• Brookfield unit says industry ‘very aware of stranded assets’
• EU is forcing investors to take climate risk into account

As if the commercial real estate market weren’t in enough trouble
already, there’s a new risk lurking in property portfolios.

Real estate companies are facing a major blow to asset valuations, as
evolving European requirements drive investors and bankers to cut
their exposure to buildings with a big carbon footprint. The issue
has increased the possibility that property owners’ assets will end
up stranded, devalued by the impact of climate regulations.

“The industry at the moment is very, very aware of stranded assets,”
said Neil Menzies, director of sustainability at Hibernia Real Estate
Group Ltd., a Dublin-based firm owned by Brookfield Asset
Management. The risk of assets being stranded is “getting greater
because it’s now legislated as well.”

Commercial real estate values have toppled after higher interest
rates and lower occupancy levels upended the financial logic of
much of the sector’s debt-reliant business model. Both the
European Central Bank and Federal Reserve have made clear
they’re now monitoring what lenders are doing to mitigate potential
losses.

Against that backdrop, Menzies says the industry is now facing a
further valuation shock as it becomes clear just how much
renovation and investment is needed to bring the majority of
buildings across Europe up to the bloc’s new requirements around
energy efficiency.

The situation is so dire, according to Menzies, that he expects the
market is “probably going to see values plummet over the next 12
months for unsustainable buildings with very high energy usage.”

The European Union estimates that about 85% of buildings in the
bloc were built before 2000. Of these, 75% have a “poor energy
performance,” the EU said. The EU has set a goal of cutting
emissions in the building sector by 60% by 2030 and completely
decarbonizing it by 2050. At 42% of energy consumed, buildings
“are the single largest energy consumer in Europe,” according to the
European Commission.

Stranded Assets:

The term was popularized by the Smith School’s Stranded Assets
Program roughly a decade ago, and refers to assets that have
suffered from unanticipated or premature writedowns,
devaluations, or conversions to liabilities. UBS Group AG has
noted that in the context of real estate, this can include buildings
that aren’t energy-efficient, ultimately making them impossible to
rent or sell, or uneconomical to own. Such properties may also
become uninsurable due to rising physical climate risks, according
to UBS.

Other EU rules also are making it harder for investors in the region
to ignore the carbon footprint of real estate, including the
Sustainable Finance Disclosure Regulation and the Corporate
Sustainability Reporting Directive.

Warnings related to climate risk in real estate portfolios have been
steadily picking up. In October, analysts at UBS Group pointed out
that new regulations are adding to the likelihood that assets end up
stranded, “potentially saddling their owners with massive capital
losses versus today’s book values.”

The Swiss bank said the issue has the potential to morph into a
vicious cycle. “Inefficient buildings will likely also weigh on
investors’ climate balance sheets and may prove less attractive to
tenants due to high energy bills and low sustainability ratings,”
according to UBS.

Though Europe is further ahead than other jurisdictions in
enforcing regulations, the risk of a shock to valuations is global in
scope.

“With North America traditionally behind other regions in building
decarbonization and sustainability, new climate and sustainability
disclosure regulations represent a major risk for the real estate
sector,” said Claire Stephens, research director of the Smart
Buildings unit at research and advisory firm Verdantix.

“We could see insurers pulling the plug on facilities with insufficient
climate resilience and investors shunning companies with poor
sustainability performance across their real estate,” she said in a
statement in connection with the December release of Verdantix’s
annual smart buildings survey. A growing awareness of such risk is
now prompting the firms to step up efforts to persuade investors of
their greenness, “particularly in industries such as hotels and
leisure,” she said.

Hibernia’s Menzies said in an interview that investors are now trying
to come up with precise estimates for when real estate assets can be
deemed as stranded, using a so-called Carbon Risk Real Estate
Monitor.

Investors and bankers using the CRREM tool can “know exactly the
date that a building is going to strand,” Menzies said. They’re asking
detailed questions about climate-related issues such as expected
energy usage, before providing credit.

“Lenders are becoming so sophisticated, they’ve got people in
house to model this,” he said.

Hibernia, which focuses on the Dublin office market, refurbishes old
buildings and develops new ones with a goal of being net zero
carbon and climate resilient by 2030. The company’s 30 buildings
were valued at around €1.3 billion ($1.4 billion) when it was acquired
by Brookfield in 2022. To verify its energy efficiency, Hibernia
partnered with CoolPlanet Ltd., which helps firms figure out cleaner
energy solutions to cut their carbon footprints.

For companies able to come up with credible sustainability plans,
the response is “a huge, huge uptake and interest in green loans and
other sustainability-linked loans, as well as on refinancing of
projects,” he said.

All in all, the decline in valuations that Menzies expects over the
next year “will hopefully” get the market to a level that creates
“opportunities for companies to come in and buy,” he said. And
they’ll then be in a position to support valuations by investing in
renovations that bring buildings up to the new standards, he said.

In the meantime, firms like Hibernia “need to show real-time
performance and improvements year on year to be able to gain the
interest from investors and lenders,” Menzies said.