There is growing criticism from investors, lenders and auditors that real-estate valuers are being too slow to incorporate environmental, social and governance (ESG) factors into their work. However, valuers in most markets still lack sufficient evidence and data to quantify and reflect ESG risk adequately. This stalemate has been dubbed the valuation deadlock.
There is a concern that if these ESG factors are not reflected in valuations then a carbon bubble could form. In effect, this means that property valuations do not reflect the costs and benefits of decarbonisation, along with other transitional risks, such as non-compliance with upcoming legislation or failing to meet market expectations or requirements in terms of ESG performance. The danger is that this carbon bubble could lead to sudden pricing adjustments and market shock were it allowed to grow too large and be reflected too late.
From a valuer's perspective, there is also a concern that valuations themselves could lose credibility if they do not adequately account for the physical and transitional risks associated with ESG and climate change.
All RICS members and regulated firms, wherever they practise, are required to comply with the sustainability and ESG technical standards in RICS Valuation – Global Standards (Red Book Global Standards). They should also follow the advisory sustainability and ESG standards, such as VPGA 8, unless there is legitimate reason not to.
Red Book Global Standards notes that 'valuers should reflect markets, not lead them'. This is one element of the deadlock: although the valuer is aware of sustainability risks, they cannot reflect them in a valuation undertaken on the basis of market value or fair value if there is not sufficient evidence that investors in the market are also doing so.
This in turn limits lenders' ability to underwrite ESG-related risks. Real-estate investors who are improving the ESG credentials of their assets suspect valuers will not reflect any consequent improvement in value, despite the capital expenditure they have invested. That sometimes makes them unwilling to invest in improvements or incorporate sustainability comprehensively into their pricing decisions, which then leads to a lack of market evidence.
The risk is then that a carbon bubble may form (see Figure 1). This could artificially skew asset values and increase the risk of them becoming stranded over the medium to long term.
Figure 1: The carbon bubble
The Urban Land Institute (ULI) has published Transition risk assessment consultation guidelines that aim to tackle the issue by standardising the assessment and disclosure of climate transition risks as part of property valuations.
The ULI's draft proposals provide guidance for owners or managers and valuers, along with standardised disclosure templates and resources for sharing and understanding ESG data.
If they are going to deflate the carbon bubble, how can valuers reliably reflect ESG risk and value its effects in a way that aligns with RICS guidance? From the perspective of a valuer, there are several barriers: namely, data, evidence and certainty.
Data relating to ESG and real estate comes in many forms, such as energy performance certificate (EPC) ratings, consumption data, environmental risk assessments or voluntary certifications, to name a few.
The breadth of potential ESG data points and a lack of agreement on which are material to liquidity and value means such data is not comprehensively collected, supplied or even understood by many real-estate professionals. This inconsistency makes it difficult for valuers to assess and benchmark ESG performance and risk.
Meanwhile, although clear market evidence is the Holy Grail for valuers, evidence relating to ESG and its impact on pricing tends to be opaque at best. One reason for this is that the market does not assess the impact of ESG in a consistent way.
Hypothetically, if an asset were available for purchase and a range of investors completed due diligence, they could each take a different approach to pricing the costs and benefits of decarbonisation.
Although investors' views of many asset characteristics will only differ marginally, it can be more pronounced when it comes to ESG factors. Conversely, they may not even have been considered in some instances.
Certain investors may consider the potential cost of decarbonisation, leading them to submit a more conservative bid, whereas an investor who does not consider these costs may end up purchasing the asset having submitted a more competitive offer.
In this scenario, the transactional market evidence of investors factoring in ESG fails to become formalised. It should be noted that cost does not necessarily equate to value and incorporating ESG into value considerations certainly does not always lead to reduced value.
Next, while valuers have some experience in dealing with relative uncertainty, there can be an additional layer when it comes to ESG. For example, the future legislative landscape, and how it will affect real-estate owners and values, is not always clear.
Many countries are in the process of creating, altering or adding to their ESG legislation, and are taking varying approaches to doing so. In many cases, it remains to be seen how or when these factors will become material to value.
Monitoring and predicting trends in the occupational, investment and debt markets also entails managing uncertainty. Many market participants are adopting ESG commitments and adapting their behaviours to align with the goal of achieving net-zero carbon.
However, this is not being done in a standardised way across geographies and sectors. It is also partly down to how different investors and lenders in the same markets incorporate ESG differently into their pricing decisions and risk analysis.
RICS and other international standards being developed, such as International Financial Reporting Standard–International Sustainability Standards Board S1 and S2, can help support the standardisation process.
Due to the variability of decarbonisation approaches and lack of benchmarking databases, there can be uncertainty around the cost of decarbonisation if reliable data is not provided. RICS standards state that valuers should not go outside their area of competence, and that additional specialist advice for such matters may be required.
Although it may be possible for a valuer to analyse and predict trends relating to these vast and complex variables, they would be to step ahead of the market if they did so. The market has not yet agreed on a clear definition of sustainability expectations or how these should be financially reflected – and thus a valuer assessing these trends would fail to reflect markets, not lead them.
There are of course differences in how ESG is reflected across geographies and sectors, and valuers need to be aware of these so they can make appropriate enquiries and adjustments. However, even within the same markets, different investors and managers are taking different approaches to reflecting ESG, making it difficult for a valuer to understand how to reflect ESG performance and credentials, even in specialist teams.
'Although clear market evidence is the Holy Grail for valuers, evidence relating to ESG and its impact on pricing tends to be opaque at best'
This challenge is not insurmountable, and it is important that these barriers are overcome. There are some recommended practices that could be adopted or encouraged to break the value deadlock.