A little thought experiment for you: if you had to completely upgrade your home’s energy performance – and face steep fines if you didn’t – would you be confident of finding the cash?
And what if you couldn’t? Re-mortgaging is an option, but only if there was enough equity in the property to borrow more. Maybe a wealthy friend could provide the capital, in return for part ownership of your home of course. But what is the outlay was more than the value of the asset?
A classic Catch-22. It doesn’t make economic sense to spend on the upgrade, but selling the asset would mean a huge discount to current values. You either sell at a big loss or hold an asset that actively costs you money through fines. Hobson’s Choice.
To bring our thought experiment into the real world, this is the situation many commercial investors are currently grappling with, and solutions are in short supply. MEES regulations mean that by 2030 all non-domestic properties must have an EPC rating of ‘B’ or higher; by some estimates, as much as 88% of assets will need some form of upgrade to become compliant. For properties that aren’t upgraded, but continue to be leased to occupiers, fines start at 10% of the property’s rateable value, rising to 20% after three months with an upper limit of £150,000. The urgent need to upgrade is clear, but poses a rather large question: who exactly is going to pay for all this?
Flight to quality
The answer is not a simple one, and in truth it varies hugely depending on each asset’s specific circumstances. But when weighing up a building’s prospects there is a clear distinction to be made between high-quality holdings and those that are at the lower end of the spectrum.
Let’s start at the top end of the market, if only because it’s a little easier to foresee what will happen. In broad terms the best assets – in strong locations with high occupier demand, and usually owned by well-capitalised funds and institutions – will face very few hurdles. Not only will upgrade costs be generally lower as a proportion of overall value, but such works could potentially even have a net positive effect on values. With corporate occupiers willing to pay a premium for sustainable space, and MEES regulations likely to trim supply at the margins, we can expect a fillip to top-end rents and values.
Given these dynamics, finding the cash to upgrade these assets will be relatively straightforward. In many cases the investor will have the money available to fund the necessary works. If needed, loans in this space will be easy to come by – we’re already seeing both banks and alternative lenders expand their offer, with products operating in a similar way to development finance facilities.
At the margins, there will be some assets – on the fringe of the best locations, older and therefore more expensive to bring up to scratch – that require a different solution, and private equity will step in for some of the heavy lifting. A number of major PE funds are manoeuvring to capitalise on this need, with teams identifying the investors that are short of cash but have assets where upgrades make sense. Globally, private equity has $500 billion of ‘dry powder’ in its warchest – expect to see a decent slice of that deployed in upgrading buildings in return for stakes in the assets.
The sums don’t work
Towards the lower tiers of asset quality, the picture is a far more complicated one. Even before availability of cash is taken into account, it is much harder to make the sums add up. These buildings will often be older – needing more spent on them to bring them up to scratch – while at the same time will be worth less than equivalent higher-quality assets. In parallel, these buildings are less likely to see the uplift in rents and values that prime stock will experience; the best many could hope for is for current values to be maintained. The ratio of required spend to asset value is squeezed from both directions, and in many cases it will simply not make sense to undertake the upgrades.
Then there is the question of available capital to complete the works. Owners of lower-grade assets are often far smaller and with a great deal less cash on hand. Many will be owned by individuals and families whose wealth is tied up in other assets, including their own homes. Unlike the institutions, laying hands on the necessary cash to fund the works will be at best tricky and in many situations impossible.
The dynamics effectively rule out borrowing – lenders will have neither the capacity nor appetite to engage with this end of the market – and the doors to private equity funds will be similarly closed. There is, in short, a lot of work that needs to be done, and not enough cash to go around.
The luckier owners will be able to redevelop sites for alternative uses, or sell them to people that can. Others will be stuck with essentially worthless assets. The Government may review the regulations timetable, but this will surely amount to a stay of execution rather than a resolution. One thing is clear: some difficult decisions lie ahead.
This piece was initially published in the May 2023 edition of Business Moneyfacts Magazine.