Decarbonizing Real Estate

Our analysts survey the hurdles, opportunities and investment trends in energy renovation.

Please note that Laurel Durkay is not a member of Morgan Stanley’s Research department. Unless otherwise indicated, her views are her own and may differ from the views of the Morgan Stanley Research department and from the views of others within Morgan Stanley. We make no claim that Ms Durkay’s representations are accurate or complete.

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Cedar Ekblom: Welcome to Thoughts on the Market. I'm Cedar Ekblom, Equity Research Analyst, covering the European building and construction sector for Morgan Stanley Research.

Laurel Durkay: And I'm Laurel Durkay, head of the Global Listed Real Assets Team within Morgan Stanley Investment Management.

Cedar Ekblom: And on this special episode of Thoughts on the Market, we'll discuss the opportunities, risks, and latest investment trends when it comes to decarbonizing buildings.

It's Tuesday, April 30th, at 2pm in London.

Laurel Durkay: And 9am in New York.

Cedar Ekblom: So, let's take a step back. Picture the gleaming towers of New York, London, or Hong Kong. Now think about these buildings breathing out carbon dioxide. The built environment is responsible for about a third of all global energy consumption and CO2 emissions. And so, if we want to get to Net Zero by 2050, which means emitting as much CO2 into the atmosphere as we take out of it, decarbonizing the building stock is essential.

We've been doing a lot of work in Europe from the research side to try and understand how the investment trends are linked to this topic. But Laurel, I wanted to have you on the podcast because I wanted to understand how you're coming at it from the other side as a real estate investor and portfolio manager.

Laurel Durkay: Yeah, Cedar, so I've seen some of your notes and I actually wasn't too surprised by your conclusion that energy renovation is seeing rising investment momentum in Europe. And this is despite the high upfront costs which are driven by government regulation, build cost inflation and higher interest rates.

Cedar Ekblom: Yeah, we decided to do this work because we've had a lot of incoming from investors around what's happening from an investment perspective because we have seen a few government policy sidesteps or backtracks in the last 12 to 18 months around this topic. And so, we did some proprietary survey work in the residential, non-residential and providers of capital space. And we had some really interesting outcomes.

I think the most interesting was that despite the fact that government subsidies have been dialed back a little bit, and the cost of investment has gone up because of inflation, actually private investment is really robust. And I think it's because there is a clear economic incentive that both homeowners and non-residential building owners are actually talking to.

I mean, the first one is that homeowners are telling us that they see a 12 per cent increase in their home equity value if they green that property. And when we look at the non-residential space, what we're seeing is that renovation budgets are up 4 per cent year over year, even in a backdrop of higher interest rates.

We see a huge runway of investment to come through on this topic. It is multi-decade. It's not going to happen overnight.

You're talking about 2.8 trillion euros of investment by 2030 on our estimates, and that number extending to potentially 5 trillion euros by 2050. And that's just in Europe.

Laurel Durkay: So the scope and need for investment really is huge. What do you think are the hurdles to delivering this opportunity?

Cedar Ekblom: It's such an interesting question. I mean, there are so many. It's a little bit daunting at points when you think about it, but we're looking at really complicated projects. We're looking at skills bottlenecks. We're looking at upfront costs being really high. We're also looking at energy policy, not necessarily being aligned in every region in Europe.

So yes, it's going to cost you a lot, but basically the respondents to the surveys tend to suggest that the benefits are actually starting to outweigh those potential costs.

So, Laurel, I think that there's been some really interesting overlaps between what you and I cover, but from different angles. Let me pivot to you. How do you think about sustainability when it comes to real estate investment in your seat?

Laurel Durkay: Yeah, bottom line is that understanding and incorporating sustainability and real estate investing really is very important; and we need to be aware not only of the physical risks, but also those transition risks associated with buildings. Taking a step back, what I'm observing is that real estate is seeing the sustainability focus really play out from three different constituents, and that's from investors, from regulators, and from tenants.

So, from that investor perspective, we're seeing increasing demand for sustainable linked financing investing. Think green bonds. In some cases, you're actually seeing more favorable spreads for green financing versus traditional -- and ultimately that means better cash flows for companies.

We also have that coming from the government. What we see is a continued evolution on regulations, and there have been several real estate specific laws being adopted across the states.

All of these have the objective of providing greater transparency on carbon emissions with the ultimate goal of reducing such emissions. Now lastly, for tenants, we're seeing increasing demand for sustainable and best in class buildings.

There's actually a growing body of evidence that shows sustainability is impacting leasing decisions and resulting in rent premiums

Cedar Ekblom: So, how do we think about integrating ESG into your investment process?

Laurel Durkay: So, there's a number of different metrics that we're looking at. We've run a proprietary analysis really trying to identify the most financially material factors. And we've ultimately concluded that the most important factors to be looking at are the absolute level of emissions and then the progress towards reducing those emissions -- water and waste usage, green certified buildings -- among a number of other factors.

Ultimately, what we need to do is put together a framework that helps us assess the expenditures in order to really adhere to the regulatory requirements that I was just describing and ultimately allow the buildings to enjoy operational cost savings from implementing sustainability measures.

This is really about future proofing buildings and enhancing value.

Cedar Ekblom: So, it sounds like really a topic around trying to understand where they may or may not be stranded assets. We've spoken a lot about this topic in Europe, but maybe you could talk a little bit about what's happening from a sort of policy backdrop in the US.

Laurel Durkay: Yeah, so government really is driving a lot of this change, both at a federal and at a state level. So, from a federal perspective, it really is more of a carrot as opposed to a stick with regard to implementation and adoption, really rewarding those who embrace sustainability. Now, interestingly, from a state perspective, it's a bit more of a stick than a carrot.

Buildings not in compliance will be subject to fines and penalties. I should also mention that the SEC is getting really involved with the adoption of new climate related disclosure requirements.

Now this isn't real estate specific, but it is impactful, nonetheless. New requirements mandate companies to disclose material Scope 1 and Scope 2 greenhouse gas emissions.

Right now, less than 30 per cent of US companies even attempt to disclose Scope 3, and that's even less for real estate. Now Cedar, these scope three emissions are really where our worlds intersect most given the built environment.

So, for a typical property owner, Scope 1 emissions represent about 25 per cent. Scope 2 is about 55 per cent of their missions. And then the remainder is going to be this Scope 3. But if you look at a developer and an owner, that's where you see Scope 3 emissions range between 80 to 95 per cent of their total emissions.

Cedar Ekblom: So, if we look towards the future, what are you hearing from clients and colleagues about where sustainability investment trends go from here?

Laurel Durkay: I think the trends have to be towards reducing these Scope 3 emissions, or maybe I just I hope that's where the trend is. You really need for building developers and owners to focus on development processes, building products and materials, and you need to see innovation within that space.

Now, how about from your side, Cedar? What are you hearing from various companies you cover about the trends they foresee?

Cedar Ekblom: The building materials and products businesses are really bullish on the long-term investment horizon on this topic. And we can see that in some of the data in Europe. The new build environment is under a lot of pressure. Higher interest rates have impacted affordability, and we have some activity in new build down 20 to 30 per cent.

And yet when you look at the renovation and the refurbishment sector, we actually have a much more resilient backdrop.

So look, our companies are really bullish on this. We ultimately see this manifesting in a higher multiple for businesses linked to this theme over the medium term. In all honesty, we're really just at the beginning of this theme. We think there's a lot of runway of investment still to come and we're keeping an eye on it.

So, with that, Laurel, I'd like to say, thanks for taking the time to talk.

Laurel Durkay: It was great speaking with you, Cedar.

Cedar Ekblom: And as a reminder to our listeners, if you've enjoyed thoughts on the market, please take a moment to rate and review us wherever you listen to the podcast. It helps more people to find the show.