In this paper, intended as a discussion starter, I will analyze the expected impact of ESG regulations on the real estate market.
My main theses – as an executive summary – are the following:
- The pressure to comply with ESG regulations increases the legal-regulatory, technical-mechanical-electronic, and financial-banking complexity of real estate.
- Managing the growing complexity requires increased knowledge and experience, which segments both the property stock and the real estate service providers.
- This will lead to the integration of expertise, as well as the integration of development, property management, and operations. Instead of globalized, but professionally segmented-specialist providers, local, fully integrated service companies will emerge, shortening decision-making and supply chains, speeding up adaptation, and response times.
Now, let’s dive into the details and examine the individual and collective impacts of the three ESG factors.
Environmental
Regulatory expectations are driving energy-saving projects because both interest rates and energy costs are high, so at the project and portfolio levels, investment funds are only available for projects that result in cost savings. To achieve energy savings, it is necessary to measure and regulate, so in addition to mechanical investments, building digitization and BMS-EMS investments are being made where knowledge and resources are available. In the case of over-financed properties, high interest rates drain the resources needed for adaptation. In portfolios with deferred maintenance, high operating costs and tenant turnover due to declining quality reduce income, or the extraordinary investment pressure to eliminate the efficiency disadvantage depletes cash flow. Portfolios that respond to regulatory pressure with digitization and investment will operate at much higher investment costs, while lagging portfolios will become unfeasible at an accelerating rate. Energy certificates and their evaluations feed back the degree of building digitization to authorities and central banks, which may be reflected in the form of interest rate discounts, partially offsetting the extra costs of adaptation. Lagging portfolios will either lose value until funding for technical conversion is created or will undergo a change of function and be completely renovated in their new role. Through energy and digitization investments, physical energy demand can be reduced by as much as 50% compared to pre-2020 levels, but the price for this is an increase in the technical-regulatory complexity of the building, requiring a different level of expertise.
Social
Regulatory expectations meet a tenant and property user demand that has fundamentally changed since Covid. Since the forced shift to remote work, employee behavior has drastically changed, turnover has increased, and retaining employees has become a priority. As a result, the focus has shifted from minimizing total property costs per capita to ensuring an ideal working environment. However, the ideal work environment extends beyond the office itself and includes its surroundings. Proximity to schools, dining, sports, shopping, and administrative services is weighed alongside the quality of the building’s interior. This connects portfolio digitization to "smart city" concepts, where the city encompasses all these functions. The change creates a complex urban planning and investment task of making these urban functions accessible. City-level complexity requires deep knowledge of the entire development-utilization-operation process, and in addition to maximizing the profit from development and real estate projects, it feeds back into business through harmonizing with urban development goals and ensuring sustainability requirements.
Governance
Here, regulatory expectations appear in the lives of real estate professionals through central bank requirements placed on investors, financiers, and insurers. Meeting sustainability goals has created an entirely new industry of energy or ESG certification companies. These new documentation requirements further increase administrative costs, effective economic size, and the complexity of processes and requirements to be managed. EU, government, and local authority regulations and recommendations are changing at a pace that makes adaptation extremely costly.
Local regulations and zoning plans allow for development aligned with community interests, but the availability or lack of government-municipal resources and their priorities, which shift with political cycles, can cause decades of delays in the development of public infrastructure and public transport. The demand for public safety has significantly increased recently, especially for security. Camera systems are meant to ensure the safety of not only buildings but also public spaces. The city is becoming digitalized, as are individual buildings.
The high interest rate and energy cost environment significantly reduces government and municipal resources available for public services, which largely determine the quality of public spaces. City centers are devalued by crime, litter, and a lack of order. Real estate in city centers appreciates in municipalities that ensure efficient and high-quality urban management, while those neglected by ideologically driven local governments are devalued.
I am convinced that underlying economic-political goals are intentions to protect the market and facilitate market concentration. ESG regulations also segment the real estate market into portfolios that meet international standards and those that do not. "Compliant" properties and portfolios receive favorable loans and insurance and are also accessible to international – that is, well-paying – tenants. "Non-compliant" properties have higher loan and insurance costs, and international tenants are restricted by their own rules, putting them at a competitive disadvantage. Ultimately, ESG requirements have a market-restricting effect, raising investment costs but also ensuring returns at high cost levels and concentrating the market towards large investment funds.
Real estate development, asset management, and operation can only handle ESG regulations by working together. Addressing energy, portfolio digitization, urban operations, security, and transportation issues is impossible without colleagues equipped with technical, financial, and legal expertise and experience. Under such conditions, Asset Management, Property Management, and Facility Management services can only be effectively provided if they are fully integrated. However, this will require locally integrated service providers in the future, like REM Property Services!
The above has been translated from Hungarian to English with the use of AI.