Environmental due diligence – minimising risks in property investments

Claire Shepherd takes a look at how the Environmental Due Diligence (EDD) process can help minimise risk on property transactions and investments. She also explains how sustainability and ESG considerations are becoming increasingly important for all stakeholders in real estate projects.

The Process

Traditionally, EDD assessments for property transactions have focused on contaminative liabilities which may be attached to a site, and which can consequently have the potential to impact upon the proposed transaction.

This EDD assessment generally takes the form of a Phase I Report which begins with a desk review of the available environmental information, both current and historical, from a range of sources including Ordnance Survey and British Geological Survey, SEPA/EA, Local Authorities and public health agencies. A site walkover is then normally completed to identify current land use both on the site and in the immediate vicinity, to establish potential geo-environmental risks that may not be apparent from desk study, and to characterise the sensitivity of surrounding land uses and features.

The findings of the assessment will then be used to provide advice on the significance of identified risks, the potential for environmental liabilities to arise for the site owner, and recommendations for any further investigations or actions to clarify, mitigate or manage risks.

Minimising risks

Both buyers and sellers benefit from the EDD process. It can offer you protection against costly environmental liability and is a useful tool for preserving your property value in a real estate transaction.

• Buyers can ensure they are getting the best investment value for a property and structure their acquisition based on what the assessment reveals.
• Sellers can save time on a deal by providing information directly to the purchaser at point of interest rather than awaiting additional surveys, and also highlight any potential issues that could be detrimental to a deal in advance.

Our advice to get the most out of your due diligence process is to do it well and do it early.

The future of EDD for real estate

Environmental concerns are becoming evermore important to a potential investment. We are seeing a move away from the traditional emphasis on legacy issues such as contaminated land, mining instability and asbestos. The sustainability of an investment is becoming more important in the decision making.

Corporate investors, pension funds and investment trusts are becoming increasingly aware of the need for responsible investment. More and more, investors are building responsible property investment strategies to guide their investment discussions. Because of this, there is growing emphasis on considering the concept of ESG investment in the commercial real estate sector : 

• Environmental factors such as the energy efficiency and emissions of buildings.
• Social factors such as how properties impact society, for example the health and wellbeing of occupiers and the local community or resource scarcity.
• Governance factors such as diversity, culture, and reputation. In a real estate context, these factors apply not only to the property owner, but also the occupiers, on-site staff and management companies.

One of the key drivers relating to the increase in ESG considerations was the release of a report by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures’ (TCFD). The report was then followed by non-financial reporting and corporate sustainability reporting requirements, which compelled large companies to include non-financial information on matters such as environmental protection and social responsibility in their annual reports. 2019 saw the European Commission publish an action plan for developing a framework for sustainable finance; and the UK government published its Green Finance Strategy which required all listed companies and large asset owners to disclose in line with the TCFD recommendations by 2022.

Therefore, as part of the Due Diligence process, ESG issues can and should be investigated more. Introducing ESG at this stage can help with assessing the potential for improvements, identifying legacy issues and analysing the impact of ESG trends ranging from climate change, changing flooding patterns, resource use or energy efficiency standards.

Sustainable funds outperformed their traditional peers across all major asset classes and regions in 2023, according to a Sustainable Reality report from the Morgan Stanley Institute for Sustainable Investing. And whilst greener, more sustainable properties may have more expensive upfront costs, studies have shown there are financial benefits. More sustainable buildings can generate lower long-term operational costs and attract higher rents and occupancy rates. In contrast, buildings with lower sustainability standards are considered expensive to run and become more undesirable as legislation requirements continue to tighten, especially with regards to energy efficiency standards.

Reputation and the objectives of the investment company are also an important consideration. If an investor already has ESG targets, it will be additionally important for them to assess the ESG performance of a new asset and what impact it will have on those targets. An investor with a target to reduce the portfolio’s energy consumption, will not wish to acquire an efficient building with a high energy demand limiting their ability to reach their target.