SustainaWeekly - Energy efficiency investments still attractive for real estate companies

Sectors:

Current market rates for equity and debt in the residential real estate space are prohibitively high for property investments in the Netherlands. However, the high cost of capital can still be recovered through investments in energy efficiency. We show that a refurbishment from an EPC label G to a B label generates a 10% IRR. Energy refurbishments could still drive demand for capital in debt markets.

Economist:

We set out Europe’s energy sector investment under different climate scenarios. We then go on to use expectations of utility companies’ capex plans over the coming years, and estimates for off balance sheet and government investment to assess which scenario we are currently tracking. Our analysis shows that we are close to investment levels under a delayed transition scenario, but well below what is required under a net zero scenario in terms of energy investment.

Energy efficiency measures for real estate investors still profitable in high cost of capital environment

• Current market rates for equity and debt in the residential real estate space are prohibitively high for property investments in the Netherlands

• However, the high cost of capital can still be recovered through investments in energy efficiency

• We show that a refurbishment from an EPC label G to a B label generates a 10% IRR

• This is derived from a 10.3% valuation uplift and only a 50% pass-through of energy cost savings to tenants

• Energy refurbishments could still drive demand for capital in debt markets

Cost of capital has crawled up considerably discouraging general investment in real estate

The rising corporate bond yields and falling equity prices have put real estate investors into a difficult spot. We look at public markets to get a sense of how much they have risen. Last year the all-in yield on a EUR denominated 10y BBB+ rated unsecured residential real estate bond was quoted at 1.1%. Today it has risen to 4.7%. The implied cost of equity on bellwether residential real estate issuer Vonovia has risen from 4.7% to 8.6% during the same period. These are market rates, but their role as a guidance for cost of capital should not be trivialised as investors can achieve these level of returns when putting their money at work in public markets. The obvious problem is that real asset markets have not corrected as much. Hence, when we, for example, invest a hypothetical EUR 100 in Dutch residential real estate at 4.0% gross initial yield (based on latest NVM data), a reasonable 3% rent and value growth per annum, and an exit in 10 years we get the net present value (NPV) and internal rate of return (IRR) outcome as shown in the table below. IRR basically estimates the rate of return on an investment and is therefore used to assess the attractiveness of an investment opportunity. As a rule of thumb, if the IRR is above the cost of capital, the return on the investment exceeds its costs and the investment becomes attractive from a financial point of view.

Our discount rate is based in a 50/50 debt to equity capital structure where we take the aforementioned 4.7% cost of debt (3.9% after tax) and 8.6% cost of equity. Obviously as the 6% IRR sits below the 6.26% weighted cost of capital and the sum accrues to a negative net present value (NPV), it would make investors walk away from this transaction. We believe that this dislocation between market rates and real asset values is visible across various pockets in the real estate space, hence 2023 could mark a year with limited property transactions from big real estate investors. At least until real asset valuations will have come down or market rates start to decline. But when real asset values drop significantly, investors will probably prioritize debt reduction instead of new investments, thereby keeping the lid on new property deals. Let’s hope markets have over-shot themselves.

Energy efficiency investments still attractive

There has been ample coverage in the press about property owners preferring energy efficient properties. This makes perfect sense as dwellers are happy to pay up for energy efficient properties to save on their energy bills. Energy prices need to remain at existing levels for at least 5 years in order to make up for the EUR 472 per sqm premium an EPC B-labelled property gets against a G-labelled property (see more on this below). That compares to a EUR 96 per sqm per annum saving in the cost of heating through natural gas. We derive our energy savings from a 30% reduction (or efficiency) when converting a G-labelled unit into a B-labelled unit, as recently flagged by German residential real estate company LEG Immobilien. We take the midpoint (i.e. EUR 500 per sqm) from LEG’s estimate as investment in energy related refurbishment for going from a G labelled to a B labelled property.

What the market is willing to pay more for label G vs label B is derived from a recent study by NVM and Brainbay, where we assume that the average energy label in the Netherlands is D and the average price for an apartment is EUR 4,719 per sqm as per latest NVM data. From this, we can derive values from G labelled properties (=EUR 4,450 psqm) and for B labelled properties (=EUR 4,922 psqm) based on the uplift percentages in the table on the next page. The total uplift from energy measures is therefore EUR 472 psqm.

While one would assume that savings could be immediately re-charged into rents by the landlords by virtue of the tenant not being worse off than paying higher energy bills, we hear from Dutch residential property investor Vesteda that only half of the savings are typically recharged in rents to existing tenants. Only after an average 8 year tenancy change, the full energy savings are re-charged to the new tenant.

10% IRR achievable through energy efficiency investments

Given what we have discussed so far, we now have sufficient inputs to calculate the return on a hypothetical EUR 500 per sqm in energy efficiency investment and bumping up the energy label from G to B. The table below shows a net present value (NPV) on a 10y investment horizon, when applying a 50/50 debt & equity capital structure, as we did before.

Clearly the 11% IRR sits much higher than what can be achieved under a regular property investment and makes up for the cost of capital, even if the entire investment were to be funded through equity. Hence, we still see an avenue for property investors to realize sufficient returns next year, whilst also contributing to curbing emissions, as lower energy intensity also translates into a 25-30% lower CO2 footprint of the building as shown in the LEG Immobilien example on the previous page. Actually, our calculations show that energy efficiency renovations can be carried out without the need for subsidies, as long energy prices will not come down to pre-Russia/Ukraine conflict levels (our calculations now assume they will remain high for the next 10 years). The key bottleneck is capacity, i.e. how much materials and labour is available to carry out energy renovation work. Still, judging by the long-term carbon reduction targets issued by Vonovia and LEG Immobilien, we already see a case for roughly EUR 2.0bn worth of investments in 2023 spread out over 4mn sqm of property area, assuming that the focus will be on poor energy labels. The Netherlands has a stock of 3.4mn rental properties (i.e. units not sqm), suggesting ample borrowing or even equity raising potential for energy efficiency measures in 2023.