How Much Will Complying With Emissions Standards Hurt Commercial Real Estate?

What commercial real estate sectors will pay the most to comply with greenhouse gas emissions rules globally, and what CRE sectors will be least affected? Answers: offices will pay the most and warehouses the least.

That assessment was part of a recent webinar conducted by Green Street, the real estate analytics firm. The session covered the cost of compliance aimed at reducing climate change globally. Daniel Ismail, Green Street’s co-head of strategic research, described how companies’ rising capital expenditures to control GHG and other such outlays, such as insurance, will affect profitability.

In 2024, Ismail said, these expenditures are relatively small. Trouble is, the costs will mount over time, he pointed out. Eventually, if current trends continue, more commercial properties will be totally electrified via renewable sources, leaving their oil or natural gas-fed furnaces a memory, which likely would be cheaper. But that could take a while.

Ismail cautioned that climate costs should hardly be the deciding factor for investors in choosing what kind of real estate to put money into. Long-term growth expectations and other factors will be more important, he noted.

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Example of a CRE climate cost: New York City enacted a new fine on buildings that exceed emissions limits, starting in 2025. Ismail said most landlords will opt for the fine ($268 annually per ton of carbon dioxide over 2024 levels) rather than pay the far weightier costs of retrofitting their properties to comply. It is unclear, at this stage, what the average fine would be, but information from the city states 11% of buildings required to comply with the law exceeded emissions limits for the first compliance period, 2024 to 2029.

Offices and shopping centers will shoulder the biggest outlays complying with climate regs, both in the U.S. and around the world, according to Green Street. Over the next five years at a minimum, office building owners will need to boost their capital expenditures by 3.5% of net operating income and shopping centers by 2.1%. The costs for self-storage sites (1%) and industrials (0.9%), mainly warehouses and factories, will be lighter.

Some sectors, though, will be able to pass along their new costs to customers, particularly self-storage and industrials, Ismail said. Offices and malls will find that much more difficult.

The pandemic and high interest rates have punished CRE economically, most notably in the office sector. In this year’s first quarter, the U.S. vacancies for offices hit 19.8%, a new record, from 17% at the end of 2019 (right before the pandemic), data from Moody’s Investors Service shows. Meanwhile, for industrial properties, vacancies are less of a problem, around only 5%, only slightly higher than 2019’s final quarter (3%), data from commercial real estate services and investment firm CBRE indicate. The industrial sector has expanded to meet pandemic remote-buying demand, but new construction is tapering off.

Investors in real estate investment trusts have suffered in general, but offices were down the most last year, losing 23.7%, per data from NAREIT, the trade association for real estate trusts.

Risk Transparency

Casten has argued in many Congressional hearings on the rule that, as climate change worsens, sophisticated investors will increasingly try to offload risk by selling assets with high climate risk exposure to less sophisticated investors. This so-called “information asymmetry” will enable some investors to effectively offload their risks onto other, less-savvy investors.

In an interview, Casten says “it’s much easier to access capital and to succeed in capital markets if you have more information than the person on the other side of the trade. There’s been a lot of investor pressure for a long time to do this.”

Casten adds that when sophisticated investors “see risk coming, they move it into special opportunities, and sell it off to, you know, a small local pension fund.,” That’s a risk, he argues, that the climate risk disclosure rule would help protect them from.

Emphasizing the information gap between different types of investors, Casten says, “if you’re the kind of operation that can afford to hire hundreds of smart MBAs and you’ve got piles of Bloomberg terminals and you’ve got access to everybody’s SEC filings, you can you can figure out where risk is parked in the system and how to insulate yourself from that.”

But in the case of smaller investors, “If you don’t have access to all that, how would you find it?”

“Why are insurers pulling out of Florida?” Casten asks. “Because we’ve gotten [National Oceanic and Atmospheric Administration] reports that say there’s going to be two feet of sea level rise, coming to the Gulf Coast by 2050. In other words, before current home mortgages will be paid off.”

Understandably, Casten argues, knowledgeable investors want to “make sure that their portfolio is hedged out against that risk.”

Investor Popularity

Both Casten and SEC Chairman Gary Gensler have underscored that the climate rule was very popular with investors in the public comment file, even amid the public backlash from industry groups and policymakers on the others side of the debate. Casten quips, “the next time I meet with an investor that’s opposed to this rule will be the first time. I’ve never met an investor that would like less information.”

Specifically, Casten says that “the folks who I think have been most broadly supportive are a lot of the state treasurers.”

Casten notes that state treasurers and other public pension fund managers hold funds for long periods of time, and “they don’t particularly want a portfolio that requires rebalancing and adjusting every year, every six months, every nanosecond.” Given their longer time horizons, they would prefer to invest in assets that do not carry longer-term risks, such as significant climate risk exposure, he says.

Tags: climate risk disclosure, Gary Gensler, National Oceanic and Atmospheric Administration, Sean Casten, Securities and Exchange Commission, Sustainable Investment Caucus