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It’s time for Canadian appraisal experts to develop the ESG valuation playbook

The increasing relevance of ESG in building valuation demands paying attention

When I think back three or four years, many people in Canada’s commercial property industry hadn’t even heard the acronym ESG.

Since then, we’ve all started hearing much more, and doing more, about Environment, Social and Governance (ESG) issues as they pertain to Canada’s built environment. As we look ahead to the next few years, it’s increasingly clear that ESG will play a central role in how we view and manage our portfolios.

ESG will also become a more relevant consideration for how buildings are valued across all asset classes in most parts of the country. We’re not there yet, but it’s time for valuation and appraisal experts to start developing the playbook to fold ESG into the building appraisal process — and the first step should focus on the risks property owners face in falling behind the ESG movement.

The main challenge when it comes to ESG currently is that our industry doesn’t yet have a direct line of sight on how to quantify the risks, costs and benefits of the ESG endgame.

If you have a new net-zero building that’s certified, will it be worth an additional five per cent? Maybe 10 per cent when compared to a new non-net-zero building? Or if your team completes a comprehensive retrofit of an existing building, say an office tower or distribution warehouse, will you be able to recoup that investment via a future resale premium?

What's happening in Europe

We are starting to see some signposts emerging in Europe. In London, since 2019, a gap has appeared between average purchase prices of buildings with sustainability ratings versus those without, according to research by the MSCI published last year.

The gap in 2022 had reached 25 per cent with buyers in London putting greater emphasis on buildings that met certain sustainability requirements via ratings from organizations like the Building Research Establishment (BREEAM), U.S. Green Building Council (LEED) and GBC Alliance.

In Paris, the gap in 2022 had touched 35 per cent, according to the MSCI research. The report said those premiums “show a considerable bifurcation in the market — and one that may continue, given the ongoing emphasis on decarbonization of property portfolios.”

It’s too early in our Canadian ESG revolution to put specific dollar figures on similar scenarios, partly because we haven’t developed a critical mass of comparable transactions in the ESG-friendly market. That said, it’s important to keep our heads out of the sand because clients and property owners are investing hundreds of thousands of dollars, in some cases millions, to do their part to reduce the emissions caused by our built environment.

Motivations to improve sustainability gaining strength

Buildings in Canada cause about 17 per cent of total national emissions. Roughly three-quarters of that caused by heating and cooling space and water. Canada's 2030 Emissions Reduction Plan aims for the country to reduce overall emissions by 40 per cent below 2005 levels by 2030 — and net-zero emissions by 2050.

Meanwhile, we’re starting to see more major companies developing their own ESG policies while also facing pressure from shareholders and the public to achieve progress towards this ESG compliance.

Findings from the Climate Impact Partners Report, for example, show that 42 per cent of Fortune Global 500 companies have made public commitments to major climate targets by 2030. Sixty-three per cent of companies have set carbon reduction targets for 2050. That illustrates that we will likely see more companies developing or enacting policies that require leasing sustainable space, or space that is capable of achieving net-zero certifications.

In the Canadian context, many companies have now publicized goals to achieve net zero by 2040 including TD Bank, Air Canada and Rogers, according to Net Zero Tracker, which provides details on national and corporate sustainability targets (though many companies still lack specific plans to achieve those goals). All of Canada's leading banks, including TD, RBC, BMO, CIBC, Scotiabank and National Bank, have net-zero targets for either 2025 or 2030.

It's also fair to say that the Amazons of the world increasingly have an ESG mindset, and it’s not just about net-zero. In some cases, large organizations are working to provide a more diverse set of amenities in their buildings including spaces like prayer rooms, breastfeeding rooms, biodiversity programs, and other progressive services and spaces.

From a demand perspective, the pressure appears to be emerging from the top-down. Major, publicly-traded companies are constantly under a higher level of scrutiny from investors and audit bodies — and that scrutiny will help spark changes.

At Colliers, we’re constantly in discussion with Canada’s aforementioned big six banks and we know they’re already developing game plans around their own internal ESG policies, as well as developing financing programs for borrowers that lean into ESG projects and prioritize funding developments and purchases of net-zero properties.

As we move forward, we’ll also see pension funds and REITs becoming increasingly cognizant of ESG compliance and re-thinking where they're investing their money with third-party partners. We’ll eventually get to a place where values are being more specifically reflected in buildings that are net zero-ready or certified, buildings that feature nature-based climate solutions, or office or distribution facilities that reflect the needs of our diverse workforce.

Property owners and clients that are already at the forefront of the ESG movement still face challenges. There isn't yet any evidence in the marketplace from a sales transaction or leasing perspective to support a differentiation between an ESG-compliant building and a non-ESG-compliant building. That’s going to change — and it will change quickly. As mentioned, the European CRE market is already further ahead on this front than North America as companies across the Atlantic tend to be much more ESG-conscious when developing or tenanting a building.

While there is no standard playbook, appraisers should be — and are — focused on how to generate a business case for ESG initiatives.

Generating an ESG value playbook

The valuation transformation may not take a specific or granular quantitative approach, but it will instead determine value premiums for ESG-friendly buildings based mostly on risk.

That is, the risk of missing out on leading clients because they have operational and property ESG requirements; risk of falling on the wrong side of government carbon-reduction policies or penalties; risk of being perceived by tenants and the public as operating in a pollution-heavy building; and risk of having orphaned assets left behind by a market seeking net-zero buildings or spaces that meet other forms of the ESG matrix.

Carbon neutrality, whether it's an industrial building or an office building, is the low-hanging fruit that will probably be the first domino to fall. In speaking with partners and stakeholders in the national market who are involved in this right now, we’re seeing signs in the design-build process that reveal a desire to futureproof buildings, especially on the industrial side.

ESG is an emerging focus in our built environment and valuation experts must be strategically aware of the effects it will have on valuations. It’s important to recognize that the formula won’t be as simple as: “If I invest a dollar in ESG, my property will be worth an additional dollar.”

The process will include much more nuanced value drivers and indicators that will also assess the overall risk in a specific market for not achieving a certain set of ESG standards, particularly elements that orbit around sustainability and net zero. As the market evolves and continues to adopt ESG, that line of sight will become clearer.

This clarity will factor-in various elements including the marketability of buildings, financing availability, tenant demand and lease-ability, and adherence to corporate or government policies. An effective playbook is coming, but it will require a collaborative approach between those that make the market (buyers, sellers and owners) and appraisers.

The challenge appraisers face is to interpret the market and apply that interpretation to a specific property at a specific point in time. Now is the time for appraisal experts to do their part in developing the ESG valuation playbook.

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