Achieving Net Zero Carbon Retail Property. Can investors deliver in the current challenging investment environment?

COP27 is upon us again but COP26, only last November, feels like a life-time ago. Permacrisis has a wearing effect, and it is not over, yet. Brexit, the global pandemic, the war in Ukraine and more frequent climate anomalies – trying times that have led to a surge in domestic and global political and economic uncertainty that has impacted our lives on many levels. A cost of living crisis has emerged from the disarray with many households now struggling to make ends meet. The effects of contracting consumer spending, and rising inflation, energy costs and borrowing costs continue to ripple through the economy.

Current Conditions in the Retail Property Market

The high street and retail property market are also suffering. Caught in the vice-like grip of falling turnover and surging operating costs, retailers and other high street operators face another profit squeeze. Yet, few have the reserves to buffer them through the lean period ahead as they have had insufficient time to recover from the pandemic. It is inevitable some businesses will fail, leading to vacancy rate rises and further downward pressure on market rents.

Yet, consumers and business operators are not the only ones struggling at the moment. Property investors, including the large institutional funds, also face a challenging operating environment although there tends to be less sympathy for these high street stakeholders. Rental income streams from their assets remain highly vulnerable to tenants collapsing and falls in demand from potential occupiers, and investors are experiencing a rebasing of property values since the fall in sterling under the Truss Government triggered a rise in bond yields which pushed up property investment yields. The outcome has been property prices falling even faster than they did in response to the pandemic restrictions.

So, why is this challenging investment market a particular issue for achieving net zero carbon in the retail market? 

Changing Legislation to Reduce Building Carbon Emissions

Investors need to be taking action now to improve the energy efficiency of the properties they own. Since 1st April 2018 and the implementation of The Energy Act 2011, all commercial buildings in England and Wales that do not have an Energy Performance Certificate (EPC) rating of E or above cannot be legally sold or let via a new or renewal lease, unless they fall into one of the exemption categories. However, from 1st April 2023, new regulations extend the Minimum Energy Efficiency Standard (MEES) requirements to include existing leases. If owners of property do not improve the EPC rating of their properties above E before the deadline in six months’ time then the new regulations make it unlawful for them to let or relet a non-compliant building. This means many commercial property landlords who fail to comply with the regulations either face possible rental income voids, or a penalty of up to £150,000 if they ignore the new regulations.

It doesn’t stop there. The minimum EPC requirement is set to rise to C in 2027 and B in 2030, a stepped tightening of minimum energy requirements which is necessary to reduce the COemissions from all buildings to achieve the UK’s net zero target by 2050.

Differences in Net Zero Carbon Legislation Across the UK

An important point to note is that these MEES regulations currently do not apply across the whole of the UK – a situation that can cause confusion. Unlike in England and Wales, there are no minimum EPC standards in Northern Ireland. The country does not have the equivalent of the Energy Act, and there seems to be no plans in the pipeline to introduce minimum standards.

The legislation is also different in Scotland. The Climate Change Act Scotland 2009 (Section 63) and The Assessment of Energy Performance in Non-Domestic Buildings (Scotland) Regulations 2016 require an EPC to be produced for all non-domestic properties on construction, sale or lease by an accredited non-domestic energy assessor, and for building owners to produce and implement a plan of action to improve the energy efficiency of their buildings. While there is currently no minimum EPC rating when selling or leasing a building in Scotland, proposed legislative developments imply minimum standards (similar to the MEES approach in England and Wales) could be imposed in the near future, and Scottish property owners could be facing the same challenges as their counterparts in England and Wales.

Are Investors Prepared for MEES?

Retail investors operate in an ever-changing market where they need to actively work their assets to reverse the decline in investment performance experienced over the last five years, as well as contribute to the recovery and revitalisation of the high street. To do this, whether it is to repurpose surplus retail space or repair and maintain existing units or make energy efficiency improvements, investors need access to capital but this has now become more costly to borrow.

Our research tracks the disinvestment in retail ownership in city centres by institutional investors and growth in property ownership by smaller private investors and overseas investors in five case study cities [1]. These changes have not only increased the fragmentation of ownership, but resulted in the replacement of equity-capital rich funds with property companies and private investors who tend to rely on debt capital. These smaller investors are struggling to effectively manage their assets due to limited access to affordable funding and advice, never mind make the improvements necessary to comply with the increasingly stringent net zero carbon targets. Savills estimate 83% of the existing retail stock needs improvement to comply with the EPC B target set for 2030, and that 60% of this stock is held by smaller ill-prepared investors [2].

Other Leasing Implications of Net Zero Carbon Targets

The changes also have potential to affect retail lease terms. Lease provisions usually require the tenant to keep their premises in good repair and to return the property at the end of the lease in the same condition it was in when originally let. If they do not then the landlord is legally entitled to make a dilapidation claim against the occupier to remedy breaches of the tenant’s lease obligations. Yet, existing lease provisions do not compel the tenant to improve the premises they are vacating beyond the condition when they took occupancy, or include explicit obligations around energy performance. Hence, landlords are unable to pass on the cost of energy efficiency improvements to occupiers. They may try to change future lease terms to enable the sharing of the burden of future targets but it is likely tenants will resist taking on additional obligations. More likely, landlords will have to carry the full burden but will seek to tighten the restrictions on occupiers altering premises to avoid alterations or fit-outs that adversely affect the energy efficiency of the leased building.

Dilapidations, always a contentious area in the landlord/tenant relationship, could be complicated further by the MEES regulations which would result in more disputes occurring. It is possible that outgoing tenants will be able to use the EPC rating they commission for the premises they are leaving to argue they are not liable to carry out any dilapidation repairs because they would be superseded by works required of the landlord to improve the building in order to re-let it.

What Could This Mean for the High Street?

These changes affect all domestic and commercial properties in England and Wales, but is a particular concern for the retail market because this is a sector of the property market already struggling and the necessary changes could potentially be hindered by the nature of its ownership structure. A significant proportion of landlords are smaller ill-prepared owners, often naively into property, who have been struggling with their debt commitments for some time and now face rising interest rates.  They cannot afford these improvement works which they cannot pass on to their tenants and some lack the technical know-how to take appropriate action. This has massive implications for the retail market as it could result in a surge in more redundant and unlettable properties blighting our high streets. Rising building costs and finance costs, at least over the next year or two, are likely to damp enthusiasm for the resale, redevelopment and repurposing of these properties before they become a problem.

Michael Gove has been reinstated as Levelling Up Secretary, giving renewed impetus to his Levelling Up and Regeneration Bill. The revised legislation maintains the original intention to introduce Compulsory Rental Auctions to force landlords to let high street premises that have been empty for more than a year. As stated in a previous blog, this is unlikely to have much effect given the financial penalties that already exist to dis-encourage landlords from sitting on vacant lettable high street properties. Yet, little consideration seems to have been given to how best to support non-domestic landlords struggling to refit their properties and make the necessary net zero carbon transition, or to provide local authorities with additional resourcing to deal with vacant properties that become unlettable because they fail to comply with the minimum energy standards.

There seems to be a policy gap here. Although some funding is available through grants for individual measures, there is no programme to support comprehensive refits of existing buildings. Policy-makers seem to be assuming landlords can afford to make the energy efficiency improvements as they tighten over the next seven years but even larger investors are baulking at the scale of the costs involved. It is inevitable there will be smaller landlords unable to meet these demands and English and Welsh high streets will see a rise in vacant units as a result.

– Allison M Orr

[1] Orr, A M, Stewart, J L, Jackson, C and White, J T (2022) Ownership diversity and fragmentation: a barrier to urban centre resilience, Environment and Planning B: Urban Analytics and City Science, (doi: 10.1177/23998083221124600) (Early Online Publication)

[2] Whittington, T (2022) The EPC cliff edge, RE:Imaging Retail, Autumn/Winter 2022, Savills, London, 18-21.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this:
search previous next tag category expand menu location phone mail time cart zoom edit close