Episode 36 – Part 1: Understanding ESG and Its Impact on Property Valuation with Joël Scherrenberg

The following transcript is autogenerated so may contain errors.

Matt Nally: 

On this week’s episode, we have Joël, who’s an active RICS member and his background sort of day-to-day in valuation.

So thank you for coming on today.

Joël Scherrenberg: Thank you for inviting me and lovely to be here to tell something about what’s happening on ESG and valuation.

Matt Nally: Awesome. Yeah. So that leads us in nicely. We’re actually going to be covering on this episode everything around ESG and valuation, and we’ll split it into two topics.

We’ll look at what is ESG and why is it important in valuation? And then later on, we’ll look at the process of moving towards ESG and valuation. So it should be a couple of interesting topics, I think, before we dive into everything, do you want to give a bit of background as to I suppose who you are and what you do day to day with this side of things?

Joël Scherrenberg: In my day to day business, my primary activities are a value of public real estate in the Netherlands. And you have to think about most of it is healthcare, but also things like museums. Sporting facilities, educational facilities, and all those kinds of things all over the country. Partially for financial institutes, partially for the balance sheet, and sometimes for decisions on.

politic decisions where they have to make a choice between one or the other.

Matt Nally: Interesting. Okay. So good background in valuation. I suppose in terms of, before we start moving on to ESG evaluations, should we touch on what do we mean by ESG? So what does it stand for and what’s it cover?

Yeah.

Joël Scherrenberg: ESG is of course the letter stands for environmental, social, and governance. But it’s as I see it, it’s more holistic approach of sustainability where you look into in this, in my kind of business, the real estate, is it fit for purpose and fit for the future? And therefore, you need a framework to assess that.

And therefore, somebody thought ESG might be a nice framework because we can link it then to the sustainable goals of the United Nations. And it looks in a broader way only then like energy consumption. And when we talked about sustainability in real estate, focus was in the past, almost only on energy consumption.

And there’s so much more to sustainability than only energy consumption. And therefore we needed a new concept and people thought ESG might be one and that’s embedded in all kinds of legislation on European level and also on a global level. And then it needs to be translated into what does it mean for real estate?

Matt Nally: I suppose on that note then, so you’ve mentioned it previously was based primarily on energy usage. So what are the factors now that, that sort of are encompassed by ESG that would affect a property valuation?

Joël Scherrenberg: When we look to property valuation, then you have to make a distinction in two lines, what kind of real estate, because for domestic real estate, things might be different than for industrial real estate.

And also you have to look to the geographical location of a real estate, because The risk of earthquakes for the UK. I cannot imagine that there has ever been an earthquake in some parts of Greek or Italy. It is a real risk. And that’s also for flooding and et cetera. When we look to ESG, then most of the risks related to real estate are driven by environmental, climate change too much rain, too little rain, drought pollution all the things you see now in all over the press in the day to day business.

And of course, also social and governance are important to real estate, but there are a little less easy to identify when we talk about social then you have to think about how is your position as owner in your relationship to the tenants? Are you contributing anything with your building to the surrounding neighborhoods?

Those are examples of social aspects. And governance is all about, are you compliant with legislation? And not only strictly by the rules, but also by what is meant by it. And that’s one of the main assets. I think of RSCs, it’s always principle based and you can say, okay I’m following the rule, but I’m contradicting the purpose.

So it’s still wrong. And governance looks as well to the purpose as to the rules. And of course, when you own a building or you exploit the building, you have to be compliant with legislation. And when I combine it with ESG, and for example, the Netherlands, then I have quite a simple example. In the Netherlands, if you want to use an office building, you need to have an energy rating of at least C.

Matt Nally: Yes. If

Joël Scherrenberg: it’s lower than C, you’re not longer allowed to use the building. Now there is where governance directly interacts with environmental and directly impacts the real estate.

Matt Nally: Interesting. Okay. So there’s a number of different factors yeah, impacting, valuation generally then.

Joël Scherrenberg: Absolutely. And what we have determined during our investigation, when we were writing this paper with a group of European valuers and RSS staff members, and also with the collaboration of a group of European leaders. He created the European Leaders Forum to help us to make sure that we have the connection with the market.

And then you have to think about those where people from investors, banks like the European Mortgage Federation Urban Lentenson, ULI APRA, INREF, those kind of organizations all contributed to this paper. And we determined that when you look to ESG evaluation, that you can divide it in three possible ways, how it can affect the real estate.

We determined value drivers. If you have, or if you don’t have a specific. Asset or then it might lower or higher your value directly. For example, in this case, had the energy label C for an office building. If you don’t have it, your building will be valued lower than with a label C. And then it’s an easy connection.

Then we determined the risk drivers. And then you can say, okay for example, flooding, but something where you can say the building has certain yeah. How do you say it? Aspects, which how it’s built doesn’t in fact, where it could flow flood or not because flooding is caused at a different place, but it might affect your real estate when flooding does happen and you can add that risk in your valuation.

If there’s a low risk, you say it has hardly any impact on the valuation. If it has a low or high risk, it might impact your valuation. That’s a risk drive. And the last one is the cashflow driver, where you see that specific measures related to ESG might change your cashflow. I have a higher rent because I have a more energy sufficient building.

I have lower maintenance costs because I have taken certain measures et cetera. So when we determined the 11 possible ESG factors in real estate, and I must say we have determined a little bit more, but we say there are about 11 factors we can now somehow determine and in a certain way measure them.

From each of those factors, we determined are the most influential value, the risk for the cashflow. And of course they all eventually end up changing the value and then the risk immediately. Because if you say, Hey I have taken certain measurements, measures, and then you say, okay it will lower my maintenance costs.

So my cashflow improves. I have less risk. Because I have improved the building, I lower my yield and Hey, I have certain assets added to the to the building. So I added to my failure directly. Then the same measure will take three times into account in the evaluation.

Matt Nally: Yeah. Okay.

Joël Scherrenberg: An investment of a thousand euros might end up in a value of 5, 000 years.

That won’t be the reality. Yeah. Therefore, as a valuer those drivers interact with each other’s. And cannot be seen separately.

Matt Nally: Okay. Interesting. And so between those three drivers, the value drivers, the risk drivers, and the cashflow drivers, is the way in which the weighted built into a framework or is it just very dependent on the individual asset that’s being reviewed

Joël Scherrenberg: and also dependent on the different factors, because for example, the flooding risk is measured differently than whether you do have solar panels or not, because those are there every day and they have their contribution every day.

But the flooding risk is there sometimes. Yeah. The potential risk is eminent, but The period where it might flood, for example, I’m living in the Netherlands and we have had the big rivers here. They only flood when there’s coming a lot of melting water from the Alps and the other mountains in spring after the winter.

So in, in autumn, there’s no risk at all at flooding because the rivers won’t rise because there won’t be any melting water. So that’s time dependent. It could happen or not. And so that the concentration, what we also determined when we are making the framework as a conceptual way of thinking about ESG, we realized that a lot of the factors you have we have determined are not specifically on E, S or G.

Often they are related to at least two and sometimes even three of them. That would be the energy label, for example. Yeah is directly related to environmental, but it’s also directly related to governance. So at the end we said we have determined the 11 factors which are relevant for ESG evaluation without telling this is E, that is S, and that is G, because we said there’s too much interaction.

Not always clear to define. Let’s just say those are relevant for each year at the end. As a failure, you determine one market value and you don’t say this is the environmental or the social or the governance value. It’s the market at the end. So

Matt Nally: yes. Yes.

Joël Scherrenberg: It doesn’t matter where you put them also.

Matt Nally: We’ll come on to yeah, the process of moving towards the issue in a bit.

But one thing I wanted to touch on first, just related to what you said is these changes that are coming into the valuation process what is driving it most? Is it obviously there’s the regulatory changes that you mentioned in terms of certain things you will have to do because of that, but is it driven mostly by that or is it the social pressures?

Is it the financial

Joël Scherrenberg: sector? It’s a combination and they enforce each other. Of course there’s social pressure because luckily more and more people are aware of the risk of the changing climate, the risk of how we are. Yeah. Some say abuse, others say use our resources. I don’t want to make it into a political discussion today.

So that’s the social impact, what and where it’s driving change and also evaluation. And of course, there’s a change in legislation coming from EU, but also on national levels. And in the paper we wrote about ESG evaluation, we made a brief overview of all the legislation, which is already in place or About to come in place around ESG and valuation, which might impact real estate.

And that’s quite a long list already. And then you see that’s on the EU level, but there’s also on a national level. And the third one is, and that’s of course, driven by the first two social changes and the legal changes is that financial institute investors are saying, okay, we see what’s happening in society.

We take our responsibility and no matter what the social demand is or what the legal demand is, we’ll set this level for our portfolio or for our investment or whatever. And effectively, that’s the biggest driver in the change. Because when the banks say, You won’t get a loan unless this, and this people say, okay, I will do it because I will need the loan.

And that’s what you now see in the, for example, there’s a lot of discussion about Paris proof 2050. A lot of people are thinking, okay, Paris proof 2050. Yeah, it’s important. Okay. But it’s 25 years from now. Will

Matt Nally: can wait till tomorrow.

Joël Scherrenberg: And even the day after that. So there’s no legislation yet. Yes, there is social pressure, but what we now see is that a lot of banks say, okay, Paris proof 2030.

If you don’t, if you’re not proof by 2030, and if you don’t show me now today, what you’re going to do in the next five years to become Paris proof in 2030. I’ll cancel your loan,

and that’s driving market change because investors say, okay I’ll need those loans to get my portfolio in order. So I have to be compliant with those needs. And also in the investor side, like we have a lot of discretion with InRef and APRA for the listed and non listed investors. And they say, our members just say.

These are our goals for 2025, 2030, 2035, whatever, and they want their portfolio to be compliant with those demands. And they say to the market, if you don’t become compliant, we’ll sell it, or we won’t buy it, or we won’t rent it, or whatever. And also, the users, the people who rent the places are, especially the large organizations, say, We only want to rent a building which is compliant with because and then is where other legislation comes in place.

CSRD, for example, Corporate Social Responsibility Director. Organizations have to report whether they are compliant or not with their CSRD and therefore they need their real estate to be compliant.

Matt Nally: Yes. Yeah.

Joël Scherrenberg: So whether or not there’s legislation for the real estate itself, the occupier has legislation where he has to fulfill his needs and that drives the real estate to change.

Matt Nally: It’s a very interesting one. Actually, the more we’re discussing it, the more you can see the way so many different factors interrelate. Absolutely. And yeah, and it’s never, it must be quite a complex one to put a framework together on, or at least as you say, there’s 11 points, but I can see why they would have taken time to come up with.

I suppose my, my, the final questions I’ve got for this topic, I think are in terms of the regulatory aspects. Or whether that’s from sort of governmental level or you level or from say, governing bodies like the RICS, for example. Is there more regulation that you think is on the way?

Absolutely. Yeah.

Joël Scherrenberg: For example whole life carbon assessment is directly related to ESG is now compliant for RCS members since July 1st to at least report about it. There will be more legislation around carbon assessment and carbon pricing in the next couple of years that will definitely impact real estate markets.

2027, for example, we have the and I don’t know what’s the European word is for, we have a legislation about what the quality.

Matt Nally: Yes, that’s a big topic. Yeah.

Joël Scherrenberg: And I know exactly what in the Netherlands what’s how the legislation in the Netherlands go, but I don’t know what the name is of the European law for that.

But in 2027, you have to be compliant. If not permits, which have been granted can be. Taken away that will definitely impact real estate. We see changes in the CSRD legislation as mentioned for 2025, only the listed companies on the stock market have CSRD responsibilities, but they have to be transparent about all the people who are in their chain of operation.

So there it already impacts other organizations. And within a few years. Also the mid cap and the small entrepreneurs will have to be following CSRD. It’s, there’s a load of legislation already in place, but not effective yet, or becoming in place in the next few years. And they are still thinking about more and more.

So it will only increase in importance. And what also helps, of course, I always talk about the homo economicus. When energy prices are going up, people are more willing. to lower the energy consumption. If prices of their, uh, your basic products, uh, iron ore, et cetera, if they go up, you want to use less.

So when we are putting prices on All kinds of materials, which are not so good for the environment. People will change and use other kinds of materials, change their way of building. There will be more reuse of of materials et cetera. So in my opinion, we’re just at the beginning. Of the big change.

Matt Nally: Yeah. Okay. And would one of those things to potentially then because if we’ve done valuing certain assets or properties, because they are not as ESG compliant with the answer to that, to stop, obviously more demand for cheaper properties in that respect be that they potentially start to get taxed in some way that means that they’re more favorable than I started less favorable than a, an ESG more ESG compliant property.

Joël Scherrenberg: Now, what in the market is that Larger organizations are more open to be

Matt Nally: more

Joël Scherrenberg: ESG compliant real estate where small entrepreneurs are more driven by personal motives.

Matt Nally: Yes. Some find it

Joël Scherrenberg: very important and do as much as they can. Some think it’s are not yet that. Open to these changes or are not able to implement it in their business because they hardly survive at all at this moment and have, don’t have the the space or the money or whatever to do the needed investments.

That’s not always that people are not. Not everybody who is not compliant with climate is a climate denier.

Matt Nally: No, very true. Yeah. It can just be lack of resource or yeah. Yeah.

Joël Scherrenberg: And what we see is that and therefore also in valuation yes, the values are changing due to the more change in demand, change in social aspects, change in legislation, but it’s coming from the big market dripping downwards into the rest of the market.

And when I have a small. part of commercial real estate in the Netherlands, which is just for a local entrepreneur. The ESG is only this relevant in the decision whether to buy or to rent this place or not, but that will change in time. And of course, some people make it already in this amount important, but overall, and then what is that.

And that’s where we have to be aware of as a valuer. If you assess a building, you can determine you are not compliant with ESG that you see the risks that you see potential changing, negative changing your cashflow, et cetera. You have to mention them in your report. You have to make them clear in your evaluation, but that doesn’t mean that the value already has changed.

has gone down today. There’s a huge risk of devaluation in the near future. And I have a lot of discussions with banks about that. They say, okay, if you see this and this, you have to devaluate the property. No, for me as a valuer, I always tell what the market value is today. When I look to my opinion, for example pay fuss it’s a nasty chemical stuff, but it’s used in many ways.

To my opinion, it should be forbidden, but it still has value today. It won’t have a value in 10 or 20 years because everybody then will be convinced we shouldn’t have used it at all. But today we do use it.

Matt Nally: Yeah, that’s very interesting, but before we move on to topic two, my final question, just if people want to learn more around ESG generally and potentially how it impacts valuation, are there good resources that you’re, you’d recommend to look at?

Joël Scherrenberg: They can start in several places because, and it’s more, do you want to know legislation, the practical implications or whatever, because ESG is. so broad topic and has so much angles you can look into it. On the RSS website, we have a lot of information about ESG, but there are so much more resources.

I’ve seen in many countries also websites from sometimes commercial organization, sometimes nonprofit organizations about ESG, where they can give links to all kinds of information. So depending what your background is and from what angle you want to look into it go to your own overall organization, go to RSCS look on the internet.

Yeah. In the paper we have written, we have made the list of some resources, but it’s hardly a total overview. It’s got so much information.

Matt Nally: Yeah, it’s a good starting point.

Joël Scherrenberg: Yeah, it’s a good starting point. Make sure that you make it practical to the things you are doing and you are assessing, because I can fill a complete library with books and papers about ESG.

But for me as a valuer, only the things about which relate to valuation are relevant.

Yeah. And therefore, as they say, there’s a Dutch saying, you don’t see the forest through the trees.

Matt Nally: Another one.

Joël Scherrenberg: And that’s absolutely a risk in ESG, that there are so much trees, you won’t see the forest at all. Just try to lean backwards a bit.

So you first look to the forest and then think, do I need the oak, the ash, or

Matt Nally: whatever? Yeah, I like that. I like that. You’re right. Cause there’s a huge amount of information out there. So yeah, just step, step back, get an overview and then work out where you want to dive in. That’s been a really interesting first topic.

I think we’ll we’ll pause there and then join us for topic two, where we’ll be discussing the process of moving towards ESG and evaluations.