Global outlook: How ESG factors are impacting real estate decision-making in the UK, US and Europe

UK

Property investors and owners are increasingly re-evaluating everything from investments to estate management policies to focus on their ESG aspirations and obligations. As a result of the continued focus on ESG considerations, it is likely that property owners and occupiers will increasingly find themselves in situations where they need to grapple with the enforcement of estate management policies focussed on ESG matters. One area where our Real Estate Disputes team thinks we may see an increase in interest in ESG considerations by property owners and occupiers relates to consents, such as consent for occupiers to assign. 

The re-evaluation of estate management policies through an ESG lens has the potential to have a significant impact on day-to-day lease negotiations and disputes relating to common lease clauses such as alienation provisions.  For example, some property owners will be looking to introduce polices which allow them to refuse to let to those with less than stellar green credentials, as well as requiring a greener approach to tenant mix.

Alienation: can property owners refuse consent on the basis of ESG policies?

Leases will generally require occupiers to obtain the owner’s consent to assign or underlet, such consent not to be unreasonably refused. 

It is already established that a property owner can reasonably refuse its consent to an assignment or underletting in order to keep a good occupier mix:

• In a recent case the property owner was considered reasonable in refusing consent to the assignment of a lease of a property on Regent Street from a jeweller to a bureau de change. The court found  that limiting occupiers to flagship retail stores was a legitimate estate management objective, even if the occupier may not have been aware of that policy.
• In another case the property owner refused its consent to an assignment of a lease from a fashion retailer to a computer games retailer, again on the basis of its occupier mix policy, which sought to keep fashion retailers together to create a fashion hub. While the policy was unwritten, the court found that it was genuine and reasonable and justified the owner’s refusal. 

There is nothing in these cases to suggest that a valid and enforceable occupier mix policy cannot extend to ethical/sustainable benchmarks, provided it is clearly defined and consistently enforced by the owner and does not reduce the class of acceptable occupiers to a level which severely restricts the prospect of assignment.

Key factors to consider in imposing ESG property policies

All of that said, when imposing ESG policies, property owners will need to take time to consider how they interact with other provisions in the lease to mitigate against unintended consequences.

For example, if a property owner specifies a very limited permitted use for the property within the lease, or limits who an occupier can sublet or assign the lease to, the potential market for that lease will be reduced. This may have a negative impact on the market rent determined at rent review, leading to lower yields.   Similarly, an estate management policy which is too rigid and arbitrarily rules out any future change of use could amount to a derogation from grant, effectively undermining the occupier’s ability to use the property. 

US

ESG in the U.S. real estate market - a shift in focus

ESG is currently impacting the U.S. real estate industry through looming reporting requirements and changes to investment criteria.

In the U.S., the U.S. Securities and Exchange Commission (“SEC”) has recently adopted rules requiring climate-related disclosures for companies that are subject to the SEC's disclosure regime. The final rules, which are described further here, are less burdensome than those proposed by the SEC in 2022, but will still require a substantially increased level of legal and accounting disclosures regarding a reporting company’s emissions, and its climate-related goals, risks and governance.

Among other actions, the SEC has already made changes to the “Names Rule” to require that 80% of a registered investment company’s portfolio corresponds to any asset-characteristics suggested by its name, including with respect to funds with ESG-related names, in order to crack down on deceptive and misleading practices by U.S. registered investment funds.

ESG is also affecting investment criteria for U.S. real estate. According to the World Green Building Council, buildings are responsible for approximately 39% of global energy related carbon emissions.  For real estate companies and funds seeking to acquire or divest assets from their portfolio, ESG provides non-financial factors for consideration during the decision-making process. This may be driven by a real estate company’s or fund’s own ESG metrics and market competitiveness, or by the desires of its investors.

External pressures are not the only reason for the U.S. real estate market’s shift in focus, however.  Green property management also happens to be a basic value driver that keeps overhead costs down and helps maximize ROI.  The greater a building’s carbon footprint, the higher the cost incurred by landowners and tenants, including utility and operational costs, penalties imposed by regulatory frameworks in some U.S. cities such as New York City’s Local Law 97, and insurance premiums to manage risks associated with climate change (ie, hurricanes, floods, wildfires and other natural disasters).  It has also been shown that tenant retention rates are higher in green buildings, and lenders are often more willing to provide debt to “green-minded” investors.  

Overall, there is significant pressure on the U.S. real estate market to concentrate on advancing ESG initiatives. As ESG-related disclosure requirements, investment criteria, operating costs and carbon-reduction regulatory frameworks continue to be rolled out, it is increasingly important to monitor these areas and keep our clients informed of the latest developments in ESG that have particular significance to their business.

Germany

ESG and tenant mix- what trends are we seeing?

Many EU-wide environmental regulations have now been transposed into German law. The number of regulations that at least indirectly influence the sustainability requirements for real estate continues to grow. At a European level, these include the Taxonomy Regulation, which provides a framework for the general categorisation of an economic activity as 'sustainable', and the guidelines of the Fit for 55 package, some of which have yet to be implemented. 

At the national level in Germany, the recently passed Building Energy Act, which regulates, among other things, the energy efficiency standards of buildings and the installation of heating systems, has a particular impact on the property sector. In addition, various housing subsidy programmes and regulations to reduce bureaucracy in the construction industry are currently being discussed.

The content of such regulations usually obliges property owners to take measures to reduce the property's CO2 emissions. Tenants are not directly obliged, although they make a significant contribution to CO2 emissions in the operation of buildings. As a result, sustainability clauses (green leases) requiring tenants to comply with relevant regulations and ESG requirements are becoming more common and the new Green Lease 2.0 has just been launched.  However, there is no legal obligation to use green leases, meaning that currently only around 30 or 40 percent of leases are concluded on a green lease basis.  

The EU-wide reporting requirements for large and medium-sized companies under the CSRD Directive, implemented in Germany through an amendment to the German Commercial Code, which require companies to report on their ESG-related efforts and strategies, have also led companies to demand that landlords take steps to improve the sustainability of their buildings and operations. While the private sector is not prohibited from renting buildings that do not meet ESG standards, they risk high vacancy rates if they do so.

In addition, carbon pricing, and therefore the carbon footprint of the building, has an impact on the profitability of leases and properties. The worse the building's carbon footprint, the greater the cost of carbon pricing to the landlord. Only if less than 12 kg of CO2 is emitted per year can the CO2 costs be passed on to the tenant.

The revision of the German Building Code and the associated Building Utilisation Ordinance, which is currently in the legislative process, aims to anchor the objective of taking greater account of climate protection and climate adaptation in building planning law. The aim of the amendment is to make better use of land that has already been sealed by simplifying the approval procedures for the extension and enlargement of existing buildings. The introduction of a green space factor is intended to increase the greening of cities and to add ecological factors to building law. Tenants will be legally obliged to accept such measures.

Residential areas in the so-called core area are to be given a stronger position and a number of measures are planned to make more space available for social housing. In addition, buildings approved and built as commercial premises are to be allowed to be converted into flats more easily when they become vacant. However, these two changes may lead to tensions, particularly with regard to noise and other emissions from commercial properties, and thus to disputes between tenants and landlords.

Conclusion

Overall, the global picture confirms an increased focus on advancing ESG objectives.  This trend is driven both by regulatory frameworks and by property owners, occupiers, lenders and investors themselves increasingly reviewing their policies and advancing their ESG initiatives.  Watch this space as this trajectory looks set to continue, as ESG factors play an increasingly important role in real estate decision-making. With so many powerful forces in play, there’s no escaping that ESG issues will continue to grow in importance for owners, occupiers, corporate boards, investors and governments. Alongside that growth will come opportunities and challenges, which we would be delighted to help you to navigate.

Authored by Trevor T. Adler, Richard G. Madris, Sabine Reimann, Benjamin Willis, Stella Bliss, and Ingrid Stables.