How big a threat is the ‘brown discount’?

Reducing emissions in line with the Paris Agreement will require most existing buildings to be retrofitted to make them greener. While the cost of doing so will affect returns, the cost of delay is likely to be far greater. Investors, therefore, may wish to consider how much return they are prepared to forego in the short term to protect long-term asset values.

Written by Kim Politzer and Aymeric de Sérésin

July 2021


Around 97% of today’s commercial buildings will not support the transition to net zero in their current form. If left as they are, they will become increasingly difficult to let or sell. This has prompted talk of a “brown discount” in the European real estate market, but so far there have been few attempts to quantify how big that discount might be. Our analysis, based on recent trends and reasonable assumptions about how the market will evolve after COVID-19, suggests brown discounts will be large enough to make upgrading buildings a prudent investment.

Investors are waking up to this idea. They have moved beyond simply wanting to see a portfolio’s Global ESG Benchmark for Real Assets (GRESB) score and now expect sustainability to be at the heart of building design, backed up by data disclosure that demonstrates its impact. Tenants, too, are demanding more, while valuers are also increasingly taking environmental, social and governance (ESG) factors into account.

How tenants, investors and valuers will drive the brown discount

We identify three channels through which an increasing focus on ESG will lead to a brown discount. The first is tenant demand as industry standards become established. Market expectations are increasingly for buildings to be delivered with the equivalent of a Building Research Establishment Environmental Assessment Method (BREEAM) score of at least Very Good, or a Leadership in Energy and Environmental Design (LEED) Silver rating.

But tenants’ focus goes beyond energy, water and waste usage. COVID-19 has thrown a spotlight on the “S” of ESG and boosted demand for health-related attributes, including good air quality and ventilation, touch-free access, health amenities such as gyms and open spaces, and end-of-commute facilities such as bicycle parking and showers. Potential tenants look for certifications from bodies such as the International WELL Building Institute, which certifies spaces that advance human health and well-being, and WiredScore, which assesses digital connectivity. A recent survey of tenants by Pembroke, a real estate manager, found that many expect to see increasing demand for such attributes following the pandemic; buildings that lack them could face weak demand, lower rental growth and falling rents.

The second channel is investor demand. As more real estate funds become classified under Article 8 or Article 9 of the E.U.’s Sustainable Finance Disclosure Regulation (SFDR), a building’s quality and how it is used will grow in importance. The simple approach will be to buy buildings that are already badged, creating a bigger green premium/brown discount.

The third channel is the valuation process. The major valuers are now recruiting ESG experts and, we expect, will soon start to factor in the capital expenditure of upgrading a building to meet higher environmental standards, or to cover the cost of carbon offsetting if an asset becomes “stranded.”

Quantifying the brown discount

By making a few simplifying assumptions, we can get an idea of how large the brown discount could be. Consider two properties, one “green” and one “brown,” that start out with the same rent and value. Prime office rental growth has averaged 3% in western Europe over the last ten years. We expect, however, that this will be significantly lower in the next five years, given the disruption to office-based work and the likely move to hybrid working. For the purposes of illustration, we make the following assumptions for green and brown scenarios:


Table 1. Quantifying the potential brown discount

Assumptions Green Brown
Rental growth 2.0% pa 0% pa
Initial yield 5% 5%
Exit yield 5% 5.5%
Void period (time to re-lease) 9 months 18 months
Inflation 1.3% pa 1.3% pa
10-year IRR 5.7% 3.5%


We assume rental growth for brown buildings will be zero at best, given tenants’ increasing focus on ESG and the strong likelihood there will be an oversupply of brown buildings relative to weakening tenant demand. Similarly, we assume a higher exit yield for brown buildings, because we expect investors, who are also putting more weight on ESG factors, will demand a discount.

Assuming the same rent and asset value at the start of the period, and that new tenants will need to be found in year five of the tenancy, when the current lease expires, these hypothetical assets produce an internal rate of return of 5.7% over ten years in the green scenario. This compares to just 3.5% in the brown scenario. 

By year ten, the difference in exit values is 21.6%. We regard this as being toward the lower end of how large brown discounts could get. Rents could realistically fall for brown buildings, so 50 basis points could turn out to be a conservative estimate of the impact on yield. For lower yields, a given basis point differential would have an even bigger effect.

There are, of course, capital expenditure costs involved in greening a building, but there are savings too. As well as the cost of carbon offsetting, brown buildings will face higher operating, insurance and maintenance costs in the years ahead. Analysis by ESG consultancy Evora suggests that, in contrast, the average savings from introducing energy efficiency measures should pay back the investment within ten years.

Greening in action

More importantly, investing in a retrofit can secure a building’s long-term value. While only anecdotal and not guaranteed, letting agents’ advice is that planned improvements to one of Fidelity International’s Paris buildings to target BREEAM Excellent, WELL and WiredScore labels is likely to lead to a 15–20% increase in rent on the asset. Attracting tenants who are happy to sign a green lease, which includes clauses to promote the sustainable use of a property, can help improve a building’s overall ESG profile. And sustainable buildings can also attract businesses. In one of our offices in the south east of the U.K., an environmental consultancy is leasing office space because it aligns with the company’s ESG goals.

A tipping point is coming.

Capital is already starting to flow toward sustainable buildings. The prospect of tighter regulation will push the market to a tipping point at which valuations could shift markedly. The U.K. government, for example, is consulting on changes to the Minimum Energy Efficiency Standards that, from 2030, would only allow buildings to be leased if they reach a B standard (a big step up from the current E), with the proviso that the investment required meets a seven-year payback test.

Today’s liquidity conditions mean valuations do not yet reflect the stark difference between buildings that are ready to support the low-carbon transition and those that are not. That won’t last forever, and owners who delay investment in retrofitting could come to regret it.