Energy Efficiency – A Changing Tide for Investors

A recent report by Rightmove underlines a trend that is only likely to gather momentum in the coming months. Investors who are serious about protecting their long-term financial interests are increasingly focusing on newer and more energy efficient properties.

The Rightmove study, published on 28 June 2023, notes that a growing proportion of properties entering the rental market now have Energy Performance (EPC) ratings of A, B or C. The agency concludes that landlords are investing in higher rated homes to “get ahead of potential legislation changes.” Under proposed new regulations, all rental properties will eventually have to have an EPC rating of C or better. If they are enacted as planned, the rules will apply to all new tenancies from 2025, and to all rental properties from 2028.

However, it is not only the prospect of legal compliance that is driving the change. The cost-of-living crisis and, in particular, the high cost of energy have both drawn widespread attention to the issue of energy efficiency. Successive surveys have shown that both tenants and homeowners would greatly prefer to live in a home that is cheap and easy to heat, and this preference is reflected in the prices that they are reportedly willing to pay.

In a press release dated 13 March 2023, Legal & General reported that there had been “a 34% uptick in searches for eco-friendly homes, and buyers are now willing to pay a +10.5% price premium for a low carbon property.”

The difference in annual running costs between the most and least energy efficient properties can amount to well over £3,000 per household (assuming that other variables such as building size and levels of occupation are similar). At a time when domestic budgets are already tightly stretched, it’s hardly surprising that tenants and prospective buyers have a distinct preference for higher-rated homes.

Consequences for Investors

For investors, this trend has numerous important consequences. First, if buyers are prepared to pay more for energy-efficient properties, landlords who own such properties stand to enjoy faster rates of capital appreciation over time. By the same token, the same preference amongst would-be renters means that investors should see faster rates of rental growth, longer tenancies and fewer voids if they own properties with better EPC ratings.

The reverse is also true, of course. Old, drafty and ‘hard to heat’ properties look set to become gradually less popular, putting investors in a difficult predicament: having either to fund potentially expensive retrofit works or to sell up and accept a below-par asking price.

Looking ahead, it seems likely that the UK will see a widening division in the market. On the one hand, more efficient properties should hold their value better and deliver stronger long-term growth in both rental and capital values. They should also enjoy better tenant loyalty. On the other hand, older, poorly insulated properties could become increasingly unprofitable; delivering lower rents while also demanding more effort and expenditure on marketing, maintenance and the installation of energy efficiency measures. Since they will typically be aimed at lower-income tenants – who are facing the worst effects of rising inflation – such properties could also be subject to the highest incidence of rental defaults, tenant ‘churn’ and losses due to void periods.

A Visible Split

There are already clear signs that this split is happening. Rightmove reports that “the proportion of properties entering the rental market with an EPC rating of A to C … has increased by 16% since January 2019, while the proportion of rental properties entering the market with a ‘D to G’ rating has decreased by 11%.” It adds that “nearly two-thirds (61%) of landlords said they would not buy a property below a ‘C’ rating,” a figure which is considerably higher than the 47% reported in the company’s 2022 survey.

This increasing polarisation seems to be going hand in hand with another important industry trend, which is a shift in the pattern of investment and ownership of rental property.

There is no doubt that conditions are going to get increasingly difficult for landlords who own older, energy-inefficient properties and it’s easy to see why many of them will choose to sell up. However, this does not amount to an ‘exodus’, despite what some newspaper headline-writers might claim. In fact, as we reported in another recent blog, what actually seems to be happening is that the buy-to-let market is moving slowly but steadily in the direction of greater quality, sustainability and professionalism.

Professionalism in the Sector

To explain that, let’s look at another excerpt from the Rightmove survey. It states that “a third (33%) of landlords who own lower EPC rated properties plan to sell them rather than make improvements to their EPC rating, compared with 20% who planned to sell rather than improve last year.” In other words, the market is witnessing a pronounced decline in the supply of older, poorly insulated homes. In many cases, however, other more experienced investors are then buying them up, refurbishing them to a higher EPC standard and then re-letting them.

The suggestion is supported by Zoopla’s June UK Rental Report. Richard Donnell, the company’s executive director of research, observes that there has been “a steady, constant flow of private landlords selling up – this has been the case since 2018 – but it is not accelerating. At the same time, there remains continued new investment in rented homes, mainly from corporate and institutional landlords. The net result is no change in the number of private rented homes since 2016.”

Some older rental properties will inevitably be lost as a result of being sold into the homebuyer market. But others will be improved and returned the private rental sector, often by landlords with more experience and/or larger portfolios than those who sell. These buyers tend to be the individuals who better understand the benefits of property as a longer-term investment asset, and who are less likely to be deterred by a short period of higher interest rates. Rightmove records that “landlords who already own five or more properties are much more likely to plan to increase their portfolios over the next 12 months (27%) compared with landlords who only own one property (10%).”

Rightmove spokesperson Tim Bannister elucidates further, noting that many experienced landlords “are getting ahead and focusing their investment on properties that will meet the new minimum standard and bringing these to the rental market. While some may sell up, those with bigger portfolios are more likely to be planning to carry out the necessary improvements to increase the EPC ratings of their lower-rated homes. (They) are more willing to invest in lower EPC rated properties, potentially to improve for the future. This suggests there may be a changing of the guard over the next few years, with landlords with bigger portfolios buying up lower EPC properties … to improve and then rent out again.”

Refurb or New-Build

Retrofitting energy efficiency measures to existing, under-performing properties is one way to secure a lettable property that should meet all the forthcoming legislation. However, that’s a potentially expensive process; the estimated costs of bringing a small D-rated property up to the minimum EPC rating of ‘C’ range between £4,500 and £9,000. However, the costs vary considerably by location, tenure, property type and size. To illustrate the point, a February 2023 report by the House Builders Federation estimated that it could cost over £73,000 “to bring an average 3-bed semi-detached house to new build standards.”

Calculations clearly differ but, in any event, it’s beyond any doubt that any retrofit costs are likely to be significant and that they could take considerable time to recoup from any profits made on rents.

Fortunately, there are some public funding streams that can support landlords who want to make energy efficiency improvements to older properties. The Home Upgrade Grant, for example, can be used to part-fund the cost of installing measures on properties with an EPC rating of between D and G. The funding can be applied to a wide variety of measures, examples of which include loft insulation, solid wall insulation, air source heat pumps and smart heating controls. Landlords will still have to pay a share of the total costs – typically around a third – but the savings can be appreciable.

There are other benefits to upgrading, too. In its 2022 Green Homes Report, Rightmove estimated that raising a property from EPC band F to band C could add 16% to its value, and that higher-rated properties also tend to sell more quickly.

Nevertheless, it’s apparent that most older properties will expose investors to unwelcome refurbishment costs. The ‘improve and re-let’ model certainly won’t suit everyone – particularly those seeking more of a hands-off ‘armchair’ investment.

A potentially simpler and certainly more predictable alternative is to invest in either new-build properties or modern conversion schemes such as office-to-residential developments. In such cases, the units in question – whether houses or apartments – will almost certainly be built to far higher standards of energy efficiency than the great majority of Britain’s existing homes.

The Building Research Establishment (BRE Group) notes that “the UK has the oldest housing stock in Europe, and most likely in the world. This is largely due to the legacy of dwellings built during the industrial revolution, which still form the backbone of our urban areas today.” As a result, a huge proportion of homes are in need of energy efficiency improvements. In October 2022, ONS reported that properties in England and Wales “have a median energy efficiency rating in band D.”

By contrast, most new properties will comfortably meet the proposed minimum standards. In March 2023, Zoopla wrote that “85% of new-build homes were awarded an A or B Energy Performance Certificate (EPC) rating last year, compared to only 4% of older homes.”

In short, a new-build or newly converted residential property should protect the investor against any need to fund energy improvement works within the foreseeable future. It should also draw more interest from prospective tenants, command higher rental values and hold its capital value better, growing more quickly over time.

Looking Ahead

The wholesale price of energy has been falling in recent weeks after the sharp peak cause by the war in Ukraine. Nevertheless, energy costs are still substantially ahead of where they were just 12 months ago. And in fact, even before the Russian invasion, energy prices were rising at well above the average rate of inflation. These high costs, coupled with growing awareness about the need for sustainability, will very likely to support a continued popular preference for more energy efficient homes. It is not a factor that investors can afford to ignore.

In a recent report, Rob Stevens, head of property risk at Nationwide Building Society said: “As climate change and energy costs become more important considerations, buyers are going to be much more aware of the features of a home that will need changing to make it more energy efficient. Buyers are already on the lookout for double glazing, but over time we’ll find that buyers will be asking a lot more about solar panels, heating systems, cavity wall and loft insulation.”

In its Green Homes Report, Rightmove make a similar assertion, noting that “around one in 10 people actively looking to move home in 2022 list ‘moving to a more energy efficient home’ as their reason for moving. It’s clearly not the main motivation yet … but it does signal that an EPC rating may move up in their key considerations. It has been taking some time, but there are also now signs that buyers are actively seeking out green terms.”

Mortgages and Energy Efficiency

The last part of Rightmove’s comment highlights another noteworthy point about investing in more energy efficient properties. Increasingly, buyers are looking for lenders to reward moves to more sustainable homes by way of more favourable mortgage terms – and many banks and building societies have begun to respond.

In June 2023, Money Saving Expert published an article examining lenders’ willingness to offer incentives for buyers who make such moves. It wrote: “A growing number of mainstream lenders are now offering so-called ‘green mortgages’. The idea is that if you're moving into an energy-efficient home or making your property greener, your lender will reward you for that with a better interest rate or cashback on your mortgage.”

It notes that there are two main types of incentive. The first of these rewards the actual purchase of a higher-rated home (i.e. bands A or B). This is typically with a lump sum bonus (e.g. Halifax) or with a preferential interest rate (e.g. Barclays and NatWest.) 

The second incentivises the installation of energy efficiency improvements in the home. Examples could include upgrading to energy efficient glazing and doors, installing a more efficient heating system, fitting new insulation or investing in certain renewable energy microgeneration systems. Nationwide is an example of one lender offering 0% finance for such improvements, while others (e.g. Barclays and Halifax) offer cashback payments.

It will also be worth monitoring the progress of a trial scheme launched by the government in May 2023. In a press release, the Department for Energy Security and Net Zero announced that “homeowners who make their properties more energy efficient could see their mortgage rate cut under a new government-backed pilot.” It notes that 26 green finance products are now being developed and tested, backed by £4.1 million of public funding. In this trial phase, the funding will be supporting domestic mortgages only, not buy-to-let products. However, the results could inform decisions by government and banks that could subsequently make sustainable measures more affordable for investors. For now, it’s a case of ‘watch this space.’

In recent months, changes in the official base rate of lending have made many headlines, and lenders have responded with changes to their own mortgage terms. Generally, successive rises in the Bank Rate have prompted banks and building societies to raise their own interest rates but, more recently, better-than-expected inflation data has improved market confidence. Since lenders no longer expect the Bank Rate to peak as high as previously predicted, some of them have begun to offer longer-term mortgages with lower fixed interest rates.

A recent example in the buy-to-let market has been Paragon Bank, which on 20th July, wrote that it had “added competitively priced limited-edition five-year fixed rate products to its range of buy-to-let mortgages, with rates starting at 5.75%.” The new mortgages include lower rates for properties with EPC ratings of A, B or C, and are available at up to 75% loan-to-value ratios.

This is just one example, of course, and many more are likely to follow as inflation falls and swap-rates improve. The buy-to-let mortgage market remains highly competitive, despite the challenges created by recent hikes in the base rate, and it seems clear than lenders are keen to encourage ongoing investments in energy efficiency measures and properties with higher EPC ratings.

Summary

Energy efficiency is destined to become a permanent feature of the property investment landscape. Awareness is being driven by legislation, by household concerns about energy costs and by a growing appreciation of the need for societies to be more sustainable in general.

Investors who recognise this and who shape their portfolios accordingly can look forward to much better and more reliable returns than those who continue to let older, poorer-quality homes.  They can also expect to incur far fewer costs and, in some cases, to benefit from preferential terms on buy-to-let mortgages.

The market shift is clear, it’s strong and it’s well-evidenced. For those who invest in newer, more energy efficient properties, it also represents a very promising opportunity.

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