The electrification of real estate: the next generation of buildings

To level set, the energy transition, or the expansion of how energy is produced, transported and consumed across industries, is gaining traction globally. There are multiple factors accelerating the transition away from fossil fuels and toward green and renewable sources of energy:

• Economic growth
• Tax and economic incentives
• Government regulations
• Energy costs
• Transportation costs
• Consumer behaviors

Often, the “energy transition” is used synonymously with “environmental, social and governance (ESG)” matters. However, the energy transition is both a subcomponent of ESG and something separate altogether. Largely, however, it focuses on the E, or environmental sustainability, and requires a careful look at both energy production and energy consumption.

The role of commercial real estate in the energy transition is coming into focus given the high amount of energy consumed by buildings across the world. However, there are a number of cross-sector implications that can drive opportunities and present unique challenges to commercial real estate.

Rising energy and transportation costs, and concern about the impact of fossil fuels on climate change and air quality, have accelerated the conversation about energy transition. The focus on reducing emissions has been met with action from both the public and private sectors. ESG-related reporting requirements, including the expected finalization of the Securities and Exchange Commission’s proposed climate disclosure rule, the International Sustainability Standards Board’s exposure draft on sustainability-related disclosures, and public company reporting requirements already established by other rulemaking entities around the world, are moving companies toward action.

Additionally, another driving factor of change is legislation. In the US, the Inflation Reduction Act of 2022 represented the largest investment in mitigating climate change in US history. It was a US-centric set of provisions, but similar incentives are happening around the world in an attempt to drive behavior. There is movement in commercial real estate to take advantage of these credits and incentives to accelerate energy transition, and it is filtering down into the broader real estate sector.

Fully electric buildings offer a clear path to decarbonization, but there isn’t a cookie-cutter answer to adoption; property use, building vintage and local market considerations must all be considered. Ramping up to 100% electricity within commercial real estate will require a transitional journey, with no one-size-fits-all model to implementation. The speed of the transition will be impacted by the flow of capital and a delicate balance between stakeholder considerations and project economics. Real estate owners and their stakeholders often have different net zero aspirations, emission reduction targets and interim hurdle dates that they are working toward. The real estate ecosystem is characterized by a highly integrated value chain that makes going fully electric complex, and it will continue to shift and evolve in the years ahead.

Aside from capital and stakeholder considerations, there are several key, practical hurdles to fully electric buildings. One is the equipment required within the building to make full electrification work. Heat pumps require a fair amount of square footage, as well as modules that are fully exposed to the air. As the heating load increases, so does the amount of modules needed. So going fully electric becomes a question of space. And in markets with high development costs, it can be a costly decision to lose income-generating, rentable area.

On the webcast, a case study involving a newly built office building in New York was highlighted; a full electrification strategy on this property would require mechanical, electrical and plumbing (MEP) space equivalent to an entire floor of rentable area, or 4% of leasable space. The question posed was simple, but with complex implications: Is the cost of going green today worth the loss of net rentable income tomorrow, and through the life of your investment?

Another concern is water temperature. For an air source heat pump, the required water temperature of 140 degrees Fahrenheit is not compatible with most existing building stock. One workaround is putting water heating equipment on the roof. At a building in Boston, highlighted on the webcast, this required a doubling of roof area to install a system that would meet the hot water demands of the space. But this isn’t feasible in all properties and markets.

Furthermore, building electrification looks different in different regions, making implementation a highly customized process. In the southern US, where the climate is typically warmer, heating isn’t as much of a concern. But in northern cities, such as New York, Boston and Chicago, reliable heating power is a must. Overall, the variability of the local climate can have a direct impact on the return on investment (ROI) of fully electric buildings.

And more importantly, the considerations of fully electric buildings look different for existing operational properties vs. new development. Retrofitting an existing building for fully electric function vs. constructing a new building that is 100% electricity powered comes with a different set of costs and considerations. Companies are invested in electrification, and, undoubtedly, there will be innovations that those in the real estate sector can consider when evaluating potential electric building strategies.

Landlords should undertake a cost-benefit analysis when exploring an electrification strategy. This analysis will vary depending on where you are located. For example, electrification in New York will produce a very different outcome than in Texas, as New York is more progressive in terms of climate legislation. New York City has already released a series of laws that are setting the standards for large cities around the world; specifically, regulation that penalizes landlords for not meeting greenhouse gas emission targets (Local Law L97), as well as mandates for all-electric buildings for new construction at a future date (Local Law 154). When weighing the decision of going fully electric, property owners can begin their own assessment by looking closely at the cost of electricity, the policies in their city or state, and the potential fines and/or benefits in that market.

Then, several key variables should be considered to evaluate the ROI of electrification. Some variables are objective, regardless of building type or market. What’s the implication of installing electrification equipment (e.g., heat pumps) on net rentable area? What’s the initial cost outlay of purchasing a heat pump? These questions are fairly easy to calculate.

Then, you get into greater unknowns. What is the rent premium in the market for electric buildings? How does this differ in a suburban location vs. a metro location? And, of course, the cost of energy must be considered.

“When you look at certain expenses, there is an absolute number you can plug in,” said EY Americas Real Estate, Hospitality & Construction Leader Mark Grinis. “What’s going to be the cost of a heat pump? That’s something you can calculate. But then you get into areas of subjectivity. What’s the cost of energy going to be in the future? There’s definitely judgment and a fair amount of uncertainty that goes into determining that figure.”

Implementation costs can vary greatly depending upon the type of design or approach you take. For example, some property owners think a good approach is to deploy a flexible design strategy to deal with market and regulatory risks. This would involve a building design that includes enough space to accommodate either a gas boiler or a heat pump. If a gas boiler is used during initial construction, a heat pump can then be installed at the end of the lifetime of the gas boiler. While this works well for certain buildings, the cost range can differ with each building’s unique situation and existing characteristics.

Ultimately, landlords must evaluate and balance the cost of accelerating the transition at their properties and the expense of electrification — including known and unknown variables.

“Property owners need to have an appetite to make economic sense out of these variables,” said Juan Palacios, Director, Climate Initiative, MIT Center for Real Estate. “In a market where going green is supported by the market and local regulations, the pathway forward could be advantageous. In a market with no demand and no premium, the effort may be hard to justify.”

The commercial real estate sector is in the early stages of adopting full electrification, as is the market to finance a property’s transition to 100% electricity. Commercial real estate leaders are still developing leading practices, incentives to offset investments are still being defined, and the ROI of electrification technology must be evaluated on a building-by-building basis. However, there is no shortage of companies and innovators developing capital strategies to finance the transition.

Look no further than to the equity markets for emerging capital vehicles; the capital markets offer clean energy equities, climate-related special purpose acquisition companies (SPACs) and ESG-themed exchange-traded funds (ETFs). There are also angel funds, bridge financing, green and sustainability bonds, C-PACE (commercial property-assessed clean energy) loans and new startups, among other capital sources.

Additionally, there is also the option to sell certain renewable-energy-related US federal tax credits, which is rising in investor interest. Specifically, property owners that generate certain types of US federal tax credits may be able to sell them in the market one time for cash, which is expected to open up a new capital source and significantly drive demand and investment in projects.

Ultimately, with both private market and public sector support, landlords will have an increasingly growing option of capital sources to finance real estate’s energy transition. We are in the early stages of fully electric buildings, but the innovation we’ve seen in the technology and financing market to date is promising.

Electrification will not happen overnight as the energy transition is not a black and white concept. But the groundwork is being laid to make it a viable option for early adopters in the commercial real estate sector.