Retrofitting must happen – but can footing the bill also drive value?

Ensuring older buildings meet evolving net zero targets will be a complex and expensive process

November 14, 2022

Retrofitting buildings to reduce their energy intensity and overall carbon footprint isn’t keeping pace with demand or with the changes needed to achieve 2050 decarbonization targets.

Globally, over 1 billion square meters of office space requires retrofitting by the midpoint of the century. It means retrofitting rates must rise significantly from around 1% to at least 3% of stock per year.

One key stumbling block is many building owners struggle to see evidence that these outlays will generate their desired returns – but that is changing.

For many decades, a typical calculation would be ‘if I can improve the efficiency of this building to save energy and it pays for itself within three or four years, I’ll do it’. That simple break-even analysis looked entirely at operating costs and was judged over short horizons.

Nowadays, where carbon reductions are required, retrofitting investments are sizeable enough that most are not self-funding on a purely operational cash flow basis. The old rules for evaluating these investments need to change.

Reassessing the risk of investing

The return on sustainability investments is often undervalued. Building owners need to move beyond operating costs to assess the impact on a building’s overall value.

Take a building that today is worth $100 million and requires a $15 million upgrade. That may never pencil out on an operating-cost break-even basis. But as tenant demand for low-carbon buildings accelerates, there’s a risk that the building’s value falls because it’s unable to meet the tenants’ low-carbon targets, which in turn affects the number of potential future buyers. On the other hand, low-carbon space can earn a substantial premium from retrofit investments.

These risk-versus-value spreads are emerging in multiple markets. In London, we estimate there will be a significant shortage of spaces with low-carbon footprints by 2025 because of the number of companies with net zero commitments, compared with the retrofit pipeline. The supply simply can’t meet the demand. Retrofitting will contribute to delivering on that growing demand and driving value from changes to valuation fundamentals including rents, voids and operating costs.

We consistently see these results in practice. A tenfold increase in mechanical, electrical and plumbing engineering (MEP)-related capital costs to decarbonize prime office in London are often more than offset by improvements in rent, reduced void periods and lower exit yield discounts. The result is that implementing a zero-carbon strategy is accretive – especially where some significant works are already planned.

As companies continue to take action on decarbonizing their businesses, building owners who wait for greater certainty or regulation will fall behind the demand curve and face valuation risks. The reality is sustainability-minded companies will vacate buildings if owners don’t invest in retrofitting them. And we’ll see more pressure from that every year.

Exploring the options

When it comes to the question of who’s going to pay to retrofit buildings, governments have a role in writing legislation and policies with incentives or carbon taxes to drive the net-zero investments.  But investors are also central to the decision-making.

Disposing of outlier buildings is one option, especially as more asset managers have raised their allocation to real estate. In multiple markets, funds are being created to buy buildings from owners who are unwilling to put them on a green pathway. They will invest in the returns expected from closing this risk-value spread – and the difference in value between an owner who won’t make the investment and a buyer who will.

Another point is many markets now have too much office space and too few homes. Repositioning buildings will become more common, where owners invest in retrofitting to improve the energy footprint while converting a building to higher value classes like living space, multi-use, student housing, or urban logistics.

As companies rebalance their office portfolios following COVID-19, many U.S. cities will see significant retrofit or repositioning activity including New York City, Boston, Chicago, San Francisco and LA.

It’s not a journey landlords need to take alone. There’s an opportunity to partner with tenants and co-invest to help them meet their carbon commitments. This may include retrofit investments, or energy assets like onsite renewables or electric vehicle infrastructure.

This suggests a tectonic shift to more collaborative investment models between owners and occupiers; we’ll see it happening more whether it’s equity-based, new commercial contracts, or built into long-term leases.

Predicting the future

Traditional industry valuation models are evolving to the specific challenges of investing in retrofitting. Data science and technology are supporting new metrics and algorithms to predict how the sector will value different building performance attributes and characteristics.

These changes are already happening in pockets. In Europe, we already see an increase in investors retrofitting one property to assess the potential impact on their entire portfolio. In the next year, as evidence of the value benefits gets stronger, we see this replicating in U.S. and across Asia.

In the coming years, the new valuation models will scale as the market impacts are more fully understood. In five years, we expect substantial retrofit investments will be making a dent at the macro level.

JLL’s new research Retrofitting to be Future-Fit estimates the cost of retrofitting the office and shopping mall stock across 17 major countries to be close to US$3 trillion. It’s a huge amount but decarbonizing buildings is critical to creating a net zero future. It means we’ll be investing at a rapid scale in the coming years – and now is the time to start planning.

At JLL, our consultants are working with investors and owners to help them understand the roadmap to retrofitting and what they need to look at in the short and long-term. Contact us for more information.

Greg Bolino, Head of Global Sustainability Strategy & Assets, JLL