This story was written and reported by Sharon Smyth in London with reporting by Paul Norman and Bert Erik ten Cate in London, Luc-Etienne Lafond Rouillard in Paris, Richard Meier in Freiburg, Germany, and Katherine Hamilton in Washington, DC.

Soaring energy costs across Europe and the world, sparked in part by Russia’s invasion of Ukraine, are reshaping real estate values and occupancy, with different sectors and countries suffering varying degrees of pain.

Since 2021, wholesale electricity prices in the United Kingdom and the European Union have soared due to increased demand as the economy recovers from the pandemic and a rise in natural gas and coal prices. The February 2022 invasion of Ukraine, which provides 40% of Europe’s natural gas, exacerbated the trend, leading to an energy supply shortage and a further spike in costs.

In the face of this, office tenants across Europe are projected to flock to the estimated 10 million square metres of new office stock to be delivered on the Continent by the end of 2023 as the crippling costs prompt tenants to seek greener buildings to lower their bills.

Speaking to CoStar’s sister title Business Immo, Bruno Amsellem, a corporate real estate advisory partner at Deloitte France, said the company has coined a phrase for just how difficult it is to understand and make predictions about how rising energy and inflation costs are affecting real estate occupancy and values.

“This is what we at Deloitte call ‘climateflation’, ie a rise in prices due to the effects of climate change that could be masked by the COVID-19 pandemic and the war in Ukraine,” he said. “Unlike individuals, businesses [in France] are not entitled to government support on energy costs, so they will have to switch to buildings that are energy efficient to reduce these costs.”

Amsellem argues that the gap between “prime” buildings, and energy-intensive assets that are unsuited to flexible office occupancy, for example, will only become more pronounced. “We will no longer think in terms of rental value and square metres, but in terms of operating costs, rationalisation of office space, but also in terms of the benefits for the company’s ‘talents’.”

The Picture Across Europe

Speaking to CoStar News at the Expo Real conference in Munich, Xavier Jongen, a managing director at Catella Residential Investment Management, which invests in residential across Europe, said rising energy costs was making it re-evaluate which countries it invested in.

Jongen said that “until recently” his company would have looked at provincial cities where house prices and rental increases have not been as strong as in the major cities as they offered less volatility and risk.

But Jongen said the war in Europe brought geopolitics back to “the investment scene and at number one level”. Now, Catella is looking at where countries get their energy from, he said.

“Poland is terrible because of the use of brown coal,” he said. “Decarbing your assets there is five to six times more expensive than in, say, Austria,” he said. “Germany has lost a lot of competitiveness because the energy mix is so bad; it is the same with the Netherlands.”

A recent report by property consultant Colliers’ Dutch arm said industrial real estate and the hospitality sector are particularly hard hit by higher energy costs, and it is likely to be the same story across Europe.

These sectors are struggling because energy costs are high relative to turnover and occupancy costs. Colliers says energy costs for industrial real estate are 40% higher than occupancy costs. In hospitality, that figure rises to 25% for food and beverage businesses and 21% for hotels. The office sector has the lowest energy costs, at 12% of occupancy costs.

Colliers says companies are struggling as natural gas prices are five times higher than they were in July 2021, but a majority are reluctant to pass on the higher costs to their customers because they too have been hit by inflation.

In Germany, Demire, which owns 900,000 metres of office, logistics and retail, did pass on ancillary costs — including energy cost — to its tenants in the first nine months of the year to the tune of 25% higher than those in the same period in 2021. This far outstripped rents, which went up by 4.9%.

But here, the impact is perhaps most pronounced in the residential sector.

Skyrocketing prices in the country, which is particularly reliant on Russian gas, are leading to rising ancillary housing costs and are reducing the potential for further rent increases for residential landlords, as tenants simply won’t be able to pay them. Assuming a rise in heating costs of at least 100% or 150% compared with 2021, total rental costs would increase by 22%, according to a recent Moody’s report on the housing market.

According to an analysis by JLL, the average sale price difference between residential buildings in Germany, whether single- or multifamily, with a poor energy performance and energy-efficient properties in the first half of 2022 is between 12% and 33%. In individual cases, the sale price reduction can be almost 50%, based solely on better energy efficiency.

Carbon pricing is levied by the government on fossil fuel-driven heating. These fees are legally distributed between tenants and landlords and are currently €30 per tonne of carbon dioxide. This will rise to €35 in 2024, €45 in 2025 and €55 in 2026. According to the country’s energy agency around 75% of the approximately 19.4 million residential buildings and approximately 1.98 million non-residential buildings are heated by oil or gas.

The splitting of costs is regulated in Germany. For commercial buildings they are divided equally between users and the owners of the building but a complex way of distributing the costs will kick in for residential real estate in 2023. The regulations mean who pays depends on the energy efficiency of the building, ranging from 0% for the landlords of the most efficient properties up to 95% for the worst performing buildings.

Sector Differences

Occupiers in the UK alone saw office occupancy costs hit a record high on the back of roaring energy prices which surged 194% from last year, according to an office cost survey published by the property consultancy Lambert Smith Hampton earlier this month.

While it is difficult to piece together like-for-like comparisons of how different real estate asset classes, they are all taking a major hit.

Plenty of major occupiers have pointed to rising energy costs as a factor in recent moves to scale back expansion and in some cases offload real estate.

In August companies from across the UK’s pubs sector wrote to the government to demand a price cap on energy bills. Pub groups said energy prices have risen by 300% in some cases and that they too are paying more for gas and electricity bills than rent.

This winter is likely to be particularly bleak for the country’s dwindling listed pub groups, such as JD Wetherspoon, Mitchells & Butlers and Fuller Smith & Turner. JD Wetherspoon has already fixed its energy prices for 2023, but this month it said it was selling another chunk of its pubs as it faces higher wage costs and sales alongside concerns about energy costs.

On 14 November, the Office for National Statistics in the UK underlined the issues stating that “energy costs have been a significant worry for businesses across the UK in 2022 as gas and electricity prices have increased”. It says 58% of food and drink service sector businesses said energy prices were the main concern for November 2022, up from 39% in October.

It is pretty bad across the beleaguered retail sector too. A welcome recovery in the first half of the year, which had encouraged a major upturn in leasing and investment activity across European markets, has rapidly slowed.

November has seen a major player on the UK high street fail with the clothing retailer Joules, which has more than 130 shops, entering administration. It, in part, blamed the cost-of-living crisis.

Segro, one of Europe’s biggest owners of warehouses, warned in its most recent results that it is getting much more expensive and difficult to build logistics hubs across Europe, partly because of rising energy costs.

The real estate investment trust has a £21 billion property portfolio spread across Europe and has said Russia’s invasion of Ukraine and the resulting energy rise exacerbated already soaring costs of labour and materials.

All of this means higher building costs but these are being passed on to occupiers via sharply rising rents at the types of prime warehouses that Segro develops. But how far can this go before tenants stop signing on the dotted line?

Segro, alongside most of the listed industrial sector, took a hit to its share price for the first time in years when key occupier Amazon said it might have enough space for now.

Another landlord that sees developing energy efficient and more sustainable buildings as a critical business opportunity is London developer GPE, which this month pointed to its huge letting to law firm Clifford Chance in the City of London as a clear example of the prize at stake.

Chief executive Toby Courtauld says Clifford Chance had sustainability considerations and how they spoke to its corporate values at the top of the list. “It was more important than the financials of the deal.”

Nick Sanderson, GPE’s chief financial and operating officer, said customer demand for space that is sustainable and energy efficient is feeding into valuation. “Our results show the high EPC rated assets performing relatively strongly compared to those that have lower ratings. We are looking out for owners of assets that have sustainability challenges. The challenge when they come to refinancing – and there will be challenges already because of interest rates – and they need to put more capex in to meet sustainability targets, will lead to opportunities.”

An energy performance certificate gives a property an energy efficiency rating from A, the most efficient, to G, the least, and is valid for 10 years and there are similar scheme across Europe.

Mind the Gap With Offices

The jump in energy costs will widen the gap between prime and secondary European office rents as businesses in less sustainable buildings spend increasing amounts on operating their premises, according to Mike Barnes, associate in the European research division at Savills, who says rents for less energy efficient buildings in Europe have flatlined over the past 12 months while those at their greener counterparts have risen 5.5%.

Berlin, Germany’s capital and largest city, has seen the largest divergence with rents for newer, more efficient buildings rising 13% year on year, compared to a mere 3% increase for secondary offices, Savills data shows. In Paris, where a tight vacancy rate of 2.4% has supported secondary rents, prime rents have risen 7% year on year, compared to 6% for secondary offices.

Energy costs are also often factored into service charges by landlords, with annual service charges surging by 50% in Amsterdam, 20% in London City and 7% in Dublin, Savills’ data shows.

“Disruption to energy markets and policy changes will continue to push forward the green agenda, encouraging occupiers to opt for prime assets to reduce their overall energy outlay,’’ said Barnes, adding that landlords will increasingly rely on retrofitting to meet standard and reduce costs.

The gap in rents between green and brown buildings will widen as European governments such as the Netherlands deem offices with energy performance certificate ratings below C unlettable by next year, while the UK government is considering implementing a minimum EPC rating B by 2030.

Another result of the energy crisis and its inflationary effect on the cost of building materials is that fit-out costs have also risen by an average 21% year on year, further weighing on tenants’ final costs. The biggest increase in costs was in Frankfurt, and London City where costs surged 30%, followed closely by Madrid which saw prices jump 26%.

According to a recent survey by JLL, 74% of commercial real estate leaders said they would pay a premium for leasing a green building to mitigate rising energy and meet wider sustainability goals. The broker says that across 10 major cities in Europe and North America, 90% of the office stock is over 10 years old, and even offices completed just over five years ago are not likely to comply with future energy efficiency standards.

Retrofitting could provide energy efficiencies of at least 10% in the case of a light retrofit and as much as 60% for a deep one, according to the broker which estimates that the potential cost of retrofitting office stock across 17 major countries across the globe including Canada, China, Germany, France, the UK and the US could reach $3 trillion.

The View From the US

The U.S. relies far less heavily on Russia for energy than Europe does, but its real estate market is still experiencing shockwaves from rising energy costs. Most notably, spikes in utility expenses may be playing a role in decreasing office leases and net-lease agreements, where the tenant pays those costs, industry analysts say.

While Europe gets 40% of its natural gas from Russia, the United States doesn’t import any. It does, however, get about 8% of its oil from there, the same amount as the European Union, according to the U.S. Energy Information Administration.

The price of electricity for commercial use was already gradually increasing in the years after the pandemic hit, but it climbed even higher after the war started, according to data from the EIA. After sitting at around 10.5 cents per kilowatt hour since 2014, electricity prices rose to 11.29 cents per kilowatt hour on average in 2021. When the Ukraine war erupted at the end of February, commercial prices started to increase at an even faster clip, jumping nearly 2 cents per kilowatt hour in the first eight months of the year.

Real estate services giant CBRE found that in 12 major U.S. markets, as in the UK, a “flight to quality” trend is playing out, where office users are paying higher rents to move into smaller, better-quality spaces that are more energy efficient. For office buildings, utility costs are among the largest single itemised expense, constituting about a third of total operating costs in most urban areas, according to a report by the Institute for Market Transformation, a Washington, DC-based nonprofit research group.

Additionally, the net-lease property sector, which is popular for single-tenant and retail real estate, has seen a drop in both leases and sales over the past year, according to CoStar data. Tenants that sign these deals are responsible for paying utilities and taxes on top of rent, an arrangement that may become less appealing as energy costs soar. While occupants agreeing to a net lease typically expect some change in utility costs over the course of a 10- or 15-year contract, long-term price spikes could cause more conservatism, an analyst from The Boulder Group in Chicago told CoStar News in March.

“If energy prices stay high for a few months, it will certainly change their costs assumptions and potentially slow down their expansion plans,” Randy Blankstein of The Boulder Group said.