‘To EPC B or not a B’ – That is the Question
08 June 2023
In my last two articles, I have started with a song title but this month, we have sought to up the ante and begin with (an approximation) of a very famous quote. So, to start this month, I would like to open with ‘To EPC B or not a B, that is the question.’
Last month, we briefly touched upon the role that Energy Performance Certificates (“EPC”) are having on the real estate market, but this month we are going to look at the impacts of the legislation and what we think this means for property value and property obsolescence.
The Government’s Minimum Energy Efficiency Standards (“MEES”) Regulations came into effect on 1 April 2018. This legislation outlawed the renewal of existing tenancies or the grant of new tenancies within buildings that have an EPC rating of less than ‘E’ (i.e. properties with an ‘F’ or ‘G’ rating). More recently, existing leases within commercial buildings that do not have at least an ‘E’ rating became unlawful from 1 April 2023.
The government has further released consultation regarding improving EPCs for commercial property to a ‘C’ or above from 1 April 2027 and ‘B’ or above from 1 April 2030.
What is an EPC?
An Energy Performance Certificate (EPC) is a certificate that sets out the energy efficiency of a property. The attached EPC report also makes recommendations on how the energy efficiency of the property could be improved. The report is carried out by a qualified assessor.
Legally, all domestic and non-domestic buildings constructed, rented, or sold from 2008 must have an EPC. As with any rules, there are exceptions linked to certain buildings (listed for example) but let’s assume it is a legal requirement unless advised otherwise.
EPC ratings are based on several factors, from how the building was constructed and its size through to how the building is fitted out including factors such as lighting and plant and machinery such as air conditioning.
EPC Certificates are assessed on a scale of A to G. The best result you can achieve is an A grade (most efficient) and the lowest being G (least efficient).
Buildings must have a valid EPC at all times and an EPC lasts for 10 years however a new EPC must be prepared on any new letting or on a sale/purchase.
A Lenders View
Banks and real estate lenders are very focussed on a building EPC for a number of reasons.
- If a building is likely to breach the EPC rules during the term of the loan, Lenders will want to ensure that the borrower has sufficient free equity to bring a building back within the legislation. Failure to do so may mean the building becomes unlettable.
- Lenders now want to see detailed business plans about how a borrower will improve a building's EPC during the life of the loan. No lender wants to have an unlettable building as security for a loan.
- However, some lenders are now looking at Green Loans which cover:
- Bringing a building back into the correct EPC rating.
- Residential development lenders can now offer facilities where there is an interest rebate if the property achieves either an A or B rating which can save a large amount in interest costs.
- Much larger property companies have in the recent past issued ‘Green Bonds’ at very low interest rates to allow them to update their property stock.
In short, this is a major area for Lenders who, in the current market environment are already more risk-averse than they were a few years ago and who are also worried about how higher interest rates will impact their borrowers and their business plans.
So how big a problem is this?
According to Property Alliance, there is 7.35bn sq ft of commercial property in the UK and according to Reuters in 2022, the UK Commercial Property market was valued at $1.6tn!! So, in terms of space and value, this is a major issue but we need to drill down further to understand which asset classes are most vulnerable and which locations.
Asset Class Issues
There are numerous asset classes in the UK but to keep things simple we are going to focus on Industrial/Distribution, Office and Retail assets as the largest asset classes.
Industrial and Distribution – In the Big Six markets outside of London (Birmingham, Bristol, Edinburgh, Glasgow, Leeds and Manchester) the last few years have seen significant new developments come on-stream for both speculative development and owner-occupier sites. This new development will have been built to higher EPC standards and as such many of the larger and newer built schemes will already be achieving high EPC’s. This is reflected in the graph below which shows a larger percentage of industrial units are rated between A to D.
For smaller units outside of the Prime markets and with older stock, meeting the new EPC standards will become progressively harder.
Build costs for industrial and distribution tend to be far lower than for offices or retail and as such works to meet compliant standards should be less costly
Office – as with industrial and distribution above, London and the Big Six will have comparatively newer stock and this will be built to a higher environmental standard. In addition, buildings which have been refurbished recently will likely incorporate better EPC ratings.
Older stock in secondary and tertiary locations will be far more susceptible to poorer EPC ratings and costs to reach compliant standards will be far more material especially if this includes renewing plant and machinery.
Retail – newer shopping centres and ‘big box’ retail units should meet the changing requirements moving forward however ageing stock in secondary/tertiary locations will struggle with both EPC requirements and footfall which will expedite the demise of the smaller local high street.
Location Issues
The Cost of Compliance – this is a question that has been posed but remains unanswered in the marketplace. The difficulty in identifying the cost is driven by so many factors, the age of the property, the size of the property, the type of construction, the existing plant and machinery in the property (air-con, lifts, lighting, wiring, plumbing) and much more all make a difference. There is more granular data in the residential property market where various studies have estimated costs to bring a building from say a D to a C is estimated at £6,155 (Habito estimate) but we do not, as yet, have this granularity of data for commercial property.
The Growth of Obsolescence – the one certain factor that runs through these legal requirements is that a large number of buildings will become unlettable and therefore not fit for purpose as we move forward. Our view is that there will become a divide between areas which have benefitted from material developments in the past few years (London and Big Six cities) and those secondary locations which haven’t benefited from new stock and have an oversupply of older and less efficient properties). How this will impact valuation and turnover in the markets is still to be seen but we should expect material price reductions to represent the costs of bringing the property back into the MEES regulation.
Conclusion – our view is that early engagement to address the problems of compliance with the MEES regulations is very important. At the moment, there is time to implement a plan to bring the building into compliance with time to spare, but the longer landlords wait, the more challenging this will become and potentially more costly.
