(Bloomberg) -- The bill to upgrade Europe’s aging cities for a zero-carbon future keeps on rising, and it’s becoming an increasingly risky bet as property valuations plunge.
The urgency is growing as demand for space gets ever more concentrated on buildings with top green credentials. That’s leaving older, less efficient, buildings at risk of an unstoppable downward drift into stranded assets.
As much as 80% of Europe’s office market is more than 10 years old, according to data from broker Jones Lang LaSalle Inc., meaning it’s outdated and in need of improvement to keep pace with emissions targets. The cost of works in London and Paris alone could top $77 billion.
Meanwhile, the annual capital expenditure needed to meet those goals is set to increase by almost 30%, real estate investment manager AEW estimated in a report published Monday.
This additional financial burden has been exacerbated by a 9% fall in values in the past year, impacting the return on capital employed, the AEW data show.
The two reports highlight the scale of the challenge facing developers, lenders and landlords. While more money is needed, the difficult equation is whether that commitment still makes economic sense.
“There is a huge amount of demand that cannot be accommodated in the current office environment,” said Phil Ryan, JLL’s director of global research for city futures. “But we don’t have the market conditions to fuel construction or upgrade older buildings.”
Canary Wharf
The twin impact of rising modernisation costs and the focus toward only the best and greenest properties is already clear to see at some sites, such as 5 Churchill Place, the former Bear Stearns offices in London’s Canary Wharf.
The vast building was bought for £270 million in 2017, but when it was offered for sale by administrators it drew bids of just £110 million.
The huge drop reflected higher interest rates, questions over future office demand in the area and in particular the bill to upgrade the property to modern standards relative to the likely value of the completed project, people familiar with the process said.
Also driving up costs is the fact that Europe is behind on the energy intensity targets envisioned by the Paris Agreement, AEW said. In addition, new data allows measurement of the carbon cost of installing energy-saving technologies like heat pumps, which means even greater operational improvements will be needed.
Still, AEW is forecasting annual returns of 8.8% across all prime European commercial real estate through 2028 as the market bottoms and interest rate cuts and rising rents create the conditions for growth.
That means there is room to absorb the higher costs, according to AEW Europe head of research and strategy, Hans Vrensen.
“Even if investors need to catch up and meet more challenging decarbonization capex targets going forward, they remain achievable,” he said.
Many developers paused or halted new starts because of higher rates and economic uncertainty.
That’s creating a supply squeeze, particularly for well-connected and green buildings that can help occupiers meet carbon reduction targets and lure workers back to the office with shorter commutes and better amenities.
In the prestigious Mayfair and St. James’s districts, for example, only about 3% of space is empty, well below their long-term averages. By contrast, the figures are 15.7% and 19.9% in Canary Wharf and Hammersmith.
That’s driving up rents for a small sliver of top-tier properties, even as wider gloom lingers over Europe’s office markets. Rents for the best buildings in the City of London climbed 10% in the year through June, according to JLL.
©2024 Bloomberg L.P.
