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How big a threat is the ‘brown discount’?

Kim Politzer

Kim Politzer - Director of Research, European Real Estate

Reducing emissions in line with the Paris Agreement will require most existing buildings to be retrofitted to make them greener. While the cost of doing so will affect returns, analysis by Fidelity International shows that the cost of delay is likely to be far greater. Investors, therefore, may wish to consider how much return they are prepared to forego in the short term to protect long-term asset values.

Around 97 per cent of today’s commercial buildings will not support the transition to net zero in their current form. If left as they are, they will become increasingly difficult to let or sell. This has prompted talk of a ‘brown discount’ in the European real estate market but, so far, there have been few attempts to quantify how big that discount might be. Our analysis, based on recent trends and reasonable assumptions about how the market will evolve after Covid-19, suggests brown discounts will be large enough to make upgrading buildings a prudent investment.

Investors are waking up to this idea. They have moved beyond simply wanting to see a portfolio’s Global ESG Benchmark for Real Assets (GRESB) score and now expect sustainability to be at the heart of building design, backed up by data disclosure that demonstrates its impact. Occupiers, too, are demanding more, while valuers are also increasingly taking environmental, social and governance (ESG) factors into account.

How occupiers, investors, and valuers will drive the brown discount

We identify three channels through which an increasing focus on ESG will lead to a brown discount. The first is occupier demand as industry standards become established. Market expectations are increasingly for buildings to be delivered with the equivalent of a Building Research Establishment Environmental Assessment Method (BREEAM) score of at least Very Good, or a Leadership in Energy and Environmental Design (LEED) Silver rating.

But occupiers’ focus goes beyond energy, water, and waste usage. Covid-19 has thrown a spotlight on the ‘S’ of ESG and boosted demand for health-related attributes, including good air quality and ventilation, touch-free access, health amenities like gyms and open spaces, and end-of-commute facilities such as bicycle parking and showers. Potential occupiers look for certifications from bodies such as the International WELL Building Institute, which certifies spaces that advance human health and wellbeing, and WiredScore, which assesses digital connectivity. A recent survey of occupiers by Pembroke, a real estate manager, found that many expect to see increasing demand for such attributes following the pandemic; buildings that lack them could face weak demand, lower rental growth, and falling rents.

The second channel is investor demand. As more real estate funds become classified under Article 8 or Article 9 of the EU’s Sustainable Finance Disclosure Regulation (SFDR), a building’s quality and how it is used will grow in importance. The simple approach will be to buy buildings that are already badged, creating a bigger green premium/brown discount.

The third channel is the valuation process. The major valuers are now recruiting ESG experts and, we expect, will soon start to factor in the capital expenditure of upgrading a building to meet higher environmental standards, or to cover the cost of carbon offsetting if an asset becomes ‘stranded’.

Quantifying the brown discount

By making a few simplifying assumptions, we can get an idea of how large the brown discount could be. Consider two properties, one ‘green’ and one ‘brown’, that start out with the same rent and value. Prime office rental growth has averaged 3 per cent in Western Europe over the last 10 years. We expect, however, that this will be significantly lower in the next five years given the disruption to office-based work and the likely move to hybrid working. For the purposes of illustration, we make the following assumptions for green and brown scenarios:

Assumptions Green     Brown
Rental growth

2.0% pa

0% pa
Initial yield 5% 5%
Exit yield 5% 5.5%
Void period (time to re-lease)

9 months

18 months

1.3% pa

1.3% pa

10-year IRR



Source: Fidelity International, 2021. For illustrative purposes only.

We assume rental growth for brown buildings will be zero at best, given occupiers’ increasing focus on ESG and the strong likelihood there will be an oversupply of brown buildings relative to weakening occupier demand. Similarly, we assume a higher exit yield for brown buildings because we expect investors, who are also putting more weight on ESG factors, will demand a discount.

Assuming the same rent and asset value at the start of the period, and that new occupiers will need to be found in year 5 of the tenancy when the current lease expires, these hypothetical assets produce an internal rate of return of 5.7 per cent in the green scenario over 10 years. This compares to just 3.5 per cent in the brown scenario. 

By year 10, the difference in exit values is 21.6 per cent. We regard this as being towards the lower end of how large brown discounts could get. Rents could realistically fall for brown buildings, so 50 basis points could turn out to be a conservative estimate of the impact on yield. For lower yields, a given basis point differential would have an even bigger effect.

There are, of course, capital expenditure costs involved in greening a building, but there are savings too. As well as the cost of carbon offsetting, brown buildings will face higher operating, insurance, and maintenance costs in the years ahead. Analysis by ESG consultancy Evora suggests that, in contrast, average savings from introducing energy efficiency measures should pay back the investment within ten years.

Greening in action

More importantly, investing in a retrofit can secure a building’s long-term value. While only anecdotal and not guaranteed, letting agents’ advice is that planned improvements to one of Fidelity International’s Paris buildings to target BREEAM Excellent, WELL and WiredScore labels, is likely to lead to a 15 to 20 per cent increase in rent on the asset. Attracting occupiers who are happy to sign a green lease, which includes clauses to promote the sustainable use of a property, can help improve a building’s overall ESG profile. And sustainable buildings can also attract businesses. In one of our offices in the south east of the UK, an environmental consultancy is leasing office space because it aligns with the company’s ESG goals.

A tipping point is coming

Capital is already starting to flow towards sustainable buildings. The prospect of tighter regulation will push the market to a tipping point at which valuations could shift markedly. The UK government, for example, is consulting on changes to the Minimum Energy Efficiency Standards, which from 2030 would mean buildings could only be leased if they reach a B standard (a big step up from the current E), with the proviso that the investment required meets a seven-year payback test.

Today’s liquidity conditions mean valuations do not yet reflect the stark difference between buildings that are ready to support the low-carbon transition and those that are not. That won’t last forever, and owners who delay investment in retrofitting could come to regret it.

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