ds newsletter q1 2013

NEWSLETTER Q1 2013

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Emerging Asias accelerating activity in green construction If energy consumption in India and China rose to American per capita levels, worldwide consumption would increase by 139%, even if populations stayed the same. Buildings are a significant contributor to Asias energy usage it is estimated that they consume 30% to 40% of total energy usage. With more than two thirds of the worlds population and a rapidly emerging and urbanizing middle class, Asia and its new buildings will have a decisive impact on worldwide carbon emissions over the next few decades. Today, per capita emissions in emerging Asia are still low compared to the ones of developed nations. But as Asias rural population moves to the cities, per capita emission will grow considerably. In general, urban populations consume about five to ten times more energy than rural populations. By 2030, urban China is forecasted to account for 20% of global energy consumption. Figure 1: What emissions path will Asias urbanizing nations take?

In China, new building stock nearly tripled between 1995 and 2005. In recent years, China has been adding roughly two billion square meters of new buildings annually of which 80% are deemed energy-guzzling. Today, there are 40 billion square meters of built-up area. Projections estimate that the Chinese building stock will triple again over the next two decades. Until 2020, 10 to 15 billion square meters of residential and 10 billion square meters of public new buildings will be constructed in Chinese cities. By 2030, the Peoples Republic will have built more new properties than the total amount of properties that exist today in the US. China is a giant construction market, far ahead of other still huge emerging markets in Asia.

Table 1: Size of construction market, USD billion

2010 2015 China 550 955 India 165 300 South Korea 74 140 Japan 92 102 Southeast Asia 46 81 The building sector in China is known for low durability, wasteful energy use and low environmental quality. Developers generally emphasize building speed and will often do anything to maximize profits, even if it means compromising building quality. An average Chinese building lasts 25 to 30 years, compared with 74 years in the US and 132 years in the UK. As Chinas huge cities frequently confront resource limitations and intolerable pollution, the government has recognized the need for more efficient and sustainable buildings. Unlike countries that industrialized earlier, China has the chance to marry sustainable development with rapid growth. With little or even no incremental cost, buildings that consume only a fraction of the energy used in conventional buildings are an obvious area to incentivize action. However, there is still little green building activity in emerging Asia, mainly because developers in these markets fear that building green will be too expensive and take too long. Indeed it requires some knowhow and experience to select the right measures that make a development more sustainable and not too costly. In addition, since property prices in emerging Asia are generally much lower than in developed countries, the incremental cost of the green attributes needs to be lower and in an affordable relation to basic construction cost. These issues, however, can be overcome. For example, improvements in design and insulation increase energy efficiency at little cost, while the cost of geothermal or solar energy solutions often still exceed their relative benefit. The challenge is to select the most effective, cost efficient measures to build green that appeal to a broad range of buyers.

Spreading the word

Over the last ten years, China has gone from just one certified green building project to nearly 600 more than 550 of them built after 2007. Drivers of the trend include concern about climate change, enhancement of brand image, and a better-informed market. New green building floor area has grown to over 8 million square meters by 2012. However, this

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still amounts to less than 0.5% of annual new construction floor space in urban China, just a small fraction of its potential size. While the few commercial buildings targeted at multinationals typically choose the US LEED (Leadership in Energy and Environmental Design) certification due to its international recognition, the Chinese Three-Star System introduced in 2006 has also seen strong growth, with roughly 200 buildings certified at the highest level of the program. Besides residential developments, most of these certifications are for government buildings. Chinese leaders believe that to initiate change, the government must step in as a pioneer. However, the increasing popularity of the green agenda in Asia is not just driven by governments but also by an awakened civil society that is spurring developers to engage in more conscientious development programs. Figure 2: Increasing searches for green buildings on Baidu, Chinas leading internet search engine

Despite growing public awareness about the environmental benefits of green buildings, as well as increasing governmental support, there is still limited public awareness of the health and comfort benefits, as well as of the associated economic rewards, that green buildings provide. As a result, genuine demand from the market to construct green buildings is also limited. A 2012 survey reports that energy cost savings and energy security are the most important drivers to build green, followed by government policy and enhanced brand or public image. If the word spreads that green also means healthier and more comfortable living, there could be a much greater boom, especially since health issues are becoming increasingly more important to Asian families. As we spend 90% of our time indoors, buildings largely determine the quality of the air we breathe, as well as the temperature and light quality we experience. At home, this means healthier sleep, better learning, and more comfort. At work it leads to more motivation, fewer sick days, and higher productivity. As incomes and living standards rise and awareness improves, consumers will demand more durable, safe and healthy buildings.

In Europe and the US, studies show that the market pays a premium for green buildings that not only outweighs the additional construction cost, but also the expected energy savings. It seems homeowners are ready to pay for better indoor quality at home, and corporations for a better environment in office buildings. Because salaries represent by far the largest cost factor for the average corporate tenant, sustainable buildings create value by reducing sick days and improving productivity. In the 2009 China Greentech Initiative Green Building Survey, the majority of Chinese building professionals believed that buyers were willing to pay a massive premium up to 20% for green buildings. The RICS Global Property Sustainability Survey of the same year found similar results, although not as extreme. Owners and investors in the BRIC countries would pay up to 10% more for sustainable buildings, with governments of India and China supporting the stance. For developed nations, owners and investors willingness to pay is lower as basic building standards are already high. Governments on the other hand traditionally act as role models.

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Singapore as a role model Singapore, named greenest city by the Asian Green City Index that compares 22 cities in Asia, has attracted numerous multinational companies to base their regional headquarters there. Many multinationals have strict corporate sustainability measures and the wide availability of green office buildings and infrastructure make Singapore an attractive choice. Besides new construction, retrofits take an even more important role to green the city, but green measures are also more expensive for retrofits than for new buildings. Singapores Building and Construction Authority (BCA) launched a Building Retrofit Energy Efficiency Financing pilot scheme last September. By collaborating with financial institutions, the program helps facilitate loans of up to SGD 5 million (USD 3.95 million) for commercial building owners and energy services companies to carry out retrofits under an energy performance contract that specifies a minimum level of energy savings to be achieved. Under the scheme, BCA shares the risk of default with the banks issuing the loans. Singapores target is to green 80% of its building stock by 2030. When the target was launched in 2005, there were only 17 green building projects on the island state. Today, the number is more than 940. This translates to more than 28 million square meters of gross floor area (or 12% of the total gross floor area) in Singapore. Further, Singapore inspired governments in Thailand and Malaysia that have also started to incentivize green buildings over the last 10 years.

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Table 2: Up to what premium would you be willing to pay for a sustainable building (RICS survey)?

Owners Investors Governments Russia 10% 10% 3% Brazil 10% 10% 0% India 10% 10% 12% China 10% 10% 10%

Australia 5% 5% 13% Canada 5% 5% 15% Germany 5% 8% 15% UK 5% 5% 10% USA 7% 5% 10%

This indicates that emerging markets can generate demand to self-sustain green building activity in the mid to long run. For now, governmental incentives are still needed.

Governmental catalysts

China has set a goal of reducing the economys carbon intensity by 40% to 45% by 2020 compared to 2005 levels. As improving energy efficiency in buildings is the least costly carbon abatement strategy available, the Chinese government has a strong motivation to promote green buildings. In 2010, the central government mandated that new buildings should use 50% less energy compared to the existing building stock, with a more ambitious target of 65% for major cities such as Beijing, Shanghai and Tianjin to be extended to the rest of the country over time. The government will step up enforcement of national building energy codes beyond first tier cities, where substantial progress is made, to the faster growing second, third and fourth tier cities where compliance still lags. The goal is that energy-efficient buildings account for 30% of all new construction projects nationwide by 2020 in order to bring its building energy consumption ratio closer to that of developed countries. A document jointly released by the Ministry of Finance and the Ministry of Housing and Urban-Rural Development (MOHURD) stated that policy incentives will be increased, industry standards improved, and related industries will be developed to meet the target. According to the document, construction of energy-efficient buildings will be subsidized according to the Three-Star System. Buildings with the highest, three star certification are eligible to get up to RMB 80 (USD 12) per square meter, and those with two stars can get up to RMB 45 (USD 7). The first subsidies for green buildings were already granted in 2010. Further, all government-funded public welfare projects and low-income housing projects shall apply green construction standards by 2014. Chinas new Five-Year Plan issued in 2012, the greenest ever, aims to accelerate the green building market. It consists of 24 general targets, whereof 12 are mandatory. Out of these 12, six are environment related. Once a policy is established at a central government level, one can assume that

implementation will start kicking in as these plans are strictly enforced. Moreover, the government also allows banks to grant mortgage discounts to eco-friendly homes. Finally, small towns where newly-built green buildings take up over 30% of the total land area will be named green towns and will be granted one-off subsidies of RMB 10 to 20 million.

Truly green?

There are still numerous obstacles to the development of green buildings, but one of the biggest is lack of consensus over what makes a building green. Only if there is a widely accepted definition of green buildings that certifies that the associated benefits are true, buyers and investors will be willing to pay for it. It is likely the only path by which a sustainable green building market will emerge. In China, the Three-Star System is by now widely known and accepted by the public. However, the standard, originally modeled upon the US LEED criteria, needs to be developed further and made simpler and more transparent. It is still quite subjective and has more qualitative than quantitative indicators. While it already offers some provincial flexibility, local certification offices may eliminate specific items if they are not compatible with geographic or climate conditions of the local area. The impact is that green building certification practices vary, and the rigidity in measurement differs from province to province.

Short history of green building ratings

Up until the early 1990s, there was no widely accepted method to assess the overall impact of a building in terms of its environmental performance. The UK took a leadership role in measuring and rating green buildings, an approach that was adopted in various guises across the globe.

1990: UKs BRE Environmental Assessment Method (BREEAM) is the first scheme launched to address energy efficiency in buildings

1994: Switzerland introduces the MINERGIE standard. Today it boasts the highest density of certified green properties in the world

1996: Hong Kong launches the Building Environmental Assessment Method (HKBEAM)

1998: US launches LEED

1998: Australia introduces NABERS and later Green Star in 2005

2002: Japan establishes CASBEE

2005: Singapore launches Green Mark

2006: China initiates the Three-Star System

2009: Malaysia launches the Green Building Index

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Because building code enforcement is inconsistent across provinces, developers may sometimes have little incentive to follow legitimate green building measures. There are 21 so-called Green Building Label Management Offices that are authorized to review projects across China for one or two star certification, while a three star rating must be evaluated by a centralized institute in Beijing. As building green expands, the challenge will be to ensure consistent and objective evaluators across certification levels. A lack of uniformity limits the reach and market impact of Chinas green building activities. The application process for the new government subsidies is also unclear at both the central and local levels, and streamlining is required to make the incentives calculable for developers. How to tackle the remaining challenges

Another 2012 survey in China reveals that lack of technical expertise was named the top barrier to energy efficient buildings, named by 23% of the executives interviewed. Interestingly, this number was only 16% the year before, indicating that decision makers are only now becoming aware of what building green actually means. Figure 3: Barriers to invest in green buildings in China, 2012 versus 2011

China has a shortage of professionals who are qualified to execute integrated green building design and to perform operations and maintenance for these buildings. International education and experience is highly welcomed by governments, developers, and constructions companies to improve the quality standards. Further, Chinese developers have stated they are hesitant to build green because of higher upfront installation and labor costs due to green design

specifications. Developers are accustomed to building quickly and cheaply. In the long run without government support, stakeholders can only be aligned if buyers and tenants are willing to pay more for green buildings, if the premium paid outweighs the upfront cost, and if both investors/owners and developers are aligned to split the associated profit. A number of actions must be taken to overcome the challenges, to close the information gap, and to improve market demand:

Improve measurements and quantitative indicators for green building certification

Execute a clear and accessible process for developers to take advantage of green building subsidies

Ensure and monitor adequate training for the green building construction and facilities management workforce

Improve public awareness of the benefits of green buildings, specifically regarding healthier indoor environment and reduced operation costs

Implications for Investors Emerging Asia has the opportunity to avoid the unsustainable development patterns of the 50ies to the 80ies in the west. Building green is one, if not the most, crucial part of the solution, and will also prove to be commercially very rewarding if challenges such as public awareness, unambiguous definitions, and proper alignment between all stakeholders are overcome. Encouragingly, evidence suggests that green building economics in emerging Asia are favorable. Consumers are increasingly willing to pay more for green buildings, the cost premium for developers can be modest, and energy savings can translate into short payback periods for owners. In addition, as Asian governments continue to reduce the carbon intensity of their economies, green buildings are the ideal area for carbon reduction at minimal cost. To start with, the 2% to 10% increased building cost (compared to very low cost conventional buildings) can easily be recovered within two to four years through the 30% to 50% reduction in operating costs and energy savings that green buildings offer. Further, rents are typically 3% to 10% higher for green buildings compared to conventional buildings, and the resale value of green buildings increases by 5% to 15%, considerably improving the return of the investment. From a risk perspective, green properties are less exposed to business cycle volatility and less prone to vacancy risks since they are generally preferred to conventional buildings. As the market anticipates stricter future regulation and as resale risk is also mitigated, capitalization rates are generally about 0.50% to 0.60% lower. Finally and maybe even most importantly, building life is massively extended, from an average of 20 years to at least 50 years. In

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addition, if the floor layout is designed to be flexible in use, the building value will also depreciate much slower than normal. Non-certified buildings on the other hand face valuation downgrades and substantial investment in increasingly mandatory sustainability enhancement. Business behavior is changing rapidly as well. Corporate responsibility policies require firms to occupy green real estate globally, which also has a substantial impact on the demand in the commercial real estate sector. More and more firms realize that occupying green space improves their corporate reputation and their ability to attract and retain employees. The premium for green buildings observed in the market is hence not just attributed to energy cost savings, but also to softer factors valued by tenants. Higher comfort, better ventilation and more natural light result in improved health, higher performance of students or employees as well as lower sick rates. Given that salaries are the bulk part of the cost for an office based corporation, the improvement in employee productivity and the reduction in absenteeism pays for the green premium many times over. n

Sources CB Richard Ellis; China Daily; CEIC; Centaline; CitiBank; Colliers International; Credit Suisse Research; Cushman & Wakefield; Deloitte; Diener Syz Real Estate; DTZ Research; Economist Intelligence Unit; Frost and Sullivan; GaveKal Dragonomics; IMF; institute for building efficiency; Jones Lang LaSalle; Knight Frank Research; KPMG; LaSalle Investment Management; McKinsey Global Institute; Morgan Stanley Research; National, Provincial, and Municipal Bureaus of Statistics; Nomura Research; Peoples Bank of China; Political & Economic Risk Consultancy Ltd; PricewaterhouseCoopers; Reuters Real Estate; Savills; Shanghai Daily; UBS Research; WTO; Xinhuanet Disclaimer 2013 Diener Syz Real Estate AG, Switzerland. No warranty can be accepted regarding the correctness, accuracy, uptodateness, reliability and completeness of the content of this document. Diener Syz Real Estate expressly reserves the right to change, to delete or temporarily not to publish the contents wholly or partly at any time and without giving notice. This document as well as its parts is protected by copyright, and it is not permissible to copy them without prior written consent from Diener Syz Real Estate. This material does not take into consideration the specific investment objectives, financial situation or particular needs of any person that enters into a relationship with Diener Syz Real Estate. No representation or warranty, expressed or implied, is made by Diener Syz Real Estate regarding future performance. This material is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of, or located in, any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or subject Diener Syz Real Estate to any registration requirement. The document may contain forward-looking statements that reflect Diener Syz Real Estates current views with respect to, among other things, future events and financial performance. Any forward-looking statement contained in this material is based on our current estimates and expectations and are subject to various risks and uncertainties.

Diener Syz Real Estate Diener Syz Real Estate is an investment manager offering specialized expertise in Asias real estate markets. Our strong local presence allows direct access to the most attractive investment opportunities. We strongly believe that sustainable real estate provides both financial and environmental benefits. Our investment approach takes advantage of a broad range of investment instruments to optimally address prevailing market cycles in Asias very dynamic market environment. We invest both capital and knowhow into sustainable real estate development projects in Asia, sourced through our strong network of local developers in cooperation with government agencies. Contact: Dr. Juerg Syz, MBA INSEAD, CFA [email protected] www.dienersyz.com

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