by Lucienne Mosquera, Managing Partner, SustainCRE

In their current form, around 97% of today’s commercial buildings will not support the transition to net zero. This poses a challenge as these buildings will become increasingly difficult to let or sell. The global real estate market is witnessing growing evidence of the ‘brown discount’, highlighting the disparity between environmentally unfriendly buildings (brown) and sustainable ones (green). However, little effort has been made so far to quantify how this gap between brown and green might evolve.

Our analysis, which considers recent trends and reasonable market assumptions, suggests that the brown discounts will be significant enough to justify investing in deep building upgrades. Investors are starting to recognize the importance of this idea. Many are moving beyond simply relying on a portfolio’s Carbon Risk Real Estate Monitor (CRREM) risk analysis or a Global ESG Benchmark for Real Assets (GRESB) score. Instead, they now expect net-zero to be a central element in building design, supported by data disclosure that demonstrates its impact. Occupiers are also demanding more energy efficiency, and valuers are increasingly factoring in environmental, social, and governance (ESG) considerations.

We believe a structural shift in demand for better quality buildings is unlikely to be filled by the current pipeline under construction, providing significant development opportunities in those locations with an under supply of new and refurbished buildings. In understanding how occupiers, investors, and valuers will drive the brown discount, we can identify three key channels influenced by the increasing focus on ESG.

Occupier Demand

The first channel is occupant demand for better quality buildings, which is on the rise. There is a particular emphasis on energy efficiency, hybrid workspaces with green building and Health and Wellness standards. The aftermath of the pandemic, coupled with the ongoing energy and debt crisis and the urgency to achieve net-zero targets by 2030, 2040, and 2050 interim milestones, has significantly heightened the need for these features. Notably, the energy crisis and ambitious net-zero targets have spurred a notable increase in demand for “no energy invoice” buildings. Consequently, buildings that lack these attributes are experiencing weakened demand, lower rental growth, and falling rents.

However, occupiers’ focus extends beyond energy, water, and waste usage. The pandemic has shed light on the importance of the “S” in ESG, leading to increased demand for health-related features and amenities. Potential occupiers seek certifications from reputable bodies like the International WELL Building Institute for health and well-being, and WiredScore for digital connectivity.

Occupiers want buildings that support healthy humans

London amenity availability score: Accessibility to culture, education, hospitality, retail, and transport amenities in the local area.In London, the legal requirement to improve the EPC ratings of buildings raises the obsolescence risk for nearly 40% of institutional-grade leases with a rating below C due to expire by 2027. This risk increases significantly to over 80% of buildings that do not meet the 2030, 2040, and 2050 interim net-zero targets.

Investor Demand

The second channel is investor demand. As more real estate funds become classified under Article 8 or Article 9 of the EU’s Sustainable Finance Disclosure Regulation (SFDR), a building’s quality and how it is used will grow in importance.

The limited supply in the market will also contribute to supporting rents and prices of existing buildings, especially those in good condition and with high energy efficiency. These buildings are likely to attract creditworthy tenants who can navigate the economic downturn more effectively.

report from M&G Investments  points out: “One of the largest industry shifts will be the focus on climate and achieving net-zero carbon and energy-efficiency targets. Evolving occupier sentiment towards energy use and worker health has also increased the incentive to improve assets to meet these targets.” The simple approach will be to buy buildings that are already energy efficient, creating a bigger green premium/brown discount.


The third channel is the valuation process. Looking ahead and in anticipation of future trends, valuers should refine their methodologies to incorporate the costs of upgrading buildings to meet net-zero aligned environmental standards and account for potential direct and indirect carbon taxes. This necessitates a thorough assessment of the wider implications of carbon emissions on property valuations.

Simultaneously, the escalating demand from investors seeking to convert short-term income into long-term secure income as an inflation hedge is driving up the capital values of premium green properties. However, it’s important to note that this surge in demand also exposes these properties to increased levels of both physical and transitional risks of climate change within a rapidly transitioning global economy.

The bifurcation of property values in prime markets serves as an early indicator, in our view, of the broader implications for all property values and markets. We foresee a scenario where markets not yet impacted will experience a “first mover” effect. In these markets, buildings that undergo genuine green upgrades aligned with accredited standards, rather than superficial commercialised green standards, will likely witness a surge in tenant demand. This, in turn, may prompt other property owners to rush to capitalise on this trend.

In our opinion, this situation presents a significant and immediate risk to property values in the near term. It’s worth noting that the calibration towards accredited net-zero standards is still in its infancy, and most green building upgrades currently result in energy savings of less than 20%. Property owners are funding valuations and risk assessments that, in our assessment, are not adequately addressing the immediate urgency of this risk. 

We strongly recommend that property owners proactively collaborate with knowledgeable valuers and risk assessment professionals who are well-informed about evolving environmental standards and their implications on property values. This collaborative effort will ensure that property valuations align with the latest standards and requirements.

Quantifying the brown discount

By making a few simplifying assumptions, we can get an idea of how large the brown discount could be. Consider three properties that start out with the same rent and value. Prime office rental growth has averaged 3% in Western Europe over the last 10 years. We expect, however, that rental growth could be (significantly) lower in the next five years for renovated properties that are not aligned to 2030, 2040 and 2050 interim decarbonisation targets. 

For the purposes of illustration, we make the following assumptions for green and brown scenarios:

Source: SustainCRE, June 2023, For illustrative purposes only.
Composite image of EPIC, comparing a baseline new building scenario against a new high performance. low carbon building and an existing building with

Business as Usual (BAU): No refurbishment, only standard maintenance. Rental prices correspond with rental prices for second-hand buildings. Asset liquidity is deemed poor, leading to higher exit yield and higher vacancy. Annual rental growth: 0%, Exit multiple: 16x, Vacancy projections: 30%, Year-10 energy savings: 0%. Asset Value €64 million.

Conventional Refurbishment: Renovation meets current regulatory and certified green requirements. The asset is valued as a first-hand building but does not benefit from a mid to longer term green premium (above average rental price in first-hand market). Asset liquidity is expected to decrease over time as net-zero regulations are tightening. Annual rental growth: 1.5%, Exit multiple: 19x, Vacancy projections: 15%, Year-10 energy savings: 40%. Asset Value €91 million.

Net zero Refurbishment: “Low Energy Invoice” energy upgrade enables owners to increase rents while offering lower gross rents (rent plus energy costs) to cater to tenants’ demands and enhanced liquidity. Annual rental growth: 3.0%, Exit multiple: 22x, Vacancy projections: 3%, Year-10 energy savings: 80%. Asset Value €122 million.

We assume rental growth for brown buildings will be zero at best, given occupiers’ increasing focus on ESG and the strong likelihood there will be an oversupply of brown buildings relative to weakening occupier demand. Similarly, we assume a higher exit yield for brown buildings because we expect investors, who are also putting more weight on net-zero compliance, will demand a discount.

Assuming the same rent and asset value at the start of the period, and that new occupiers will need to be found in year 5 of the tenancy when the current lease expires, these hypothetical assets produce an internal rate of return of 9% in the green scenario over 5 years. This compares to just 3.5% in the brown scenario. 

By year 5, the difference in exit values between brown and green is over 45%. We regard this as being towards the lower end of how large brown discounts could get. Rents could realistically fall for brown buildings, so 300 basis points could turn out to be a conservative estimate of the impact on yield. For lower yields, a given basis point differential would have an even bigger effect.

Retrofitting low/no carbon buildings to achieve net-zero is both technically and economically feasible, often at comparable costs to conventional renovations. However, achieving full decarbonization to reach net-zero may require additional capital expenditures. But there are significant savings to be gained. In contrast, brown buildings will face escalating operating, insurance, and maintenance expenses in the future. Our analysis indicates that introducing energy-efficient measures with “no energy invoice” capabilities, leading to net-zero energy consumption, can generate average savings that recoup the incremental investment within a ten-year timeframe. 

Approaching a Paradigm Shift

More importantly, investing in a retrofit can secure a building’s long-term value. While not guaranteed, recent MSCI data shows a discount today of as much as 20% in London for properties of average performance versus a premium of 25% for efficient top-rated properties.

Capital is already flowing towards sustainable buildings, and the anticipation of stricter regulations will propel the market towards a tipping point where valuations may undergo significant changes.

Post-Covid liquidity conditions have yet to reflect the stark disparity between buildings capable of supporting the low-carbon transition and those that are not. However, this situation will not last indefinitely, and owners who postpone retrofitting investments may ultimately regret it as valuations of energy-consuming older buildings have already started to plummet since 2022.

This article originally appeared on LinkedIn: