UK: Real Estate Executive Report - Evolution – Revolution.

Foreword

Welcome to the fourth Real Estate Executive Report

For this fourth edition of our Real Estate Executive Report we are looking to the future. We are all painfully aware that the last couple of years have been traumatic for the real estate industry. Recent historic political upheaval has also added uncertainty, as changes resulting from the general election begin to come through. However, at Deloitte we want to start to look beyond these issues and consider – what next for real estate? In this edition, we therefore focus on the issues and themes that we expect to the be shaping the industry once these macro issues have played themselves out.

Sustainability and carbon impact is increasingly becoming an established part of the business vernacular. The new Government has also placed sustainability at the heart of its agenda and is making moves to give the renewables sector the long term certainty to attract significant investment. It appears the time is coming when these considerations will form a key part of any real estate transaction. This has implications not only for profitability, but also for less tangible issues such as corporate branding and the tenant's desire to communicate their business priorities. We have recently acquired dcarbon8, a leading carbon and sustainability consultancy and we have asked our team to consider key sustainability issues and how developers are starting to actively manage the carbon impact of a building – taking into account the entire life-cycle through construction, operation and eventual demolition.

Those organisations that have managed the cold winds of the economic crises successfully have often done so through an obsession for making their organisation as lean, efficient and effective as possible. We expect these themes to be embedded within our clients' commercial strategies beyond the current economic turmoil. Although many of our clients have made substantial progress in this area we believe that there remains low hanging fruit for management teams to focus on during the next stage of the recovery. To this end, we have included articles setting out further ideas for cost saving initiatives, looking at IT efficiency in the workplace, and considering a factor that is often overlooked in our industry – how to get the most out of your employees by motivating and engaging them.

We have also included our regular update on the real estate tax landscape, focusing in particular on those tax issues facing fund managers attempting to raise capital in the current environment.

To conclude, we look at a more immediate area of focus for the industry – business rates revaluation and what this might mean for you.

Finally, it is exciting to acknowledge that Deloitte has made some news itself since the last edition, through our merger with Drivers Jonas LLP, creating a new real estate advisory business – 'Drivers Jonas Deloitte'. We look to the future with great optimism for this new venture and are delighted to welcome our Drivers Jonas Deloitte colleagues, a number of whom have contributed to this report.

We hope you find this report useful and welcome your feedback on the contents.

Mark Goodey

Deloitte Real Estate Industry Leader

The evolution of sustainable construction

Sustainability in the built environment

Corporate sustainability is now a fundamental part of business. It is no longer an add-on, but an essential part of company activity, whether it is confronting the issues of global warming, ethical trading or the need to conserve finite resources.

The construction sector is at the heart of sustainability, not least because it is responsible for almost 50 per cent of the UK's carbon dioxide emissions¹, but also because the built environment is so dominant in our lives, influencing the way we live and work.

It is also clear that many large organisations, ranging from the automobile industry to the public service sector, see their buildings as a fundamental part of their brand communication, staff retention and most importantly, a reflection of 'how we do business'².

A key question for developers is therefore, how can the sector evolve from its 'bricks and mortar' approach and emphasis on energy efficiency, to holistically embrace sustainable construction – and do all this whilst not compromising service or profitability?

There is growing public demand for organisations to act responsibly, from the paper they buy to the new offices, stores and warehouses they use. Many consumer facing brands are now responding to this demand and actively marketing their sustainability performance to maintain and generate new business. Whilst building developers may not have front line visibility, they are also responding to this evolving market as they recognise that businesses are willing to pay extra to occupy more efficient, greener buildings. Increasingly sustainability is being seen as not only good for the environment, but also good for business.

Where are we now?

In 2008, the Climate Change Act establised a legally binding framework which aims to cut UK greenhouse gas emissions by 34 per cent by 2020, with a further reduction of 80 per cent by 2050³.

To aid the transition to a low carbon economy, much legislation and planning law has arisen to reduce emissions, such as Part L Building Regulations, the Merton Rule, Code for Sustainable Homes (CFSH), Energy Performance Certificates (EPCs) and the requirement for developers to meet local authority sustainability targets.

However, the legislative drivers for reducing carbon emissions in the construction sector remain immature, and legislation to date is focused on reducing the operational performance of a building, rather than looking at whole life cycle sustainability impacts.

Moving towards lifecycle thinking

In a 'survival of the greenest' approach, leading companies such as Marks and Spencer (M&S), Sainsbury's, Land Securities and British Land, are going beyond legislation, by proactively addressing carbon impacts across the construction supply chain.

For a typical building that meets the latest building regulations, the carbon emissions associated with the materials used to construct it now cover at least 40 per cent over a 60 year lifespan (the remaining 60 per cent being energy in operations). With growing operational energy efficiencies and a move towards low carbon sources of energy, the embodied carbon increasingly makes up a substantial component of the total carbon impact. As a result, the market is now evolving from simply assessing energy in the use phase to the consideration of how much carbon it emits over its total life cycle.

Modelling the carbon impacts of a building or product over its lifetime covers both operational and embodied carbon emissions (figure 1).

This considers raw material extraction and manufacture, delivery, the physical act of constructing the building on site, its operational use and maintenance and the final disposal of the building.

Only by adopting this holistic approach can we ensure that environmental impacts are not being displaced elsewhere. For example, installing mineral wool loft insulation will undoubtedly reduce the operational impact of a building by reducing its energy demand, but what of the carbon emissions from manufacturing and installing this product? Perhaps these embodied emissions exceed the savings made in operation?

Factoring the environmental impact of building products into a building life cycle model therefore enables us to balance carbon reductions based on the substitution of low carbon materials, recycled content and energy efficient technologies.

The approach is being applied to large developments and cities. For example, Barangaroo in Australia (shown above) and Masdar City in Abu Dhabi are both addressing carbon in their supply chains, in part to advertise their green credentials and attract investment, new businesses and residents.

Managing the supply chain

In 2009, in a bid to further reduce carbon impacts from their developments, Development Securities Plc commissioned an investigation into their supply chain to locate the greatest embodied carbon impacts. This assessment was conducted for their commercial developments, One and Two Kingdom Street, PaddingtonCentral, London.

"For years, the property development industry lacked the incentives to promote sustainability", Paul Patenall, Development Manager at Development Securities. Despite this he believes that attitudes are changing, "At Development Securities we believe that everyone in the supply chain must play their part.

We commissioned a study to advise us on how to achieve carbon neutral buildings at PaddingtonCentral and with the introduction of the Carbon Reduction Commitment (CRC) Energy Efficiency Scheme, this will be a key point to the successful letting of property."

"This study enabled us to better understand our embodied carbon and cost effectively target our suppliers, helping them to deliver the pro-environmental materials and design that we require", demonstrating that "combined savings of up to 10 per cent against total carbon impacts could easily be achieved through materials choice; for example, opting for high recycled content in concrete or installing high longevity fit-out."

Meeting planning guidance – the Merton Rule

As a result of the drive to reduce operational carbon, the Merton Rule was established in 2003 and has now become part of national UK planning guidance. This requires new developments to generate at least 10 per cent of their energy needs from on-site renewables (and potentially 20 per cent in the future). Although it is non-statutory, many Local Planning Authorities (LPAs) prescribe this rule to developments of 10 or more homes, or more than 1,000m2 of non-residential development.

Studies have proved that over a building's lifetime, tackling embodied carbon can save just as much, if not more carbon than the Merton Rule⁵. Furthermore, this can be done at considerably less cost, and has already been approved by Daventry LPA as an alternative method of tackling carbon for a 2 million square foot distribution centre developed by ProLogis.

Understanding the role of the tenant and the landlord

For companies such as British Land which holds a portfolio of 26 million square foot retail and commercial office properties, carbon reductions are being increasingly sought through changing behaviour in their tenants. Whether as a result of reduced service charges, CRC requirements or increasing asset value, property managers are engaging tenants through green leases and the development of shared environmental goals, recognising the roles of both landlord and tenant in carbon reductions.

One of British Land's most recent developments is Ropemaker Place, an 81,000m2, £155 million low energy commercial office building in the City of London. Research showed that for a landlord such as British Land, the embodied carbon within the supply chain represented 40 per cent of the building's 60 year lifetime carbon footprint (the remainder being operational)⁶. Furthermore, as the Government reduces the carbon intensity of grid electricity by scaling up renewable energy, the study showed that the embodied carbon could become as much as 70 per cent over the building lifetime, emphasising the need to target embodied carbon reductions as well as energy efficiency.

"For British Land, as landlords, understanding which emissions we are responsible for, and which our tenants were responsible for, helped us to develop and communicate our targeted strategy to reduce overall carbon emissions", Sarah Cary, Sustainable Development Executive at British Land. "We ask our tenants to show their commitment to the environment by jointly signing a Carbon Reduction Memoranda of Understanding, and collaborating with us to maximise energy saving opportunities and invest in improving energy efficiency."

The future is blue – Is water the next oil?

With many calling water the 'next oil', it is unsurprising that water accounting is gaining considerable attention in the sustainability arena. Increasing populations with growing affluence require water intensive food and goods, and finite water supplies are being stretched between natural ecosystems, agriculture, industry and domestic demand.

Recent research by the 2030 Water Resources Group shows that with no efficiencies, water supply in 2030 may only meet as little as 60 per cent of demand⁷. Countries such as the UK, believed to have an abundance of water, are now facing the reality that, per capita, they currently have less water than Spain and Portugal (figure 3).

At a corporate level, companies are increasingly encountering various water related risks which could threaten direct operations and their supply chain, whether through limited availability, increased costs, tightened legislation, fewer permits to operate or reputational damage seen through customer purchasing behaviour.

'Water footprinting' is being used as a means of understanding the water consumed in direct and indirect operations at the local level, identifying key risk areas, in order to adopt timely mitigation responses for sustained business activity and growth.

Recently, dcarbon8 completed a water footprint positioning study for M&S. Addressing water use beyond their direct water use, Crispin Burridge Head of Plan A for Property at M&S announced, "We are now looking at the impact of embodied water in our construction materials and ways to reduce our overall impact. We understand that our aspirations to be more resilient to climate change will require us to take a holistic view of our total water footprint".

Joined up thinking

To date, the market has been concerned with reducing operational carbon in buildings through energy efficiency, renewable technologies and the purchase of green electricity. However, it has become clear that this strategy alone will neither deliver Government carbon targets, nor will it deliver broader objectives of living within the Earth's natural limits. The time is now right to begin to look at whole lifecycle impacts of the built environment by adopting an integrated approach that takes into account the long term environmental and cost implications of development decisions.

By incorporating sustainable materials and minimising carbon, water and waste, the market will advance towards truly green, cost effective building design that is both good for business and good for the planet and its future generations.

New approaches – Creating 'Whole Life Value'

Whole Life Value (WLV) is a new and integrated approach which combines life cycle carbon models with Whole Life Costing (WLC). Different design scenarios can be modelled and optimised not just in terms of carbon and cost but also additional sustainability indicators such as water consumption or impact on biodiversity.

Crispin Burridge at M&S believes that "the adoption of a Whole Life Value model is crucial to a more informed way of working. A model that incorporates our key drivers such as maintenance and replacement cycles, utilities data and environmental factors such as carbon, will place us in a stronger position to understand the longer term impacts of our decisions".

The story continues

As the economic and environmental benefits of resource efficient buildings become better understood and recognised, these developments will become the norm rather than the exemplary exception.

In order to achieve this, the recommendations below aim to direct developers and investors in adapting to sustainable construction, and to prepare for the continuing evolution of green buildings:

Footnotes

1 Communities and Local Government, Energy Performance of Buildings, 2008.

2 Architecture as Brand Communication, Brauer G., 2002.

3 Department for Environment, Food and Rural Affairs (DEFRA) 2009.

4 British Land, Ropemaker Place, dcarbon8, 2009.

5 M&S DIRFT Expansion, dcarbon8, 2007.

6 Life Cycle Assessment of Two Kingdom Street, Paddington Central, dcarbon8, 2009.

7 2030 WRG, Charting Our Water Future, Economic Frameworks to Inform Decision-making, 2009.

Cost reduction – Is there any low hanging fruit left?

The ever increasing focus on cost

In a survey conducted by Deloitte in 2006¹, more than a quarter of FTSE 100 companies stated that they had started a cost reduction programme in the last 12 months and more than a third of the companies said that they had undertaken five or more cost reduction programmes in the three previous years. This was four years ago when the economy was strong and the outlook much more positive. In the intervening four years the economic environment has changed enormously with debt finance expensive and hard to find, company receiverships at an all time high and the country in debt to the tune of £950 billion². Against this backdrop, is there really any fruit, low hanging or otherwise, left to harvest in any current cost reduction programmes?

For real estate companies in particular, times have been hard with capital values depleted by 30 per cent over the last four years³ and little trading occurring over the last two years. For the majority of real estate companies their whole focus has had to change. To survive many have not only had to reduce costs, they have also had to change their revenue focus. They have not been able to rely on generating income from trading property, but instead have had to turn to maximising revenue from the existing portfolio. This causes a dichotomy: how can you seek to maximise revenue from the same assets you are stripping more costs out of, especially when you have reviewed the cost base most years? Surely to cut more will put current income at risk. In fact, more money may need to be invested in the portfolio just to hang on to existing tenants!

In this challenging operating environment-visionary, courageous leadership is required. To maximise revenues and minimise costs, real estate executives have to turn away from entrenched practices and think more strategically about the cost base. There can be no sacred cows. Successful real estate executives are looking at making their business more customer-focused. They are looking at and focusing on what tenants do and do not want from the property they occupy, and are re-defining their end-to-end processes. This, they hope, will leave them totally focused on value adding activity. Utilising the outsourced market becomes an option to assist better value delivery and overtly demonstrates value for money to their tenants. This root and branch examination of the business is revealing new low hanging fruit when it comes to cost cutting, and positions bold real estate companies to realise opportunities in the market.

The customer perspective – Making tenants happier for less

The market has, in the main, been slow to embrace customer service. It has by and large, stood remote from its customers and hidden behind the veneer of the institutional lease. Indeed, the UK Occupier Satisfaction Index 2009 published by the Property Industry Alliance and CoreNet Global UK found that commercial property occupiers are neither satisfied with the value for money they are getting, nor with the quality of service they are receiving compared to their other business-to-business relationships. This is disappointing but is addressable.

If one drills down further into the findings of the UK Occupier Satisfaction Index 2009 you will discover that whilst on the face of it, tenants are saying that they are being treated as a valued customer, they feel that the industry does not understand and is not responsive to their needs. They also say that communications are not as good as they could or should be, and that they are dissatisfied with the timeliness of the service charge management information they receive and with the value for money provided by the service charge. Retailers and small tenants in particular have these concerns.

Communication, or rather the lack of communication with tenants is the common theme underlying all of these areas of dissatisfaction. This is both communication with tenants to understand and to respond to their property needs, and also to communicate with tenants in a transparent, timely and accurate manner about the property they occupy.

Internal processes – Focus only on doing what adds value

It is all very well to say you are going to be more customer focused, however you also have to be able to demonstrate it and to continue to demonstrate it. This heightened focus on customer service, coupled with the change in business focus from capital appreciation to income maximisation from the existing assets, often requires huge cultural and behavioural change. Those involved in the provision and management of real estate may well have to learn new skills and roles, in terms of the activities they are asked to perform. Furthermore the processes for assessing their performance may also have to change.

To embed these changes and deliver tangible results requires a fundamental review of the real estate business and also its activities as outlined in figure 2. Whilst manufacturing industries have embraced these types of reviews for years, for many real estate companies, this is new territory.

Visionary and brave leaders embrace this fundamental and far reaching review of their companies' operating processes and structure. To succeed, clear goals and objectives must be defined and communicated down from the top of the organisation. Every aspect of the organisation must be reviewed and the processes redefined to ensure they are aligned with corporate goals and objectives (figure 3). Existing staff, suppliers and service partners including lawyers, surveyors, contractors and facilities managers should all be invited to participate in defining the new operating processes and to challenge existing practices. The emerging ideas should also be tested with tenants. The challenge is to get those involved with the review to think about how things could be done better and to put aside historic practices and barriers. The definition of the new operating processes should be detached from the allocation of responsibilities for activities. This comes later.

The consequence of undertaking a fundamental review of operating processes against a clearly defined vision and set of strategic objectives for the business, is that some activities that are currently performed, will be identified as no longer adding value and others will be identified for streamlining due to duplication of activities or multiple hand-offs between teams or people. These are the areas of new low hanging fruit where costs can be cut and efficiencies improved. Typical areas highlighted are around service scope, service levels, governance structures, data entry, data manipulation and reporting.

There may also be value adding activities that are identified which are currently not performed or are activities that have no clear owner. Often these are related to chasing-down and closing out of reactive calls.

Having redefined your processes and aligned them to your strategic goals and objectives, the next task is to determine the best way to deliver and source these activities and what the interfaces should be.

Leveraging the outsourced market – Building strong collaborative relationships

A common recurring theme from outsourced service delivery – which is particularly pertinent in driving out cost and improving quality of service – is that they fail to deliver the promises. This is either through lack of conversion into sustainable and commercially viable arrangements at the outset of the outsourced contract, or through the effective maintenance of the innovation benefits through the subsequent life of the relationship. Figure 4 outlines some of the common issues faced by real estate companies and how they can guard against them through the procurement lifecycle and incorporate the appropriate activities within the newly defined processes.

Conclusions

There is still low hanging fruit for real estate companies to harvest from cost reduction programmes, but to identify them requires a root and branch examination of current operating processes and relationships. The trading environment has acted as the catalyst for bold real estate companies to re-evaluate what their company does and how it does it.

With the resulting increased focus on revenue generation from the existing portfolio and on customer service, brave and courageous real estate executives are taking a leap away from entrenched practices. They are redefining their operating processes and model. This enables a total focus on value adding activity by using the outsourced market to deliver better value, thereby demonstrating value for money to their tenants. It is these real estate companies that are positioning themselves to respond nimbly to the opportunities in the marketplace.

Footnotes

1 Survey of over 120 UK senior executives on the issues they faced relating to cost reduction programmes. Conducted by Lighthouse Global Ltd on behalf of Deloitte, 2006

2 Office of National Statistics: Last figures reported to the European Commission, 2010. Based on December end 2009 figures – general Government debt was £950.4 billion, equivalent to 68.1 per cent of GDP

3 IPD All Property Capital Value index, movement between February 2006 and February 2010 rounded up from – 29.89%

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