How much investment might be needed to upgrade Central London’s energy inefficient office stock?
January 10, 2024 7 Minute Read
There is a growing demand and supply imbalance in the Central London office market, with demand largely directed at a limited pool of high-quality office space. This partly reflects the importance of energy efficiency and sustainability credentials to occupiers, investors, and lenders. Improving the energy efficiency of Central London’s secondhand stock would be one step towards addressing the supply and demand imbalance.
What’s the scale of the challenge?
We estimate around 15.9 million sq ft of Central London office space will be released back onto the market by the end of 2027 due to upcoming large lease expiry events. There is data available to adequately assess the EPC rating for about 80% of this stock – c. 12.6 million sq ft. Of this, only 6% is classified as energy efficient with an EPC of A or B. 94% – or 11.9 million sq ft – of the stock has an EPC lower than C, so is categorised as energy inefficient based on Sustainable Finance Disclosure Regulation definitions.
How much would it cost to upgrade this stock?
If not upgraded, the 11.9 million sq ft of energy inefficient secondhand stock will be unattractive to an increasing share of occupiers and investors and could potentially become obsolete.
Using proprietary CBRE retrofit cost data, we estimate the cost of upgrading this 11.9 million sq ft of space to EPC A or B would be in the region of £370 million. This is purely the cost of energy efficiency upgrades and does not include other unrelated building improvements. The cost equates to about 9% of this stock’s capital value, based on median capital value data from MSCI.
While £370 million is a significant sum, this is an investment to enhance income and asset value.
Does upgrading make financial sense?
While this will vary from asset to asset, we can use investment performance trends identified for Office property by CBRE’s Sustainability Index to compare the relative value trajectory of stock with and without the efficiency upgrade.
Figure 1 shows there would be a sharp fall in capital value for the inefficient stock if left unchanged; this is in line with the historic falls in capital value of inefficient stock from our Index. In contrast, while the upgraded stock starts at a lower value due to the upfront £370 million CapEx costs, its capital value is more resilient. The analysis shows that the CapEx costs could be offset within three years.
Figure 1: Combined capital value and income of 11.9 million sq ft of inefficient office space under different upgrade scenarios
Source: CBRE Research
The main reason for this unexpectedly short ‘payback period’ is the rapid depreciation of value for inefficient assets. While building upgrades may not offer immediate returns in terms of operational savings, the renewed occupier and investor interest is likely to result in a stronger investment performance that quickly outweighs upgrade costs. However, we do acknowledge there will be cases where upgrade costs are unlikely to be recouped and repurposing to other uses may be preferable.
Choosing the right time to carry out upgrade work helps to accelerate the benefits of the investing in refurbishment. Waiting until a building is vacant can reduce costs and allow for a lease re-gear as soon as the building returns to market, potentially generating higher income immediately. Owners of inefficient offices should assess their strategy for efficiency upgrades in time for the next lease expiry.
Our analysis applies assumptions to two distinct scenarios. These are:
Upgrade scenario – All 11.9 million sq ft of inefficient space is upgraded to EPC B during year one. The upgrade costs of £370 million are removed from the stock’s value. The stock receives no income in year 1 but thereafter receives the historic level of income return reported for efficient offices by the Sustainability Index. In all years the upgraded stock experiences the capital growth reported for efficient offices between Q1 2021 and Q2 2023.
No upgrade scenario – None of the 11.9 million sq ft of inefficient space is upgraded to EPC B or better between year one and five. In all years the stock receives the historic level of income return and capital growth reported for inefficient offices by the sustainability index between Q1 2021 and Q2 2023.
Neither scenario applies a discount rate, accounting for the future value of money. Assuming a higher discount rate would extend the ‘payback period.’ Neither scenario assumes the use of debt and associated interest payments. Funding upgrade work with debt may extend the payback period.
These scenarios are theoretical and serve to illustrate potential CapEx payback times, we do not expect either of these scenarios to occur.