean I mean in our portfolio, most of our tenants are covenant-driven. Um but if you have um smaller units where the tenant quality is sort of more local, they're not that particularly interested actually. But if you could explain to them what you're giving them, I think they would be. And they certainly do understand cost. So if you can show cost if it's a complicated thing to do, in in actual fact, to show someone they're going to save money. Um we've we've managed to get B's, we haven't managed to get A ratings on flats, for example, and tenants have moved in and and said, you know, you're not that they're not saving, or they don't know how to save. Or uh I think that that a lot more work has to be done from a design stage to make sure that if you have a B rating, it does filter through to a cost saving. Yeah. And I don't think that's as easy to do as as it might sound. Um it's something that because we we we have um an in-house design part of our business, so we are for looking very closely at our next development and how it's going to filter through to a cost saving to a residential tenant, for example.

SPEAKER_02

I'll probably just pick pick up on something there, Ken. So we talked about you talked about EPCs. I'd be really interested, Tiny. And when you're looking at the valuation, um EPCs can be, by their nature, a bit binary. So do you look beyond that and outside that? And if you do, kind of what do you look at?

SPEAKER_01

Yeah, I think um I'll sort of go back to something that Ken said a minute ago, which was on the demand side. So um if you think about let's just talk about office markets for just a minute. If you look at the large corporate tenants, um most now have corporate objectives and statements around ESG. So that means that they will gravitate towards buildings that actually meet that requirement. Um and and a a case in point is is JL where I work. So, you know, when we're in the process of um uh moving next year into a building down here in sort of Bishopsgate. So that building um has a whole bunch of uh attributes that that meet the corporate objectives of of JL. So, you know, it it gets harder to uh attract those types of tenants if if you're not able to meet the requirements. And I think um that also will become more important at the at the renewal stage. And we are starting to see some transactions around renewal where there might be um perhaps a pathway put in place uh with the the landlord. So it will be look, we'll stay in place as long as we can see you have a a pathway to um meet uh improved sustainability targets, which could be you know improved energy efficiency and EPCs and so on. Um often referred to as green leases, um sometimes with get out clauses, uh if those objectives or targets, KPIs, whatever you want to call them, aren't met. Um so again, from a valuation perspective, that's a good thing and a bad thing because you obviously retain the tenant, but there's a risk that that tenant break exactly if if you're not able to um to to meet those KPIs. And I think that in terms of the whole then ecosystem of of players in that in that space, which would be the owner, the tenant, and quite possibly the lender, is everyone's got to be aligned around that that pathway to actually reposition that building. So um Yeah, absolutely. Uh I think your original question was um what what factors do EPCs play in the uh in in that. I I guess I've sort of given you a bit of a twist on the answer, but it's important. Um and so from a valuation perspective, it's not so much the you know what what's the EPC rating, because as you say, it's it's it doesn't really represent um uh a full picture of of sustainability attributes, it's just one thing relating to energy performance. So um it's it's we would look at it and say, well, how attractive is that building going to be in terms of keeping or finding new tenants? Um and if it's sitting at uh at at one level, what what does it need to get to and what's the cost of getting it there in order to hold value up? And and maybe a little later you might ask me a question about uh what happens if you do nothing in in in that case, um, you know, is there a premium or a discount?

SPEAKER_02

So we can get into that very surely. Yeah. So Ken, I'd just like to pick up on some of the stuff around timing, if I could. So so how do you think about um I guess the cost implication and the timing implication of of making adjustments to the buildings?

SPEAKER_00

So if I go back to something maybe that we had completed in 2018-19, um when our focus wasn't uh um as much on the EPC ratings or the sustainability of the building, so very simple development. Um we've already allocated to improve that building after sort of four or five years of refining what we're doing in our portfolio. So we certainly do look at um, I mean, it's not really older stock, it's it's a few years old if you think about it. So it was new at the time, or or we had refurbished and made the upper parts brand new, and um, and um, and we've allocated um uh a fund uh to improve that building, to improve the EPC rating, but also to give the occupiers um uh a more cost-effective solution than what they've got right now. So I think that e and that's what that's why our next development will potentially have a longer life in terms of its design and its configuration. Um that's what we're looking at um in our design because we're we're the internally designing, so we can do that um in real time. Uh and that's what we're doing. So um, yeah, I think that that a port I think that that to keep your portfolio at a valuation that you you know to promote valuation, to give yourself um uh because it's quite difficult these days, especially the way interest rates have increased, yields have have jumped, um, and it was gonna happen, um, to improve value, which is the whole asset valuation job. My role would be as a director of of of a portfolio to improve value. So, so um, and and and I think that sustainability can now come into that, which it didn't before. And I think that from a valuation point of view as a as a valuer, you're looking at that and you're looking at the lease renewable. In actual fact, you said something fairly important that there comes a time when if you're expecting a landlord to invest, that has an impact on the capital value of the building, doesn't it?

SPEAKER_02

Well, that's um so I'm gonna come back to some of those points, but um, the point that you kind of finished on last time would be good to just pick up. So the kind of the risk of doing nothing. So yeah, how how do you how do you look at that from the perspective of a a kind of professional advisor to industry?

SPEAKER_01

I think so we we we are starting to see, so if I go back to valuation principles, I mean it's all about where's the evidence. So um we're starting to see evidence not all in one place, so we're but we're seeing you know a global pool of transactions, particularly around, say, capital transactions, so sales, um, but also leasing transactions across all sectors that are starting to demonstrate that there there is a uh a discount um particularly in terms of um if we just talk office buildings because that's probably the easiest example. So if you own an office building that is slipping away from where the demand is, and you don't have a plan in place to reposition that building, and it just simply think of it as obsolescence. You know, it's nothing you have from that, right? It's just uh becoming obsolete. So for buildings that are being put to market without a clear plan to reposition those buildings, there is absolutely a discount uh in terms of the transaction. Uh there are fewer um buyers that are willing to take an unknown step where they don't have a plan. Um, and the buildings that do have a plan tend to try transact because there are various players in the market that are looking to reposition assets. Um from a tenant perspective, we're starting to see something similar. Uh in fact, we've we've just been working with one particular um logistics tenant who was looking at their renewals across the the properties that they occupy. And their position was it's from a sustainability perspective and and that that sort of the broader context of um you know not just building new buildings, for example, but being able to reposition. Yeah, absolutely. They they actually had a look at what would happen to the value of the properties that they occupy if they were to uh stay, leave, or uh work with the the owners to actually make some improvements to the building, which would mean that they would stay. Um so what all of that means is is that um the risk of doing nothing means that you start to slip from the rest of the pack for those who are. So your you know, your your rental uh renewals are are at risk. Um the amount of rent that you can uh charge may not be at a premium, but again, you'll see you possibly see discounts, and we start to see that um you'll certainly have a uh an issue in terms of um the price that someone is prepared to pay for that building so they'll make an adjustment in terms of the you know the return that they require, which means you know there's an adjustment around cap rate. Um and and then I I think the other factor is uh um the cost of of finance for buildings that don't have a clear plan as well. I think um there's risk from a lender's perspective uh that is starting to appear in the market as well. Is um you know, so you it it's more expensive to finance it, whether it be debt or equity. Yeah, absolutely. Yeah.

SPEAKER_02

Um and it was I think the slip will happen quicker, right?

SPEAKER_01

The slip will happen quicker than the premium. So to stay in the game, you've got to be playing the right game.

SPEAKER_02

Absolutely. Ken, if I could just come back to you on some of that. Um so when you are thinking about uh thinking about making uh sort of captain investment into some of the buildings, do you ever think about the risk of not? So if do you ever say, okay, well, if I didn't invest, I you know I would follow this path, or is it just actually I want to improve my building and keep it sustainable?

SPEAKER_00

Yeah, I think I think that that we are an active we're we're very active in improving the portfolio. Um I think you have to be these days. I think the days are gone where values just rise willy-nilly. And I think that tenants, especially commercial tenants and covenanted tenants, are very well advised. And you know, they're they're chipping away at the rents if they can. Um that you know, if they've got a good rent review value or a surveyor that's acting for them, you know, they can they can decimate the value of your asset. And I think that um, you know, yeah, I think these days if you're a commercial property investor, um, it's become even more it's a specialised subject. I mean, there's so many resi resi guys out there that couldn't get into the game. And I think that sustainability um it's a broad word sustainability, actually. So when we say that very broad judge, you know, what does it mean? Um I mean, what are we talking about really? Um but but it's not EPC, it's um I mean in sustainability and construction, for example, is where does the timber come for us, right? You know, when we're talking sustainability for an occupier, it's a very different subject. A resi occupy is different to an industrial occupier. Um but my view is and my background is property from through and through, isn't it? So um, so so I'm a technician too, so um, so we we have I have a view that that we are looking at the portfolio uh to improve it. Um I'm a bit concerned about review times. Um they do pose a big part of uh of this problem that's coming along that not many many uh investors know about, and if they have good advisors, they should ask the question. It comes up in a lot of CPDs and and uh um uh the question has come along in the last year or so where you know how do you do a rent review where there's a break option coming up and uh the building has a very low rating, uh and or there's a break option coming and it really poses some issues. So I think it's it's important if you're running a commercial portfolio, um, that you are allocating time to uh regular um assessments of that portfolio, annual assessment, yeah, which you would never do before. You wouldn't even assess a building in ten years.

SPEAKER_01

I think um and Kim, there's a there's probably a strategic question now that a lot of fund managers need to ask themselves, and that is there may be some buildings in the portfolio that are probably perfectly positioned where they are where you don't have to spend a lot because you've got a particular tenant profile. But if that doesn't match your overall corporate strategy, um I I I think we'll start to see, you know, fund managers or asset managers question whether they want to keep those buildings in the mix. And it might be, well, are we better off to sell that building now? Yeah, uh and maybe redeploy it into the ones that are a better fit, or perhaps, you know, go in and invest that capital in something else that we're trying to grow.

SPEAKER_00

So Yeah, you're absolutely right. I was a doubt or whatever. I said I I was gonna get to the point where you might say, well, it's time to dispose of the asset. If it's if it's time for it, for it, or if you're changing your portfolio into more, more sustainable, the word sustainable portfolio, um, you know, some of the stock you might have is is just better off redeveloped or sold off. Yeah, you know, change change your portfolio. I don't think that used to happen in the past. So, you know, people just used to stick to it and really not and I think there are still a lot of people not doing that. And that is a dangerous place to be. Um, people that get involved in commercial portfolios that are not experienced might find that they have a uh a significant loss of income stream uh and they don't know why that happened. They they they're wondering how it could have happened, yeah, and then the word sustainability comes along. So it's interesting how the banks are approaching this, yeah, actually.

SPEAKER_02

And that draws me to my next question quickly. But yeah, we could do a higher square jumping in. No, no, no, this is great. So, I mean, uh we could we could spend we could do a whole other podcast on uh what sustainability means. But so is is there anything in addition the bank could do to help you on your journey? So for the answers yes, please, uh what what would you like to do?

SPEAKER_00

I think I think your bank particularly is so interested and that that they're providing us with so much you know, you you you calculators and and things. Um I mean what what else can they do for us? I mean, I I I think that if they could give us more of a guide in what they are looking for, yeah, rather than what we do is think, you know, what you know, try to second second guess what the bank wants. You know, I do like to know what what the bank wants to invest in. You know, because you you know the bank will will will be sort of very interested in the Resi side or the industrial side. You don't tend to know. Yeah. Um but clearly I can see that what the bank is doing is saying, well, think about this. And I know I know that a lot of um investors like Like myself, who who aren't technicians aren't aren't particularly interested. They want to see their bottom line.

SPEAKER_02

Yeah. And I I th I think that's probably a good way to describe it. We we're we're thinking about it. And to the point that I think we're making here is if you're not on that journey, you will it'll take you a long it'll take you a long time to catch up and it'll be very expensive. So it can be, yeah. Yeah. I mean we're in the sem very similar position.

SPEAKER_01

Well I'd I'd think about it that the the risk that the investor is taking is the bank's risk or not anything. So I think it's about alignment of risk, isn't it?

SPEAKER_02

Yes, it's a pro it's just a different proportion of the risk.

SPEAKER_01

Yeah, you you you want to make sure that your cash flow uh is is protected just as much as the uh the owners do.

SPEAKER_02

Absolutely. I'll come for one final question to T Tito, if I can. So what if there's one thing that the valuation industry needs to kind of help in this journey over the next few years, what would it be?

SPEAKER_01

Oh that's a that's a tricky question, but uh let my my view that I'm expressing internally and to uh to the the whole cohort is um valuation is is remains exactly the same as it has always been. So I would say you need to actually dig in and understand the market. So if you're a valuer and you're listening to this, do your job properly, be thorough. Um, don't just rely on what you see on a a website that's telling you that something has transacted, dig into the detail. Uh I say to the the people that work for us, um, I always give them the story about when, you know, in the old days when I was a young person, I used to speak to people and um you speak to people, understand the detail, know what's going on, understand the structure of those leases, um, understand what's happening from a lender's perspective. Um, you know, dig in, do your job, do your research, and uh and and really it's the same job you've always done. Do you just need to analyse the components that are important to those deals and apply them um to your calculations?

SPEAKER_02

That's great. Thank you very much. We managed to get it through a whole session without saying the word data as well, which is obviously underpins a lot of what we're doing. But yeah, that's great, thank you very much. So, Town, Ken, thank you very much. That's it for another episode of Property Perspectives. Uh please, if you liked the episode, click like and subscribe.