Video Transcript: Understanding real estate in uncertain times

Transcript

Mark Addley: Welcome to this webinar on commercial real estate. I'm Mark Addley, a partner in our real estate deals practice with a core focus on restructuring. This is a second of our Act Now Webcasts and today, we will be answering some of the important questions we're being asked by our clients in the real estate sector. Our economy has moved to a higher interest rate environment seemingly for longer, which directly impacts real estate evaluations and debt service ratios. The profile of many real estate asset classes has moved into operational assets and investors today have much wider considerations to deal with. ESG is here and whilst the policies may be subject to change, the tenant expectations are not. If we add to this an international pool of cash that remains available and keen to invest in the sector, then we certainly have plenty to talk about today.

Thankfully, I'm alongside a panel who has a wide range of expertise. I'm pleased to be joined by Simon Hampton, Amber Whaley and Suzanne Netherway. Simon has led the PwC real estate corporate finance and advisory business for over ten years. He has lived in the sector for all of his professional career. Amber co-leads our real estate ESG team who works closely with our climate and sustainability team, but focuses on advising real estate clients around each letter of E, S and G. I'm also really pleased to have Suzanne join us who is in the real estate legal team, and she'll share some of her experience from many years in the sector. You'll see a space to submit questions on your screen, please do so and we will try to answer these later on in this presentation. Okay, so, it's time now to get into some of the key themes. Simon, I'm going to start with you. We're very busy at the minute in our real estate business and across many of sub sectors we're seeing a real bifurcation between winners and losers. Transaction volumes have been low, but there are green shoots. Can you give us your overview of the market.

Simon Hampton: Absolutely. Quite a timely time to ask that question. Two weeks ago, I was at EXPO REAL in Munich. One of the largest international real estate conferences. What's interesting is you'll get a different answer to that question depending on who actually is answering it because real estate at the moment is a real bifurcated challenge sector. So, let me talk about some of the challenges first and then some of the upsides and what we're seeing in the market today. So, the bad news is that since GFC, investing in real estate for investors was actually pretty easy. We had historic low interest rates and historic low inflation. Post pandemic, that has radically changed and we're dealing with numbers now which many of us in this industry have experienced for a very short period of time or never. So, obviously, interest rates where they are now, you won't have seen that since the GFC in 2009. Looking at inflation in double digits, including core inflection, if you're the business workplace today and you've seen double digit inflation, you're 60. So, we've got some interesting headwinds, which we haven't seen for a long time and the bad news is that real estate asset values, capital values that impact obviously, investment are massively correlated to invested rates and obviously, as interest rates have risen, we've basically seen the inverse of that bond deals falling. And unfortunately, if you own an office, as do an awful lot of people at the EXPO REAL conference, you've basically seen the inverse correlation between interest rates rising and bond yields falling and that basically has caused very material hits on asset values.

So, to give some numbers on that. Office is probably down 45%, 50%. Logistics is probably down 25 to 30%. Retail shopping centres are probably down 70% since their peak, although actually, have stabilised a reasonable amount, I think. And also, there's this additional factor which we call a dominator effect which actually impacts all investors. Same as everyone investing into their pensions, people have allocations to different asset classes. So, as that fixed income bond profile has fallen, people are finding themselves over allocated to real estate. So, the short version of what that is, evaluations have become quite strained and raising equity for real estate has become more difficult. The good news is, because it's not all bad, that the operational asset classes, which is where a lot of people have been moving their money too have performed incredibly well and that's off the back of inflation. If you have good inflation and you're doing short let business, you capture that rental uplift very quickly. So, we have seen people moving aggressively into those operational asset classes in recent years. Including things like self-storage, definitely hotels which have performed very well from an ADR perspective. Rented apartments, rented residential, student. So, those business have performed very well and have captured inflation strongly.

The issue though is that even in those hot businesses, because their prices are corrected less, if you wanted to borrow to invest in those businesses today, you actually don't have a creative leverage. So, actually, people are finding that challenging. There is definitely a sentiment change which is more positive. Obviously, on the 21st of September the Bank of England in the UK held interest rates at 5.25%. The next meeting is on the 2nd of November. If we get hold, hold, I think people start to say, 'Okay, there might have been this falling knife thesis. That knife might be on the floor now and I now at least have a base from where I can understand where my cap raid is to start investing again.' And we've actually seen that mostly recently, including at expo, a lot of the North American capital which has been out of the market for a while, certainly through the summer has been coming back to the market. So, that's good news. The current theme I think they were seeing, just to build on the, you know, 'Where are you borrowing to invest?' Is going to come back to re-financing. So, we have roughly, I think, £177 billions of commercial real estate loans in the UK. I think 20% of that comes up for re-financing in 2024. That's a big number, it's £35 billion. Now, obviously, that's across all different asset classes, but the big one at the moment that people are focusing on is clearly office and that's why it's not just about the macro, which is an issue here. You also have hybrid, you also have artificial intelligence, and you also have ESG, which we'll talk about in a minute, which is impacting people's views on offices.

But at the moment, from where I'm sitting and I'm sure you're seeing the same thing, the banks appetite to lend and re-financing those offices has diminished sustainably. And the conversation I think when you go in to look at re-financing an office with the bank is probably something like this, loan to value of course, has increased sustainably. From when that loan was 1% and basically, its value was where you thought it was. Your LTV is probably now 65%. So, clearly, the bank will want some degree of pay down. Secondly, the interest service will probably be service coverage, nowhere near where it used to be. Probably be 0.5%, 0.55%, something like that, that you're looking at re-financing probably at 6 or 7%, potentially with some interest rates swap protection. You know, there may not even be enough cash flow coming out of that asset to service the debt. So, the second question the bank will want to know is, 'How are you going to pay the interest?' And then the third, which gets to our ESG comment is very much, 'Okay, well, the requirements are coming in the UK, they're in statutory law. Even if they weren't, it probably doesn't matter. Respectable companies want to occupy a respectable space. You need to move your EPC probably from a D to a B for us to want to re-finance that loan. And the answer probably is consensually, go and sell the building because not many investors that own those buildings are going to want to conform to all of those three things.

So, that's why it's very, very complicated and if we see that level of building is being sold on the market in the UK, or around the world for that matter at the same time, it's going to have a value of office, which could fall in further.

Mark: Yes, okay. So, just picking up on that theme, I'm going to come to you, Amber because I think what Simon's getting at there is the potential for stranded assets and we always hear stranded assets and the ESG narrative together. I do also think that a lot of people get confused with where we really are at with ESG in terms of what's real, what's not real. So, it'll be really helpful for you to share your views on ESG and where it really sits today.

Amber: Yes, of course. I think confusion is probably an apt term, Mark these days. I think there's been a lot of change in the last few years and even if you look back twelve to eighteen months ago, we were still focused on this debate. Well, to what extent is there a green premium versus a brown discount? And I think the conversation-, my sense is that we've moved on from that. There seems to be more of a general acceptance that having an efficient building that runs on renewable energy will be good for value in the long-term, but admittedly there is still a bit of confusion and work to be done about how to get there because of the challenges that Simon has set out. But I think when it comes to things like stranded assets and looking in particular about when assets can't or haven't started making those, sorts of, changes, when is that magical point when it will become stranded? And I think there isn't an obvious answer to that. There's different tools out there that clients that we're working with are trying to use, things like the crem tool, it can show you when you're off track of a 1.5 degree decarbonisation pathway, for example, and that intersection is supposedly when the asset will strand. But equally, there's a lot of clients that we work with that are more concerned with things like the minimum energy efficiency standards and I know, Suzanne, you'll probably talk about the EPCs in more detail.

So, I don't think there's one perfect scientific formula for this is when that particular asset will strand. I think it will drive off more than just the environmental factors as well. I think things like tenants looking for more place making environments and more experiential and amenities to bring people back to the office. That will drive, to my perspective, as much as the environmental criteria will and there's no perfect solution. It'll vary by asset class, it will vary by location. So, again, a lot of question marks still in the market, but I think in terms of avoiding getting into that situation obviously, you don't want to be left with a stranded asset and I think fundamentally, it's just going to come down to some careful planning and really, having a more forward-looking viewpoint. It's having an honest look at what the CapEx requirements are going to be. The reality is, a lot of these retrofit solutions that we're seeing being considered, they just don't have a fast payback period on them. So, if it's not going to be something that's going to payback during your ownership period, does that mean you don't do it completely? But then will you struggle to sell the asset? Are you setting up the next owner for continuing that value story of the asset? So, it's really coming down to prioritisation and how do you balance the phasing of some of those interventions? Because in a longer-term scenario, they need to happen at some point, it's just a question of what do you when to maximise your value during your hold period.

Mark: Yes, no, that makes sense. And I guess, Suzanne, I'll come towards you. There's a whole regulatory aspect I guess, to the EPC element of it but then I'm hearing and getting equally confused as I am on the ESG front about wider regulatory things that are either here now that are coming in. So, I think it'll be helpful to share your perspective on that.

Suzanne: Sure. So, I think there's probably three pieces of legislation which have the most impact from a legal perspective in the real estate market over the last year or so. The first is the energy performance certificates and minimum energy efficiency standards, which everyone has touched on already. The second is The National Security and Investment Act and the third is the Economic Crime Act. And if we take each of those in turn in relation to EPCs and MEES, in the context of commercial assets, we know that the MEES regulations came in in April of this year and they now require the majority of commercial properties to have a minimum EPC rating of an E if they're going to be traded or let. That means if you fail to comply with those regulations, then there is the possibility of receiving a fine from a local authority. Those minimum standards are going to rise in 2027 to a minimum C rating and in 2030 to a B. And we're seeing lots of enquiries from clients, both landlords and tenants about what that means for them. Particularly in such a challenging market where there might be significant costs that need to be spent on assets and as Amber mentioned, do you actually retrofit your building? Or do you entirely re-build it and what does that look like from a legal perspective?

We're also seeing-, recently you will have noticed that the government have retracted some of the deadlines in relation to residential premises and they've pushed those back and with the upcoming election next year, it may well be that the government decides that they want to actually push some of these requirements into the long grass somewhat, but I think general consensus is that the market will still, as Amber says, require that landlords and property owners make those minimum standards or exceed them by the timings that are currently set out in the legislation. Tenants and investors and funders will have zero emissions target and they will want to have their net zero targets met and there are increasing expectations from stakeholders in any business to meet those minimum standards. But there is a sense that landowners and landlords should really be aiming high now and taking that short-term pain to create assets that meet the grade C, B or even A now into ensure that they future proof them. And looking if you take that short-term pain, you'll then hopefully avoid any potential future recession, continued high interest rates, inflation and the increasingly high costs of construction as well.

We're seeing lots of enquiries in relation to development from developers who are looking at getting development finance and what lenders are expecting from their developers in order that they don't get a stranded asset and that they're investing in something which can be traded at a later date if needed and we're also seeing lots of enquiries from tenants who have concerns that their landlords might not be able to meet the future minimum energy efficient standards and what that means for them, can they break their lease, for example and what that means for their stakeholders and will that impact on their transformation in the longer-term. And then if we look at The National Security and Investment Act. That come into force last year and for the first time the UK now has a national security investment regime. It means that under the regime, if you have certain transaction which meet specified criteria, there is a requirement for you to make mandatory notifications to the Secretary of State if it's deemed that there might be a national security risk. Now, national security isn't defined in the act but it's quite broad and it allows the Secretary of State to do all sorts of things in relation to a transaction, including putting conditions in place for that transaction or blocking it entirely and also, unwinding transactions that have already occurred.

So, what you want is to get that rubber stamp for your transaction before you actually go ahead and invest significant time and money in it, otherwise you could end up having wasted your time entirely. Now, the ability for the Secretary of State to call in and review those transactions is a real risk for individuals and for entities. There are seventeen specified areas in which if you operate in their activities, including where you might invest in land overseas, but where the activity takes place in the UK, you have that mandatory reporting requirement. And for our clients those include, areas such as, communications, defence, artificial intelligence and a whole host of other areas that you might not necessarily think would result in any risk. You want to ensure that you have made your mandatory notification in good time, so that you aren't' faced with any further delays and we now know that in the first year that the act was in place, 866 notifications were made. Three quarters of them were mandatory and a quarter of them were voluntary and of those, five transactions were actually blocked. Now, they were largely in the communication sector, and they largely centred around transactions where there was some element of influence from China or Russia, but it is a real risk.

And then if we turn to the Economic Crime Act. That adds a reporting level for any overseas entity that owns or wants to own UK real estate and whilst the aim of it is to have increased transparency, what it does is add an additional layer of reporting requirements. And we're seeing a lot of enquiries from overseas entities who may not have already registered and the deadline for that has already passed. So, enquiries from them about how they register but also in the context of ongoing transactions, ensuring that any SPV that's been setup to acquire an asset has got all the notifications submitted and is able to register the transaction without any delay at the Land Registry.

Mark: Can I just pick up on this point because this is a bit that I find quite interesting actually, just in terms of-, so, there's a lot of regulatory change that's happened or is happening and you mentioned how some of your clients or tenants are looking at how effectively they have breaks with landlords if they're not complying with whatever future regulation comes in. But how much of these regulations are actually biting today? You know, you hear some things around the EPC but even going to that Economic Crime, how much of it is real and what are the consequences?

Suzanne: So, the thing is it's probably a story of two halves in relation to EPCs and MEES. Local authorities do have the power to fine but we're not really seeing them actually using those powers as yet and that might be for political reasons. But the green party is doing particularly well, for example, and so, it might be that in future, if they come into power in a certain area that you might find there were more fines because that is part of their agenda. But in relation to the Economic Crime Act the opposite is true and we are seeing entities that have had significant fines for no compliance with the legislation, yes.

Mark: Okay, interesting, thank you. Okay. Thanks very much for that. So, we've got a situation where there is definite bifurcation. There are definite winners and losers, but there are a number of challenges that are out there, and I guess, Simon, it'll be really good just to start to think about how do we as a real estate community change some of the-, sort of, move some of these challenges into opportunities for real estate investors or across in the real estate world? I'm guessing you're probably going to start with offices as that's the obvious place to go.

Simon: Well, also because it's one of the largest asset classes in the world in terms of money invested in it and there is definitely a risk on investment thesis around repurposing office. You know, so called brown to green and that makes sense to me. There is a future of office, and a lot of people are talking about it and to come back to Suzanne's point, that 2030 deadline, that's six years away, just over. That's one lease term. So, this is a real thing that needs to occur now, and I think the two questions in investors' minds really surround, 'Is now the right time for me to moving back into that asset class?' And that completely comes down to, 'When do I feel the value have fallen? And such that the assets I'm buying aren't going to fall further.' And then it is definitely a repurposing opportunity into something different. Now, it could by the way, be a super upscale office. It could be flex space, it could be a hotel, it could be residential, it could be student accommodation. There's lots of things that people are looking at to convert this real estate into. Now, of course, once you've got the view in your mind that the price is right, you then need the planners to be on board and of course, what a lot of people want to do, particularly in relatively old historic cities like London is demolish the asset, start again.

Now, we're probably all familiar with the story that's been going on in Oxford Street here in this town. Your body carbon is created of course, when you demolish an asset and that does make it more difficult for investors because a lot of our floor plates in these historic cities are awkward. They've got pillars in the wrong place, the floor plates are oddly configured, the lift cores are small. So, you do need to be quite creative, I think about how you're going to do it. Get planning permission, you'll then need to get development finance to do but there's definitely a view that there will be a right moment, there is a future office, and we need to upscale them, even if not for the regulatory, statutory rule, but because that's what people want to occupy.

Mark: And I guess, on that, Suzanne, what's your view on, sort of, the regulatory hurdles that you're going to have to get over for this?

Suzanne: Okay, so I think, following on from what Simon has said, in relation to office, particularly office to resi conversions, we're seeing a lot of enquiries in relation to that, and then from a legal perspective, I think you need to consider both your commercial aspirations versus actually the reality of the asset from a legal perspective. And looking at things such as, and what the historic planning use has been and the appetite for a local authority to actually have those conversions, although it is easier to do it now that there have amendments to the planning legislation. But looking at things like title restrictions and access rights, and if you're looking at bigger spaces, there are tree preservation orders that would prevent you from doing development over large swathes of your property, potentially, and things like restrictive covenants which can still bite on freehold land. But one thing that clients often forget is that if they're looking at a property in a built-up area, consider the neighbouring land owners because often there are rights-to-light issues. And if you're doing any, sort of, development that sits within an envelope, you might be fine, but anything that might in any way go outside the existing envelope may well result in you needing to deal with rights-to-light settlements, and they can be incredibly costly and very time-consuming, and really adversely affect whether actually a conversion is financially viable. And if you're looking at EPCs, you want to future-proof that asset by getting a B or an A grade now so that you've created a best-in-class asset to ensure that you don't have that stranded asset and your tenants do want to occupy it in the longer term. And you want to create a piece of land that will withstand any of the lender requirements, green finance coming through at some point in the future, and there will be increasingly challenging requirements from tenants who will have very challenging green aspirations for their own firm and so you want to make sure you're meeting that head-on.

From a National Security and Investment Act perspective, you want to make sure that you've made that notification. If you have one and you suspect you need to get a notification in, you want to do that as soon as possible because whilst the government says it's going to take 30 days to review any transaction, if they decide that they want to ask additional information, that pushes back that timetable so much more. And the last thing you want is to invest significant time and money in the transaction only to find out that it's got conditions attached to it that mean it's no longer financially or commercially viable, or ultimately has been decided that they can't even proceed at all in the first place. And for the Economic Crime Act, again, it's just a question of timings and making sure you've got your verification agent on notice as soon as possible, and if you're setting up SPVs, getting all the information you need now so that you aren't delayed and don't end up having a transaction which hasn't been notified and then you've got delays with registration at the Land Registry, which can just impact on other things you might be wanting to do with a property further down the line.

Mark: Okay. A lot to take on board.

Suzanne: Yes, definitely.

Mark: And a lot to be aware of and to be proactive around. I'm guessing, again, Amber, back on the ESG front, you know, you can't do any of this without a big ESG ribbon wrapped around it all. What do you think?

Amber: The gift that keeps on giving, there, Mark. Just to pick up on the green finance point, actually, I think it's an interesting trend. Now, we're certainly seeing a lot more of those products on the market, but there's still a good bit of variation in the spreads being offered. And I guess one thing just to be mindful of, it's certainly something that's worth exploring with a lender, but most of those products will require some sort of verification or assurance of the KPIs that are driving that ratchet mechanism, and it's just worth making sure that you're prepared for that additional reporting that will likely come along with it. And more broadly, I guess, there's certainly a shift of capital from brown to green, as to coin Simon's turn of phrase. You know, there are definitely more attractive assets and buildings out there if you can tell that, not just the environmental story, but the social and the governance story, of the building, of the portfolio, and that ability to articulate that will really help you maintain that attractiveness to capital in the longer term. And it's interesting because it matches some of the trends we're seeing in the reporting world. There's been a sea of new sustainability reporting requirements coming down the pipeline, all trying to get at that transparency point and really driving communication of each of those areas, and one of the most common, I would say, questions I get from clients is, 'Well, what if I commit to preparing for this one piece of reporting legislation?' And then it changes or it gets repealed or it gets morphed into something new, and to be honest, I don't think there's going to be a way to avoid that in the short term. There are so many new bits of reporting rules coming down the pipeline at the moment. I suspect we're still a number of years off before we've got a stable, just normal reporting cycle where you just tick through your sustainability reporting the same way you do your financial reporting. I do think we'll get there, but I don't think we're there yet.

So, in the meantime, it's really about doing a scan, what pieces of reporting are likely to impact you, and then look for the commonalities across them, because even though there's nuance in the individual disclosure requirements, they're all more or less aiming at the same issues or the same topics, so it's really just doing a bit of a read-across. If you look at something like climate change in particular, there's been a lot of emphasis on it in the last few years. Most of the big reporting frameworks require some sort of disclosure around climate change, and fundamentally, it comes down to how are you, as a business, managing the risks and opportunities of climate change within your business, within your portfolio. So, in terms of a 'no regrets' approach to that, sort of, disclosure, do you have a policy on that? You know, have you embedded climate change into your risk management practices? And just doing that even if you haven't gone through the whole data collection exercise and you don't have a roadmap day one, at least starting to think about how would you get there, and that will make those reporting requirements easier down the road. Another common area where we hear just the ultimate challenge of collecting the data is around the decarbonisation, and that ties into some of the EPC rules. But ultimately, it's, again, a case of even if you don't have all the data today, what can you still be doing that will benefit the asset in the longer term while you collect the data? So, I think there's a lot to be said for some of the modelling and estimates and assumptions that you can use to get an 80-20 view of the world, because fundamentally, that will give you enough to put some flesh around a short, medium, long-term plan. Where are you going to need CapEx spend? Where is it going to be? Potential hotspots in the portfolio that maybe will take more effort or focus and you need to spend a bit more time on.

I think decarb is probably one of the areas where you just fundamentally can't get away from needing some data at some point, and I think it's just acknowledging that it won't be a quick fix, you know. We're all, I assume, familiar with the challenges around real estate in particular and getting transparency over the tenanted versus landlord space and the energy consumption in those areas. So, I don't think it's going to be an overnight fix by any means, but the sooner you start and the sooner you start identifying where you've got gaps, then you can start taking steps to fix them, and still having that longer-term view so you can make some more strategic decisions.

Mark: Perfect. I'm going to pause you there because I can see we're getting quite a few questions coming through from the audience, and I'm going to come onto those in a minute and I want to make sure we've got time to cover a few of them. Just before we go there, it'd be really interesting just from each of you very quickly to just give what are your, sort of, key practical steps that the audience should be thinking about in terms of commercial real estate today, I guess from a commercial and ESG and a legal perspective. Maybe start with you, Simon.

Simon: I think it comes back to customers. We said this before, when we were going through the retail shopping centre situation, where the vernacular changed from 'tenant' to 'customer', and I think that has definitely continued. If you're looking to do one of the things that we've talked about, say, for example, you do want to do a refurbishment or a change, work with your customer early to understand what it is that they want, particularly if it's office. You know, all of your customers are working really hard to bring people back into the building five days a week. They'll have very specific thoughts about, therefore, what they're looking for in terms of a footprint, in terms of amenity, so I would say do engage heavily around that area. And we talked a little bit about the operational real estate areas. Lots of areas in real estate now are actually going direct-to-consumer, business-to-consumer. You're talking about individuals, in self storage, in student accommodation in rented residential. You know, at the end of the day, the concept of a branded operating platform has become very thematic over recent years. It's that interface which gives you, as the capital, the interface with your customer, and I think the market is realising there is real value in either building that, or buying it and having that in-house so that you're actually able to get your direct communication with your customer.

Mark: That makes a lot of sense. Amber.

Amber: I think it might sound like a pretty basic one, but I think take stock of where you're at today both in terms of what's in your portfolio, what regulatory regimes are you going to fall under, and really what data do you already have, because in a lot of cases, asset managers, property managers, have a good bit of data. They just don't know it because they haven't had to collect it in that way.

Mark: Perfect, makes sense.

Suzanne: From my perspective, I think it's probably having a look at your assets, and if you want to future-proof them, making sure that you are putting in chain any of the legal steps that need to be taken at as early a stage as possible to ensure that you've got everything in place that you need before you invest significant time, energy or money in whatever project, and before you realise actually it's no longer viable.

Mark: Perfect, makes a lot of sense. Some good tips there. Right, I'm going to come to the questions. Thanks to the audience, and please do keep the questions coming in. Simon, I think this first one's going to come to you. So, what are your predictions for the future of UK house builders?

Simon: Well, okay. Housing, probably the hottest topic in the UK, and a political football, and there are always the arguments asked around, you know, are house builders land-banking, is it in fact the planning policy? The reality is that we have a chronic undersupply of housing in the UK, and there is a community of people who build their housing and they're called house builders, and they are having, you know, also probably all of the headwinds thrown at them that we've just talked about in commercial. You know, that debt cost is somebody's mortgage. The deposit that they need to find is someone's free cash from their lifestyle, and, you know, therefore-, and, of course, Helped to Buy has been removed. So, the house builders are, kind of, on their own at the moment and they're also trying to build housing at a period of time where the development costs are still very high. Like, I think it's strong optimists for house building in the UK and that's why we're seeing massive demand for rental. If people aren't buying housing, then they need to find somewhere to rent it because everybody needs a roof over their head, and there are lots of talk going on and there are lots of government agencies working on how we bring through housing, and I'm sure there will be some form of solution to the whole system and lots of people looking at it. But fundamentally, as we sit here today, what hasn't happened is land prices in the UK haven't really corrected and it starts at the top of the funnel and it breaks back to, ultimately, a land price. So, I do think at the moment we're on this, kind of, see-saw of a correction in land prices, and I think if land prices fall a little bit, I think house building becomes a lot more easy.

Mark: Okay, thank you. Amber, I think I'm going to come to you on this one. So, we hear, and I guess we have talked quite a bit today, around the 'E' in 'ESG', but how are we seeing real estate businesses focus on the social and the governance aspect of it?

Amber: So, this is a common question I would say that we get quite a lot because the knee-jerk reaction is, 'Bricks and mortar. It's all about the "E",' but I think it really comes down to what the asset class is in terms of how the 'S' and the 'G' will manifest themselves. I mean, we touched on some of the reporting requirements that quite often fit under the 'G' bucket, but on the social aspect, I would say it really depends on who the stakeholders and who the users of the building are. We've done work with student accommodation portfolios in the past, and if you think about it, it's a group of students, a lot of whom might be living away from home for the first time. So, what are you doing to make sure that they have proper safeguards and support structures on-site to support them in that stage of their life? Even things looking like office amenities that we mentioned in terms of place-making and attracting people back to the office, but from a well-being standpoint. So, having things like shower facilities, bike racks for people commuting in a greener way, or having well-being centres for, I don't know, yoga classes or massage therapy or those sorts of things, on-site, just to make the experience of being in the building a bit more beneficial to people's well-being. I think, quite often, people default into, 'Well, if it's a social aspect of real estate, it must be social housing,' but there's a much broader spectrum I think depending on the asset class that can come to life. Yes.

Mark: Yes, I have to admit I'm hearing that a lot as well from my clients and I'm not surprised you're saying that, and it is interesting how we're shifting more towards that way as well, away from the 'E' and into the other parts of it.

Amber: I think the only other thing that I would add on the governance piece, I think it follows that shift of looking at real estate as a service rather than real estate as just an object, and I think being more involved and more aware of what's actually happening on the ground in these buildings is a way of demonstrating that you have good governance around the properties.

Mark: It's a great point. Simon, I'm going to come back to you on this one. How are international investors playing a role in UK real estate? I guess that's an interesting one because they've been quiet for a while.

Simon: It is. So, the UK always has been, always will be, one of the favourite destinations for international money to invest into, notwithstanding that we're a small island. There's a lot of people in it, there's a lot of buildings in which those people sit. We also have a very solid rule of law that international investors like. And at any given point in time, you'll always have an enormous, kind of, volume of UK domestic investors, and there's a type of thing that they buy. Typically, it'll be on-shore and they're usually like pension funds or core funds. Coming out of Asia, very quiet during pandemic for obvious reasons because people like to come onto the ground in the UK, and if you're not based here, it was difficult to get into the country. But those flows out of the Far East came back quite quickly. We've certainly seen a number of deals that I've worked on recently out of Australia, Malaysia, Japan. So, that international capital has come back and has actually remained back. The difference there is that, often, that community are office buyers, so they may be a little bit more muted. Although they've been here looking, they'll be a little more muted in terms of what they've been buying, with the exception of student housing, a lot of Far East investors are very attracted to student housing. The North American investors have been quite out of the market I would say since pre-summer, and, you know, I think they called the issue relatively early. They see it first in the US, and typically, these things tend to start West and then they'll move East as the cycle unfolds. What's interesting, though, is that type of North American money, particularly the opportunistic end, that tends to come back first. They were very evident in Munich a couple of weeks ago in expo, having been absent for a while. And the one thing we know from the recovery from the GFC, yes, actually, things tend to recover more quickly than we think, with the benefit of hindsight, and the people who moved first and did some of the bold things that we're talking about, GFC told them they made a lot of money by doing it. So, we're starting to see quite a lot more international demand come back. It's quite risk-on. Some of that, of course, will be because we might have had the floor in interest rates, which is great, and long may that continue.

Mark: Yes. And I guess, your point earlier around operational assets are still highly attractive, and with inflation where it is, it should be coming back.

Simon: Yes. Look, I mean, we're seeing in things like rented single family housing, or BTR, which is apartments-, we've seen 12%, 15% rental growth. That's phenomenal, right. Now, the question of course on everyone's minds is, 'Okay, but if that's compounding,' to the consumer, ultimately, because of the BTR market, 'Can you underwrite that level of growth infinitum?' But nonetheless, the performance has been stellar, people have been investing heavily in those sectors, and as I said, also investing in the operating brands that are associated with them.

Mark: That makes sense, thank you. I think we've got time for one, final question. This might be a combination of Suzanne and Amber, and maybe come to you, Suzanne, first. In terms of the difference between green and brown borrowing, what are we seeing in documentation now, in legal documentation? Are the covenants tight on, you know, what you've got to hit? And then I guess probably for you, Amber, is there a difference in price? You know, where do we expect that pricing going?

Suzanne: So, from my perspective, I think things are still at a relatively early stage and people are still testing the market. We aren't seeing massive differences in the requirements for lending for green and brown, but I think that's coming soon. But I think, lenders, at the moment, there's a gap between what people are willing to spend and what lenders are wanting to offer and we're trying to find that middle ground. And at the moment, I don't think we're quite there yet as to where we're going to land with regards to the documentation, it's still relatively early days at the moment.

Amber: I think, horrible answer, but I think it really depends. It depends on the lender, it depends on the underlying asset. I mean, the last data that I saw, I think it was a spread anywhere from two basis points to twenty in terms of the differential that we're talking about, and within that, there's not a core set of KPIs that the lenders are hanging them off, right. So, in a lot of cases, deals that I'm hearing about, it's still being negotiated after the deal is already signed, in terms of what the actual metrics that that loan will hinge based off. So, in terms of trying to predict where we might fall and what the pricing's going to be, I'm not sure my crystal ball is quite that clear yet. I could see it narrowing over time, again, as that basic requirement of assets just being of a greener standard to begin with. I could see there being less benefit, I guess, from a green loan product as things just-, the gap narrows in terms of asset quality over time. But what that timeline will look like or how big the spread will remain, I'm not sure I could give you an accurate estimate.

Mark: Yes. I guess the reality is the availability of loans as well. You know, there's going to be much more cash available for green loans than there is for brown loans and so that's going to come into the play as well.

Amber: I think accessibility will be a far bigger drive than price differential, personally.

Mark: Yes, okay. Okay, super. I'm going to draw this to a close now, so thank you very much for your answers there. Today has been a great insight into what's a complicated picture across commercial real estate. As trailed at the start, there's bifurcation across many sub-sectors, and there are certainly opportunities out there, however it's clear that the economic headwinds, particularly interest rates, alongside the tenant ESG demands, will have an influence on the sector, going forward. We're going to follow up individually with any questions that we didn't have time to answer. And I just want to say one, final thank you to Simon, Amber and Suzanne for your insight today.

Suzanne: Thanks, Mark.

Amber: Thanks.

Simon: Pleasure.