Sustainability

Owners and occupiers of commercial real estate will face significant challenges when trying to navigate the complex regulatory landscape, as new directives come into effect. Assets with good sustainability credentials are likely to experience enhanced cash flow stability and greater yield compression.

Key Takeaways

1. Investors will have to publicly disclose and implement their climate transition plans aimed at retrofitting assets to align with the Net Zero Carbon Pathway, as mandated by European legislation. Additionally, investors must address the financial implications associated with the adaptation to prospective climate-related risks.
2. In 2025, the first group of companies will commence reporting in accordance with the European Sustainability Reporting Standards (ESRS) for the fiscal year 2024. Additionally, the implementation of Basel IV will introduce further complexity to the real estate investment landscape.
3. The EU’s Corporate Sustainability Reporting Directive (CSRD) and the recently passed Corporate Sustainability Due Diligence Directive (CS3D), will require companies in scope to publicly disclose their climate transition plans and implement them to the best of their ability. This reinforces the need for corporates to have a robust transition plan to achieve climate goals.

Navigating the uneven recovery

European real estate investment markets are expected to see a gradual but uneven recovery in 2025, as some sectors are expected to perform better than others (see Capital Markets). Investment decisions will be increasingly influenced by various elements of asset quality – including sustainability.

In this context, there will be more emphasis on delivering sustainability attributes to enhance asset value, and particularly in mitigating the risks associated with future obsolescence.

The current pricing landscape presents a strategic opportunity to drive transformation. Assets failing to comply with sustainability standards are likely to suffer downward repricing, due to the scale of investment required for refurbishment to meet these standards.

Shift in perception likely to affect values

Sustainability features are increasingly viewed as industry norms rather than optional enhancements. As a result, some occupiers are willing to pay rental premiums for such assets, and to seek discounts for non-compliant properties. Investors are often willing to pay more for assets with strong sustainability features because they expect improved cash flow and returns through superior rental growth, depreciation, and yield. However, value might come from better tenant quality, faster leasing, and improved occupancy rates, rather than just rental income itself.

Figure 24: Premium certain investors are willing to pay to acquire assets that meet sustainability standards (2024 vs. 2023)

Figure 25: Are lenders willing to offer margin stepdowns for assets with strong ESG credentials?

Assets with good sustainability credentials are likely to experience better cash flow stability resulting from improved tenant retention and consequently lower vacancy rates and operational costs. We expect a sharper compression of yields for assets with high sustainability credentials.

Financing strategies will evolve

Lending institutions are expected to implement incentives and strategies aimed at financing retrofitting.

There will be considerable variation in local market practices, depending on the maturity of the market and the robustness of financial institutions. Conversely, in line with their aim of reducing the carbon footprint of financed portfolios, financial institutions will be selective in approving refinancing for assets requiring upgrades.

CapEx requirements, along with strategies for securing this financing, will be on investors' and landlords' agendas. A clear valuation of transition risk is essential for investors to be able to formulate a compelling business case for sustainability initiatives. Ultimately, property owners and investors require assurance that any proposed investments will augment the value of the property.

Complex reporting landscape

CSRD reporting will become mandatory for many

The EU's Corporate Sustainability Reporting Directive (CSRD) and the recently enacted Corporate Sustainability Due Diligence Directive (CS3D) mandate that eligible companies publicly disclose their climate transition strategies and execute them as fully as possible. The CSRD will require compliance from approximately 50,000 companies, collectively representing 75% of the total turnover of EU enterprises. This will pose significant challenges, as the processes of data collection and third-party auditing will require corporates to commit substantial time and resources.

Basel IV comes into force on 1 January

The Basel IV reforms are set to be implemented in 2025 and will introduce significant changes to credit risk management, capturing climate-related financial risks. Specifically, they will constrain the use of internal risk models and will require an increase in bank’s capital.

This could restrict capital for commercial real estate, if increased capital requirements force banks to raise more equity or lend less, leading to higher costs for borrowers. The reforms will likely have a disparate impact in different regions, due to regional differences in banks’ use of internal models for calculating risk. Basel IV will also establish a new framework for property valuation, recommending that national supervisory authorities develop specific evaluative criteria.

EU disclosure requirements for real estate investments

Figure 26: The regulatory landscape of corporate sustainability in the EU