The property sector – the CO2 debate as disruptive event

By Christian Alpers, Certified Business Accountant (Dipl.-Betriebswirt), Certified Property Valuer (IHK) and partner at Falkensteg GmbH, and Rüdiger Bauch, Attorney- at-Law in Germany and Certified Specialist in Insolvency Law

The abbreviation “ESG” is encountered more and more frequently, in the property sector as elsewhere. It stands for Environmental, Social, Governance. Environmental of course refers to environmental matters, Social relates to social responsibility, and Governance, meaning corporate governance, concerns an organisation’s leadership and management culture. Together they mean a sustainable investment which takes account of environmental and social concerns and is subject to responsible governance. This article looks at the “E” in ESG, the environment.

Environmental sustainability is an increasingly important consideration in investment planning, as is illustrated by the clear position taken by the world’s biggest financial services provider BlackRock. This year, BlackRock CEO Larry Fink wrote that sustainability would be a central standard for future investments. Environment is now an economic factor and no longer a mere add-on criterion – including in the property sector.

The state is one of the actors driving development in this area, so a quick review of the history is needed here. Germany has a long tradition of government intervention in the property sector. The key tool for such intervention is public construction law – the construction of new buildings in particular has always been subject to extensive government regulation. The planning consent procedure gives the state broad scope to influence and examine a building at the planning stage. Initially, the focus was less on protecting the environment and more on simply reducing energy use and thus dependency on primary energy sources.

Following the 1974 oil crisis, the first version of the Thermal Insulation Regulation (Wärmeschutzverordnung) entered into force on 1 November 1977. It set out specifications for thermal insulation to be installed in new buildings with the objective of reducing energy consumption. This was something new: the Regulation was the first piece of binding national legislation to set out energy standards for construction. The magical date of 1977 is still important today, because the only acceptable form of energy performance certificate for buildings constructed before 1977 and not renovated since then is a demand certificate (Bedarfsausweis).

The Thermal Insulation Regulation was modified, i.e. its requirements tightened up and brought into line with new technical standards, a number of times. The second Thermal Insulation Regulation was introduced in 1984 and the third in 1995. Finally, the Buildings Energy Act (Gebäudeenergiegesetz) was introduced on 1 November 2020. On 1 February 2002, the final version of the Thermal Insulation Regulation was replaced by the Energy Saving Regulation (Energieeinsparverordnung). The Energy Saving Regulation also incorporated elements of the Heating Systems Regulation (Heizungsanlagenverordnung), which entered into force in 1978 and was amended several times until the final version took effect in 1998.

In 2009, this legislation was joined by the Act on the Promotion of Renewable Energies in the Heat Sector (Erneuerbare-Energien-Wärmegesetz). For the first time, this Act made the use of renewable energies in new buildings mandatory in an effort to further reduce dependency on external energy sources and drive forward the transition to renewable energy. Finally, in 2020, all of this primary and secondary legislation setting out the statutory basis regarding energy aspects of building design was consolidated in the Buildings Energy Act. This Act also brought a number of new developments, among them a wide-ranging ban on the installation of oil-fired heating systems from 2026.

Since the 1970s, then, the German federal legislator has worked continually and systematically on energy standards in the property sector and will need to continue to readjust and adapt these standards in the future as technology advances. Overall, it is clear that statutory interventions worked as intended. By 2018, consumption of final energy for heating and hot water had fallen by 10% since 1977, despite the fact that over 1.75 billion m² of residential space had been built during that time. Economic development had been decoupled from energy efficiency.

In the present debate, it is clear that all of this was just the beginning and that we can expect rules to be tightened massively in future, because action is urgently required if the aim is to comprehensively fight climate change. The German Federal Government’s Climate Action Plan, derived from the Paris Climate Accords, currently states that commercial properties will be climateneutral by 2050.

Even more far-reaching measures are needed following a recent ruling by the German Federal Constitutional Court (Bundesverfassungsgericht) that the Federal Climate Change Act (Bundes-Klimaschutzgesetz) was not sufficiently ambitious. The Court found that the Federal Government had cause to take sufficient action to mitigate climate change, as failure to act would constitute an encroachment on the freedoms of future generations. The Federal Government has since begun to act. It plans to introduce, if not direct CO2 pricing, at least a hefty surcharge on the cost of energy consumed (CO2 surcharge). No legislative proposal has been presented as yet. But it is certain that the judgment of the Federal Constitutional Court on 24 March 2021 and the political response to the “hundred year” flood in July 2021 will bring major changes.

Profit, return, growth – for a long time, the property sector acted almost entirely on the basis of economic criteria. This was also true of virtually every sector of the economy. The quality of an investment was measured above all in terms of the financial return that it brought. Today things are no longer quite so simple. Alongside economic factors, environmental and socio-cultural factors are becoming increasingly important. Climate change is a particular driver of this development. Heatwaves, natural disasters and rising sea levels are forcing a rethink at every level of society, including in the property sector. The Federal Government – in line with corresponding agreements at EU level – has set an ambitious goal: Germany will be climate-neutral by 2045. This will require rapid transformation in almost every area of life. The property sector will play a key role in this transformation. In June 2021, the Federal Ministry for Economic Affairs and Energy (Bundesministerium für Wirtschaft und Energie) stated that buildings in Germany had produced around 120 million tonnes of CO2 in 2020. The objective is for Germany’s building stock to be virtually climate-neutral by 2050 at the latest. This can only be achieved if the energy consumption of a substantial proportion of buildings is significantly reduced while renewable energy usage is increased.

The effort required to do this will be immense. Energy-efficient new buildings are one part of the answer, but improvements also need to be made to the existing building stock. Tried and tested measures, such as insulating façades, better windows and new heating systems, will not be enough on their own to achieve the necessary reductions in CO2. New technical solutions which are efficient and cost-effective are needed. The pace of modernisation of existing buildings to meet climate standards also needs to accelerate significantly. Across Germany as a whole, the proportion of houses and apartments that are made energy efficient each year has long averaged at about 1 per cent. The owners of those properties pay a lot to do this: the most recent figure is EUR 40 billion per year. There have already been some noteworthy successes: In 2020, the property sector was responsible for the emission of 120 million tonnes of CO2 equivalents. Thirty years previously that figure stood at 210 million tonnes.

As renovations continue, the energy consumed by buildings will decline. At the same time, more and more renewable energy is being used. Over the last year, environmentally friendly heat pumps have been the most important primary energy source for new heating systems. Much is still to be done, however. By 2030, emissions from buildings must fall to 67 million tonnes of CO2 equivalents. The current rate of renovation is not enough to achieve this and will have to rise to at least 3%.

If the profitability of an investment can no longer be decided on returns alone, and other sustainability criteria are also important, does this mean that investors will have to forsake returns? Not at all. On the contrary: property investors who act in accordance with ESG principles will improve the quality of their portfolios and create prospects for higher rental income. But those who obstinately ignore sustainability aspects can expect reductions in both income and profits and will lose out to the competition. Why is that the case?

First, let’s look at the direct costs. Use of sustainable technologies drives construction costs up. New buildings which use geothermal or solar energy, for instance, cost more than projects which do not include energy-efficiency measures of this kind. In existing properties, retrofitting costs – which are usually already high – frequently correlate with the timing of the work. Replacement of a heating system will obviously be less costly if done during scheduled major renovation works rather than midway through a life cycle.

The costs of energy-efficient building and renovation work are cushioned by government support in the form of direct grants or loans on favourable terms, such as those granted by the state-owned KfW-Bank or the investment banks of the individual federal states. The capital markets also support sustainable investments. Borrowers who obtain funding via Green Bonds or ESG-linked loans can often access better terms. Funding is subject to the money being used exclusively for sustainability projects (this is the case with Green Bonds) or the borrower undertaking to meet certain sustainability objectives, after which it can use the funds as it wishes (this is the case with ESG-linked loans).

On the downside are properties which do not meet these criteria. Owners who drag their feet on investments typically lack liquidity and access to financing, and sooner or later end up as debtors in individual enforcement proceedings or insolvency. For example, the installation of oil-fired heating systems, even as replacements, will not be permitted from 2026. A sequestration or insolvency administrator handling a non-compliant property will be in a problematic situation. In financial terms, it is usually the lien holder with first priority who has to pay up and remedy failures by the debtor.

But even once the immediate crisis is over, ESG standards will determine questions of financing, refinancing and disposal at least to some extent. Over the coming years, properties which do not comply with ESG standards will become a burden. So it is advisable for investors to address these issues and standards at a very early stage.

When looking at the returns on ESG-compliant investments, we need to distinguish between financial returns and those that are not directly financial. Property investors who consistently consider the environmental and human effects of their investments will reinforce their reputation, both with the public at large and within their own industries. Though this does not affect liquidity directly, it brings many benefits in terms of competition and, more and more frequently, in the employment market. In addition, these investors need have no fear of sanctions that the state may impose in an effort to reach climate goals.

Conversely, failure to take ESG criteria into account could have serious long-term consequences for a property company.

That brings us to the direct economic effects of ESG-compliant investments. Large institutional investors in particular are already increasingly aligning their decisions with sustainability criteria. Insurance companies, for instance, have a vested interest in investing in environmentally beneficial properties, as in doing so they can counter the damaging impacts of climate change and the ever more extreme weather phenomena it brings. Listed companies are required to produce sustainability reports and open themselves up to critical questions from their investors. For the property sector, this means that the ESG quality of a property is becoming a factor that influences market value. As long as the supply of demonstrably sustainable properties is limited, increasing demand will drive up prices for such properties. And as supply increases, ESG-compliant properties will over time become the market standard. That will curb prospects for further price increases.

On the other hand, non-sustainable properties will be at risk of accelerating falls in value as demand for them declines over time, and it is possible that debt financing is already inaccessible for properties which will not meet future standards. In a survey of financing experts carried out by property consultancy firm JLL, 14% of respondents stated that sustainability already has a “big”´influence on market value. About a third accorded it “moderate” importance.

Achievable net rent excluding operating and heating costs (referred to in Germany as “cold rent”) is also closely related to the ESG quality of a property. Landlords who make energy improvements to their buildings create higher quality residential space for new, often higher income tenants. New lettings will bring significantly higher cold rents than before the improvements. Landlords can ensure that existing tenants contribute to the improvements to their homes by adding 8% of the cost of the work per year to the annual rent. In this case, though, increases in rent following renovations cannot exceed three euros per square metre per month over a six-year period. Tenants and the advocacy groups that represent them are frequently highly sensitive when larger housing companies in particular carry out energy improvements and pass on part of the costs within the limits permitted in law. This goes to show the many and complex conflicts that the property sector needs to navigate: On the one hand, extensive green renovations have to be paid for, but on the other, affordable living costs are a significant social good.

During a research project, the Federal Office for Building and Regional Planning (BBSR) found that following energy improvements, housing companies charge lower cold rents to existing tenants than they do to new tenants – a consequence of the statutory cap. The full picture for all involved does not become clear, however, until operating costs are also taken into account. Ultimately, tenants care about the total cost of their home, that is to say how much rent they pay in total, including operating and heating costs (referred to as “warm rent”). Energy improvements, and in particular the use of renewable energies, reduce these costs. But this saving is not usually big enough to offset the accompanying increase in cold rents immediately. The BBSR found in its study that “warm rent neutrality” is achievable only in exceptional cases.

Institutional investors need proof that ESG-compliant property investment is profitable. From their perspective, the potential markup on cold rent may not be high enough to justify energy improvements. A study carried out at the Technical University of Darmstadt came to the following conclusion: “Investments in building energy improvements bring above-average returns for landlords.” Other studies, such as that by the German Energy Agency (dena), deliberately leave open the question of profitability, as in its view the answer to that question is often dependent on factors which vary from region to region.

However, there is also the time factor to consider. From the investor perspective, the returns will, in the long term, significantly exceed the costs. Failure to implement energy improvements will make a decline in value likely, and in the worst case could result in properties being left vacant.

Is transformation along more sustainable lines a blessing or a curse for the property sector? This is not the right question to ask. ESG rating arrived on the institutional investment scene some time ago and is now a huge trend globally. It is changing the rules across all sectors of the economy. Without proof that an investment meets certain ESG standards, investors run risks that will bring negative consequences in the long term. So it is inevitable that property companies will need to incorporate sustainability considerations into their business model. Not least because financing is more easily and cheaply available for “green companies”.

In short: Compliance with sustainability criteria is an additional indicator of financial performance and is becoming a competitive factor that shapes markets. However – and the sector still has work to do here – binding standards are needed regarding social responsibility and governance issues in particular, as this is the only way to ensure transparency and comparability.

In light of the magnitude of energy consumption by both commercial and residential properties, it is clear that the CO2 neutrality that is desirable for environmental reasons cannot be achieved without a significant contribution by the property sector.

Given the number of existing properties, it is becoming apparent that the legislator, in addition to introducing rules for new builds, will be unable to avoid making energy improvements to existing properties mandatory. Though the previous tactic of offering funding to encourage owners to improve their properties voluntarily has enjoyed some success, the ban on installation of oilfired heating systems from 2026 shows that the legislator wants to pursue the modernisation of old buildings more vigorously. This is because two thirds of the 19 million residential buildings now standing were built before 1979, that is to say before the first Thermal Insulation Regulation entered into force. According to a survey carried out by the Institute for Housing and Environment (Institut für Wohnen und Umwelt), only 25 to 30% of them have been modernised to date.

This is not enough, and so regulatory pressure to improve buildings can be expected to intensify.

With regard to any (future) statutory obligations, the question of whether the parties subject to those obligations will be able to carry them out should also be taken into account. Alongside the fact that many private individuals have invested in property for their retirement income and energy improvements are a significant financial burden, there are also practical problems. Aside from the rise in construction prices over recent years, availability of building materials and building firms is an increasingly pressing issue. Both are already in short supply, and so the question in Germany but also in the other European countries is how the desired work can be implemented at all.

Christian Alpers heads the Real Estate department at FalkenSteg. FalkenSteg is a partner-led restructuring, corporate finance and real estate consultancy with locations in Düsseldorf, Frankfurt am Main and Munich. The Real Estate department specialises in the management and sale of distressed properties.

The property sector – the CO2 debate as disruptive event

The essay is available for download here.