Canadian Zero-Carbon Multi-Unit Residential Buildings: An Analysis of the Cost and Asset Value

Paul Morassutti:

Myopically focusing on costs, while important and you have to do it, I think misses the bigger picture. And that's what we're finding now When we talk about net zero construction. There does tend to be a heavy focus on cost and return. I think the bigger question is, what do you want to own, 10 years from now?

Michael Torrance:

Welcome to Sustainability Leaders. I'm Michael Torrance, Chief Sustainability Officer at BMO. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities, to explore how this rapidly evolving field of sustainability is impacting global investment, business practices, and our world.

Disclosure:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates, or subsidiaries.

Angela Adduci:

Welcome to another episode of Sustainability Leaders. I'm Angela Adduci with the BMO Climate Institute, and today I'm joined by Kathleen Beaumont, the Director of Impact and ESG at Forum Asset Management, and Paul Morassutti, the Chairman at CBRE Limited. Kathleen and Paul, thank you very much for joining us.

Kathleen Beaumont:

Thanks for having us.

Angela Adduci:

Today we'll discuss a recently published research collaboration between BMO and Forum Asset Management. This research focused on operationally zero carbon high-rise residential buildings. We examined the costs associated with the construction of these buildings, and their expected value relative to buildings constructed to base standards. We were fortunate to have CBRE participate as an expert reviewer of this research, and I'm really excited to dig into the findings, here. So Kathleen, you were a really great partner on this project and I would love for you to describe for our audience, why you felt this research was so important to undertake.

Kathleen Beaumont:

Thanks, Angela. Yeah, look, ultimately we know that we are in an environment where if we continue down the current path, it's not good for our climate future, and ultimately buildings account for a large share of global greenhouse gas emissions. It's well understood that about 40% are generated by operating carbon and embodied carbon in the built environment. In Canada, buildings account for 18% of those emissions, direct and indirect. And half of those come from residential buildings. But there hasn't been a ton of research completed for residential buildings in particular, for a variety of reasons. And we wanted to take a first stab at starting the conversation here. And look, ultimately, zero carbon buildings are more expensive to construct right now. There's higher upfront costs to construct, but we think that these higher upfront costs can be offset by operational savings and this can result in overall higher asset value. What we attempted to do was demonstrate this through a case study in this paper and validate that intuitive thought. We wanted to explore this perceived dilemma a little bit further.

Angela Adduci:

Thanks, Kathleen. So I do want to get to my research findings, but before we do, I want to make sure that we're setting the right context here. So for both of you or for either of you, what are some of the most frequent questions that commercial real estate developers are getting from market participants about zero carbon construction in Canada?

Kathleen Beaumont:

Fundamentally, I think they're the same questions market participants ask about conventional construction in Canada. It's just through an enhanced lens. What kind of municipal regulations are in place? Are there opportunities, and what are the requirements? What are the financial implications? What are the costs associated with going green, and what are the incentives available if I do make the greener choice? And also, what are the benefits of the decisions we make? What operating benefits are there? What leasing benefits are there? What capital raising benefits are there for making these decisions? So I think really it's just reframing how we ask the same questions and just kind of absorb additional insight in our decision-making process.

I don't know, Paul, if you have anything to add to that?

Paul Morassutti:

Well, I think that was a very good answer. I would add that it depends on the part of the world that you're talking about. So, clearly when we're talking to global investors or investors who are located in the UK, EU, Australia, they're way ahead of North America, so their questions are different. In Canada, we are in really early innings of true ESG awareness in the commercial real estate sector and residential sector. And so a lot of the questions that I get, as Kathleen alluded to, are fairly basic. They revolve around, what's involved in terms of additional costs, what's involved in terms of payback. And since I have a background in valuation, I'm frequently asked, how much more will my building be worth, compared to a building that doesn't have some of these features? And so from my point of view, I spend a lot of time and we spend a lot of time in Canada really just educating the industry on what's happening in other parts of the world, what's happening with coming regulation, reminding people that the choice will not be yours alone to make, you're going to be forced to do a lot of this stuff.

So it's those types of things. And I would add that much of this discussion, almost word-for-word in some cases, is analogous to the discussion we had around the first times we began building to a LEED standard probably 15, 16, 17 years ago in Canada. And at that time, there was a lot of discussion about, what's the additional construction cost? Can I get extra rent to cover it? Will my cap rate be lower? And what ended up happening, that discussion went away fairly quickly, because LEED standards became almost the de facto building code, and people just began to realize that if you want to have a building that is future-proof and is not economically obsolete the day you open the doors, you have to do this, and myopically focusing on costs, while important and you have to do it, I think misses the bigger picture. And that's what we're finding now When we talk about net zero construction. There does tend to be a heavy focus on cost and return. I think the bigger question is, what do you want to own, 10 years from now?

Angela Adduci:

That's really interesting context, and hearing about how there are parallels with LEED and how that ultimately played out, is really fascinating.

So we've set the stage. Let's jump right into the findings.

Kathleen, what were the main takeaways from this research and did anything surprise you about what we found?

Kathleen Beaumont:

So, ultimately our analysis finds that building to a zero carbon performance standard on average can be as profitable as conventional building standards. But we found that profitability is currently significantly contingent on government incentives and collaboration across both public and private sector. We also found that zero carbon buildings can be more future-proof investments amidst a rapidly changing climate, economic, and regulatory environment. And ultimately we believe that these two things result in a lower risk profile, benefiting from operational and regulatory cost savings, which can result in lower cap rates and higher asset values. I wouldn't say anything surprised me with the results. Intuitively, like I said, the results are validating more or less intuition. I think most notably though is that we are in an environment that requires collaboration across both the public and private sector. As Paul mentioned, we're in the early innings here in Canada. And because of that, it is a collaborative effort across all stakeholders.

Just look at the horrific flash floods that we experienced in Ontario. The Don Valley Parkway, a major thoroughfare in Toronto, was so flooded, cars were underwater. The social and financial implications of these more frequent events and are growing exponentially and it's becoming harder for regulators to ignore this and it's more likely to see more aggressive climate policy than not. And buildings that positively contribute to a lower carbon future are more likely to be prepared for a variety of regulatory environments. And ultimately I think that what we found was, because of that, we can see compressed cap rates that demonstrate a lower risk profile for this type of zero carbon building.

Angela Adduci:

So, Paul, you touched on your background evaluations a little bit earlier. I'd like to turn to you for a moment and dig in on this. So this research, as Kathleen noted, really questioned assumptions that may be held about the cost and the value of building to zero carbon standards. And we know, we've seen, that cost is one of the biggest factors, if not the biggest factor, that affects decisions on zero carbon construction. So, given this expertise and valuations, what do you think this research and our findings will mean for asset owners and investors and developers in Canada as they move forward?

Paul Morassutti:

First of all, I would say that the research that Kathleen and Forum has put together, A, is excellent and B, we really need more of it in the industry. And I think bringing up what happened in Toronto, the flooding, is very timely and very important and it emphasizes the importance not just of net zero construction and buildings being resilient, but cities being resilient as well. And increasingly as we go forward, cities that have climate resiliency will have almost a halo effect over buildings in that city, and buildings that are built to a certain standard. I agree with Kathleen, they will have a lower risk profile. And cap rates effectively are nothing more than an assessment of the risk profile of an asset. And if you are looking at a building that rates better in terms of its investment attributes, and I think climate resiliency is one of those attributes, you'll have a lower cap rate.

The factors that we point to, to support value premiums, and I can talk in a little bit about how long I think those premiums might last for, again, it goes beyond costs. So if we move out of the residential area for a moment, and I think this will be true in residential shortly, you look at occupiers of buildings, tenants of buildings, increasingly, right across the spectrum of different asset types, we're seeing companies that have strong ESG commitments and if they have a strong ESG commitment, maybe it's to be net zero by 2030, 2040, they have to be in a building that is aligned with those standards. And so increasingly, if you have a building that's not being decarbonized or if you're not building to a net zero standard, you are losing out on a huge part of the market. You're also losing out in terms of your exit ability, because again, increasingly, investors, both large and small, but certainly large investors, want to buy assets that are aligned with their net zero commitment. So your ability to sell will be much better if you have a building that's future-proofed.

As Kathleen noted, lower operating costs translate into higher net rents and better NOI. That's a given. The third thing I would point to is this changing regulatory environment. So in New York this year for the first time, there's regulation in place that will penalize owners of buildings that emit higher GHG emissions than the standards that are being set. And there are about, at last count, almost 100 different states and municipalities that were adopting similar regulations in North America. So from a regulatory point of view, you're going to be forced to do this.

And then lastly, I would say here in Canada we do have a carbon tax. Don't know how long it'll be around, but it is in place right now and you will have higher tax bills if you are a higher energy emitter. And in Toronto, if you're building to higher standards, there are D.C credits that are available.

Angela Adduci:

Paul, you brought up the regulatory environment and you brought it up in the near term and the present. Looking out toward the more medium term, and this may be a bit of a tougher question, given the ambiguity here, but how do you both anticipate the economic and regulatory environment in the next, let's say five to six years, will influence demand for building to these zero carbon standards?

Paul Morassutti:

I would say we have to move through some of the current noise in the market, and a lot of the noise is sort of this anti-woke, anti-ESG backlash that I think is somewhat temporary in nature, somewhat related to the fact that costs of all type have gone up over the last few years and there's this real concern about inflation. That's the reason why the governor of New York just axed the congestion tax in New York that had been planned for a decade. So we have to get through this sort of tumultuous period that we're in. Once we get through it, in my opinion, with each year, all of this is going to become more of the norm, rather than the exception. And the parts of the industry, and we've been very vocal in talking about this, the parts of the industry that continue to stick their head in the sand, they may end up with assets, particularly in the office market, but in general, you're going to end up with assets that are not worth as much as other assets that have proper sustainability strategies in place. So I just think it's going to become more normalized with every year that we go forward.

Kathleen Beaumont:

Even if the regulatory environment doesn't evolve the way we think it might, and it just kind of remains complacent or goes the other way, these particular assets are very long-term in nature. And so even if we think about today or five years, in 10 years that might be different, in 20 years might be different. And so if you build to a future that is more likely or complacent, you're going to be better positioned from an asset value perspective, and that risk of obsolescence is lower. And so regardless of the policymakers in power, I think that it's prudent to be mindful of a variety of scenarios, which includes aggressive climate policy and not.

Angela Adduci:

Kathleen, you touched on this, this research shows that government incentives are currently playing a pretty crucial role in the feasibility and the profitability of zero carbon buildings, but we also know that the private sector is a critical player here in many ways, as well. So, given this dynamic between government and industry, how do you think public-private partnerships can keep driving zero carbon construction forward?

Kathleen Beaumont:

Right. Look, like we said, cost is a big deciding factor right now in particular on the zero carbon building sector. And because of that, we need leaders, and leaders still have external stakeholders. And so without these public-private partnerships or financial incentives to demonstrate the profitability or the investment return or the investment opportunity for zero carbon, I think that that relationship is required right now, because we are in the early innings. We have limited transaction data, we have limited proof points, particularly in Canada, in the multires sector. And as a result of that, these relationships are going to be critical to demonstrating success. And so my hope is to start with this type of research and this type of study to get the conversations going, so that we can have relationships and create these case studies in real time and then in a couple of years, demonstrate that and kind of look back and have additional proof points so that eventually the carrots and the sticks will be different.

The carrots are kind of what's required right now, but ultimately the sticks are going to come, or at least we think they might come. And sticks, by sticks, I mean regulatory pressures and policies and penalties and fines and taxes and all the things that we hate to hear as businesses. But ultimately, right now the carrots are really, really important. And I think what BMO is doing with the Canadian Infrastructure Bank on their retrofit initiative is really important. I would love to see something like that evolve to include new development. I hope that something like that could happen.

Angela Adduci:

Final question from me, for both Kathleen and Paul. I'm curious to hear what additional questions this research raised for you about zero carbon buildings, that could perhaps be the focus of future analysis.

Kathleen Beaumont:

We didn't touch... We kind of alluded to it in the paper, at the end, where we said we focused on the information that we know today, things like operating costs and current regulatory environment, meaning the carbon tax we have in Canada, but it's difficult to include currently today, the quantitative analysis on things like potential building code updates, investor net zero commitments, resilience to extreme weather events and fluctuating energy costs, insurance availability, lending practices. Intuitively, all of these things are likely to impact the costs and expected value of a building, but it's so early on, it's kind of hard to quantify that. And like Paul said, it's already a really difficult environment to make valuation decisions, already. And so I think we want to make sure we don't challenge ourselves too much, and we want to put some things in the too hard bucket for right now and focus on the things that we can focus on. And that's kind of continuing to push this narrative and make people start thinking about this, versus the complacent world we have been operating in, from a development perspective.

So I think as much as we tried to answer some questions, the intent of this study was to really actually create more questions so that more people are coming into this field of research to help answer them. And so that's things around quantitatively justifying and validating some of these more qualitative things that we're talking about, like regulatory environment, like investor appetite and asset obsolescence, like resiliency. And I think the other one is really around demand. Are residents going to be starting to demand this sort of living environment? Maybe, maybe not. It's hard to say. Some are saying yes and some are saying no, but again, we're in an environment right now where it's already so hard to pay your bills, it's hard to justify asking more just because it's a zero carbon building. So, ultimately, I think there's more questions that came out of this study than answers, but I think that was the intent, right? Let's start the conversation around this. And I'm really excited about how we progress this kind of narrative and conversation over the next couple of years.

Paul Morassutti:

Yeah, and I think I'm really not an expert in ESG, and so in many cases, I'm struggling as much as other people in the industry. And I think part of the feedback I hear from developers and owners, and again, it's somewhat similar to what we heard when we began building to LEED, but many developers are kind of struggling with, what exactly is the de facto standard that we should be building to? What is a green building? What's a sustainable building? What's your definition of it? Is it a building with a LEED designation, which is really just a point in time kind of snapshot designation? Is it a fully net zero building? Is it a carbon neutral building? Is it industrial buildings in Toronto today are being built to a net zero ready standard? So I know developers do sort of struggle with, just tell me what the rules are and we'll build to those rules. And right now it kind of feels like the rules are in flux, and standards seem to be in flux.

Angela Adduci:

Is there anything else that either of you would like to add to this conversation before we wrap up, here?

Kathleen Beaumont:

I just want to say thank you to you, Angela, and the BMO Climate and Research Institute team for partnering on this. I think it's been a project that I've been trying to work on for a little while now, and getting someone to come on board to help just start the conversation was harder than I thought it was going to be, but I'm really glad to have had you guys as partners. And then obviously, bringing in folks like Paul and the CBRE team, where you can really have some additional credibility around this type of research, is important.

Thanks, Paul.

Angela Adduci:

Well, I definitely echo those sentiments. Thank you both. I really appreciate your partnership on this research and really appreciate you joining us, today.

Paul Morassutti:

Thank you.

Angela Adduci:

Bye for now.

Michael Torrance:

Thanks for listening to Sustainability Leaders. This podcast is presented by BMO. You can find our show on Apple Podcasts, Spotify, or your favorite podcast player. Press the follow button if you want to get notified when new episodes are published. We value your input, so please leave a rating, review, and any feedback that you might have, or visit us at bmo.com/sustainabilityleaders. Our show and resources are produced with support from BMO's marketing team, and Puddle Creative. Until next time, thanks for listening, and have a great week.

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