ESG factors are crucial in driving commercial property growth

published 26 October 2022

Will Fulton and Jamie Horton, Investment Managers, UK Commercial Property REIT

In a tougher economic climate, the ESG credentials of individual property assets are increasingly likely to be the difference between stronger and weaker performers.
We are achieving our net zero targets through a blend of careful restructuring of existing assets, selective sales and targeting assets with strong ESG credentials.
Commercial property assets not deemed to be “future fit” are likely to see limited occupational and investor demand.

There have been plenty of encouraging signs emerging from the commercial property sector this year. Rents are normalising after the pandemic, vacancies are low and falling, while capital values have been stable. However, there can be little doubt that the market will be more challenging from here against a backdrop of weakening economic growth and higher interest rates. The Environmental, Social and Governance (ESG) credentials of individual property assets are increasingly likely to be the difference between the strongest and weakest performers.

On the UK Commercial Property REIT, we are targeting net zero landlord emissions by 2030 and net zero for all emissions by 2040. This is a challenging target and can, we believe, be achieved through a blend of careful restructuring of existing assets, selective sales and targeting assets with strong ESG credentials for inclusion in the portfolio.

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Those commercial property assets not deemed to be “future fit” are likely to see limited occupational and investor demand as ESG considerations become ever more prominent in tenant and investor decision-making. This is likely to be particularly important in areas such as offices, where the overall market is shrinking and tenants are becoming more discerning.

Decision-making

Where we have existing assets that do not meet ESG criteria, we need to decide whether to refurbish them and bring them to the required standard or sell them. This decision is based on a number of factors, but in particular, whether we can recoup the capital expenditure required to improve the credentials of an individual building.

Most recently, we divested of our holding in 9 Colmore Row in Birmingham. The potential for stranded offices is a key risk for the trust and we were worried about the capital commitment to improve the building. We managed to sell it at a profit. It was a similar picture with Network House in Hemel Hempstead, which we sold last year. The asset was not of sufficient quality to justify the necessary capital expenditure to re-let it. It was bought by a developer that wanted to use it for residential redevelopment.

However, there will be assets where we believe the development costs are worth it, in terms of higher rental income and improved capital values. Newtons Court is a multi-let site in Dartford, east of London. Unit 12 is its largest block – 20% by floor area – and had been used as a fruit-ripening area. When the most recent tenant left, we spent around £3m on an ESG-friendly refurbishment, using energy efficient materials, and installing solar panels on the roof. It went from a D to an A rating. The unit has been well-received and we now have a new ecommerce-group as a tenant at a strong uplift in rental income.

It was a similar picture for our Tudor Park industrial estate in Radlett. Warner Brothers has been the largest tenant, holding some of the warehouses on a long-term basis and some on a tactical basis. It recently decided to vacate Unit 7, an 86,000 sqft warehouse with an imperfect layout and poor ESG credentials. We have indicative planning permission for a larger building that we can redevelop to a modern specification. This should drive higher income from the asset.

Activity

ESG analysis is also a vital part of our decision-making for any new purchases made for the trust. For example, this year we have committed to fund the development of a 305-room hotel in the centre of Leeds – Sovereign Square. This meets all our investment criteria – the quality of hotel space in Leeds is weak in spite of the City’s economic activity. The site is in the centre of the city, and alongside groups such as KPMG. Its ESG credentials are also very strong – with a target ‘A’ on its Energy Performance Certificate. This helps ‘future proof’ the asset and give it a stronger yield profile.

We are already seeing the benefits of this approach in the portfolio, with a low void rate – around one-fifth of the benchmark – and stable yield. Our aim is to build a diversified portfolio with rental and earnings growth and a complete ESG overlay. In a more difficult market, focusing on best in class assets will be vitally important. To deliver on our targets, we need to pursue this strategy with vigour, divesting where necessary, managing assets to bring them to the highest quality and buying assets with the highest ESG credentials as they become available. This is vital in ensuring the portfolio is fully fit for the future.

Important information

Risk factors you should consider prior to investing:

The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.
Past performance is not a guide to future returns.
The value of property and property-related assets is inherently subjective due to the individual nature of each property. As a result, valuations are subject to substantial uncertainty. There is no assurance that the valuations of Properties will correspond exactly with the actual sale price even where such sales occur shortly after the relevant valuation date.
Prospective investors should be aware that, whilst the use of borrowings should enhance the net asset value of the Ordinary Shares where the value of the Company's underlying assets is rising, it will have the opposite effect where the underlying asset value is falling. In addition, in the event that the rental income of the falls for whatever reason, including tenant defaults, the use of borrowings will increase the impact of such fall on the net revenue of the Company and, accordingly, will have an adverse effect on the Company's ability to pay dividends to Shareholders.
The performance of the Company would be adversely affected by a downturn in the property market in terms of market value or a weakening of rental yields. In the event of default by a tenant, or during any other void period, the Company will suffer a rental shortfall and incur additional expenses until the property is re-let. These expenses could include legal and surveying costs in re-letting, maintenance costs, insurance costs, rates and marketing costs.
Returns from an investment in property depend largely upon the amount of rental income generated from the property and the expenses incurred in the development or redevelopment and management of the property, as well as upon changes in its market value.
Any change to the laws and regulations relating to the UK commercial property market may have an adverse effect on the market value of the Property Portfolio and/or the rental income of the Property Portfolio.
Where there are lease expiries within the Property Portfolio, there is a risk that a significant proportion of leases may be re-let at rental values lower than those prevailing under the current leases, or that void periods may be experienced on a significant proportion of the Property Portfolio.
The Company may undertake development (including redevelopment) of property or invest in property that requires refurbishment prior to renting the property. The risks of development or refurbishment include, but are not limited to, delays in timely completion of the project, cost overruns, poor quality workmanship, and inability to rent or inability to rent at a rental level sufficient to generate profits.
The Company may face significant competition from UK or other foreign property companies or funds. Competition in the property market may lead to prices for existing properties or land for development being driven up through competing bids by potential purchasers.
Accordingly, the existence of such competition may have a material adverse impact on the Company's ability to acquire properties or development land at satisfactory prices.
As the owner of UK commercial property, the Company is subject to environmental regulations that can impose liability for cleaning up contaminated land, watercourses or groundwater on the person causing or knowingly permitting the contamination. If the Company owns or acquires contaminated land, it could also be liable to third parties for harm caused to them or their property as a result of the contamination. If the Company is found to be in violation of environmental regulations, it could face reputational damage, regulatory compliance penalties, reduced letting income and reduced asset valuation, which could have a material adverse effect on the Company's business, financial condition, results of operations, future prospects and/or the price of the Shares.

Other important information:

Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

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