Embracing the future: approaches to ESG in real estate valuation

The first step in the additive approach is to identify the relevant sustainability criteria for the property being valued. These include energy efficiency, water efficiency, use of recycling materials or ease of maintenance, among others. The additive approach focuses primarily on the technical characteristics of a property. Environmental, social and economic aspects of sustainability are only included indirectly if they impact the technical characteristics. The second step is to quantify the impact of the sustainability criteria on the property's cash flow, e.g. by computing savings in energy, water and waste charges. The discount rate used to discount cash flows to present value can also be adjusted in line with the property’s sustainability characteristics. To keep the discount rate transparent, we recommend reporting the add-ons and deductions separately (see figure 1). Applying a further add-on or deduction for sustainability characteristics of the property being valued (e.g., ESG conformity) is also possible. A deduction (add-on) is applied to the discount rate for a property with strong (weak) sustainability characteristics, as it can be viewed as a lower-risk (higher-risk) investment.

The additive approach offers a simple and transparent way of incorporating sustainability characteristics in real estate valuation, concentrating on the quantifiable impact of technical characteristics on the cash flow. However, it should be noted that there is a risk of double-counting some of the sustainability criteria in this approach, as the property characteristics are broken down into sustainability-relevant and non-sustainability-relevant factors. More concretely, this means that individual criteria, for instance the building and furnishing standard, which are already taken into account in the conventional cash flow-based valuation process, may be included in the valuation process for a second time.

The main aim of valuation is to take into account all of a property’s features relevant to its valuation. Alongside the cash flows and property risks, this includes the building characteristics, the quality of the location and environment, the impact of the property on society (e.g., creating jobs, improving quality of life) and its economic sustainability (e.g., climate-related risks and resource depletion). Hence, the appraiser has to include a wide range of relevant characteristics and needs to ensure there is no double-counting resulting from the non-transparent inclusion of sustainability criteria, as can occur in the additive method. The solution to this is the integrative approach. In this method, alongside the technical characteristics included in the additive approach, property characteristics in all three dimensions of sustainability (environmental, social, economic) with potential relevance to valuation are reviewed on a case-by-case basis using a longlist system (see NUWEL guidelines for further details). The appraiser can use this as a checklist to review whether a particular characteristic is appropriate and relevant to the valuation. This integrated list, which includes both characteristics relevant to sustainability (e.g., micro and macro location, plot, functionality, expected lifespan, etc.) and those not relevant to sustainability (e.g., resource use, health, functionality, lifespan, land consumption etc.), eliminates the differentiation between these characteristics and significantly reduces the risk of double-counting or non-inclusion.

In the discounted cash flow (DCF) valuation method, all criteria relevant to valuation, including the sustainability characteristics, are taken into account in the modeled cash flows. The presence or absence of sustainability characteristics (see previous section) is therefore monetized. For example, ESG-led measures such as the rental of roof space for solar panels can generate additional revenue that would not be available for a comparable property without solar panels. ESG-led costs can relate to renovating a property to make it more energy efficient and so reduce costs in the long term (e.g., lower energy costs through renewable energy sources, lower maintenance costs, lower repair costs through improved insulation and high-quality materials that avoid building defects and dampness, lower operating costs as there is usually less cleaning and maintenance work in energy-efficient buildings, and so on).

Only factors that cannot be included in the cash flows are incorporated as a property-specific risk in modeling the discount and capitalization interest rate. Figure 2 gives an overview of the sustainability criteria that can be integrated in the four value drivers of rental income, vacancies, operating and maintenance costs and the discount and capitalization interest rate. In concrete terms, this means that estimates of the annual gross yield of sustainable properties may assume rising rents (different growth rates and higher net payment capacity by tenants due to falling operating costs) and thus longer rental terms due to improved marketability and a smaller market. Life is healthier and more comfortable in energy-efficient buildings, which may be reflected in higher rents and tenant satisfaction. On the cost side, this means sinking operating costs (e.g., due to investments to improve the sustainability of a building during the investment period). The discount rate may also decrease due to the lower property-specific risk. The overall improved marketability of sustainable properties also means that a lower exit yield (higher property value, lower risk, potential for a long-term increase in value) will be reflected in the discounted cash flows.

In order to value the impact of ESG criteria using scenario analysis, we first have to identify relevant scenarios reflecting different developments in environmental, social and governance factors. One possible breakdown would be into the following scenarios, for example:

1. Environmental factors

When evaluating the impact of climate change on the climate resilience of a location and therefore on real estate values in different regions, we need to start by assessing the frequency and intensity of natural disasters such as flooding, storms and droughts. The aim is to develop scenarios with different levels of energy efficiency, renewable energy use and sustainability standards for buildings. The influence of these factors on operating costs, market demand and long-term value trends can then be analyzed.

2. Social factors

Population trends and demographic change are significant influences on the demand for different types of property and the attractiveness of particular locations. To forecast these factors, demographic trends and population movements need to be considered. Social equality and community integration are also key elements in the value of a property via factors such as gentrification, access to education and healthcare and social integration. All of these affect a location’s long-term attractiveness and sustainability and thus have a complex influence on property valuation. For instance, a stable neighborhood can lead to higher demand for property in an area, as can a low crime rate or access to good schools and educational institutions. This leads to higher quality of life and therefore higher property values.

3. Governance factors

Reflecting regulatory changes, i.e., incorporating developments in building regulations, environmental protection legislation and tax policies is critical. Corporate governance and transparency are also becoming increasingly important in real estate companies, as they have a demonstrable effect on investor confidence, cost of capital and long-term performance.

4. Combined scenarios

Integrating multiple ESG factors in comprehensive scenarios makes it possible to analyze the interrelationships and synergies between environmental, social and governance criteria and also obtain a holistic insight into the long-term effects on property valuation.

In practice, we begin by identifying the most important variables for property valuation. In the next step, we determine the probability distribution for the different key variables representing their relative importance. With these key variables as inputs, the value of a property can then be determined using various financial models. Using the defined probability distributions, various scenarios are simulated by taking different combinations of probabilities for the key variables from the distributions. This creates a set of possible future scenarios. Scenario analysis does not produce a point estimate of market value, as per the RICS definition, but a plausible range (i.e., a range for the market value based on current market conditions).

The real estate sector faces two important challenges: firstly, reducing CO2 emissions and secondly renovating and retrofitting old buildings to improve energy efficiency. To meet the climate targets, a significant increase in the retrofit rate and increased use of renewable energy are required, particularly for heating. The widespread use of oil heating is a major challenge for the sector’s CO2 footprint.

ESG criteria go beyond merely measuring emissions and are thus indispensable. Energy retrofitting and modernization not only increase the attractiveness and value of properties, but also contribute to meeting climate targets.

Incorporating ESG criteria in real estate valuation is an important step to better understanding the long-term value of properties and minimizing ESG risks. By incorporating environmental, social and governance factors, we can quantify their potential impact on property values and so create a stronger basis for decisions.