Energy Efficiency & Property Investment Choices

The subject of energy efficiency has gained considerable prominence in recent months. The need to reduce carbon emissions remains one important reason, of course, but the fast-rising cost of energy has become an even more powerful driver of public awareness.

As world economies emerged from the Covid pandemic, industry and travel resumed in earnest and demand for energy returned to more normal levels. Consequently, the wholesale cost of oil and gas surged dramatically and, since then, countries across the globe have been contending with massive price hikes.

In the wake of the Chancellor’s Spring Statement on 23 March, economists, charities and think tanks have all responded with their own particular takes on the cost-of-living crisis and what the lifting of the energy price cap will do to ordinary household budgets. We’ll examine these subjects in more detail later on but, in short, a high rate of inflation and soaring domestic energy costs are likely to thrust over a million people into poverty.

With average earnings lagging far behind the rate of inflation, real incomes are falling at exactly the same time as higher energy bills and higher taxes are adding to ordinary families’ costs. The government’s own Office for Budget Responsibility calculates that this will precipitate the biggest fall in living standards since 1956.

The purpose of this article is not to dwell on the seriousness of the economic situation. Rather, it’s to focus on the subject of energy efficiency, and how high energy costs could affect property investment choices in the years ahead.

Energy Efficiency and Tenant Demand

Even before energy prices began to shoot up, various UK surveys were showing that energy efficiency and sustainability issues were becoming more important considerations for tenants. Some of this was the result of personal conviction and principle, and some the result of financial concerns.

Now, in the wake of extensive media coverage and commentary by high-profile personalities such as Martin Lewis, tenants have never been more conscious of the rising cost of energy. In recent weeks, this has been greatly emphasised by responses to the Spring Statement, coverage of the lifting of the energy price cap and, of course, the war in Ukraine.

Through this constant media exposure, the subject of energy costs is now very well known to ordinary Britons. Consequently, it’s almost inevitable that it will have an effect on their property choices, if and when they move between rented properties or start to rent for the first time. That, in turn, could begin to shift market demand in favour of newer and more energy efficient homes. For investors considering their next acquisition or making strategic changes to their portfolios, this is likely to be an important consideration.

EPC Ratings and Tenant Costs

Britain has some of the oldest and least energy-efficient housing stock in Europe, and this is one of the chief causes of the fuel poverty that now effects millions of people. According to a government/ONS press release in 2021, “The median energy efficiency score for dwellings in England was 66 and 64 in Wales … which is equivalent to band D.” By contrast, “Dwellings in England and Wales constructed after 2012 had a median energy efficiency score of 83 which is equivalent to band B.”

On 18 March 2022, the Home Builders’ Federation (HBF) published a report stating that “In the year to September 2021, 84% of new build properties received an A or B EPC rating for energy efficiency, while just 3% of existing properties reached the same standard. In contrast, 58% of existing dwellings had an efficiency rating of D-G.”

The difference in these ratings can have a marked effect on the costs that tenants must pay. HBF calculates that on average, “new build homes are saving … £435 on household energy bills per property each year.”

Similarly, ONS writes that “The median estimated energy cost per year for an existing dwelling (is) more than twice as much as that estimated for a new dwelling.” This is especially important at a time when millions of people are facing energy price rises of around £1,300 per year,  and when the war in Ukraine poses a risk of more price rises to come. For many tenants, choosing an energy efficient home could mean the difference between financial survival and building up unsustainable levels of debt.

Rental Demand Prospects

Tenants haven’t always been especially savvy on energy efficiency. In March last year, the Energy Saving Trust wrote that “Tenants don’t always apply the same level of scrutiny to their potential new home as buyers do. But if you’re about to rent somewhere, then making sure it’s energy efficient is more important than ever before.”

Since then, awareness has improved, mainly in response to rising costs. In November 2021, for example, Energy Live News wrote that “the number of Google searches for ‘can’t pay bills’ reportedly increased by more than 1,300% (and) … ‘electric bill help’ search numbers jumped by 2,400%.”

In February 2022, Ofgem announced that as of April 2022, the energy price cap would be lifted. It said “Those on default tariffs paying by direct debit will see an increase of £693 from £1,277 to £1,971 per year … Prepayment customers will see an increase of £708 from £1,309 to £2,017.”

The price cap is updated twice a year and the next review is due in October 2022. Expectations are that it will rise by +12% to around £2,240, though in light of uncertainty over Russia’s invasion of Ukraine, some are forecasting that average costs could rise by even more, to over £3,000. This tallies with remarks made by the Chancellor in his Spring Statement, when he conceded that the war in Ukraine could make further energy price hikes unavoidable.

Given such a situation, it seems inevitable that wherever they have the choice, tenants will choose energy efficient properties. In the coming years, that is likely to mean that, overall, investors will see stronger demand for newer and more efficient properties. That strength, in turn, should enable them to command proportionally higher rental incomes and to enjoy higher rates of capital appreciation.

That’s not to say that older, less energy efficient homes will fall empty; rental demand is almost certainly too strong for that. However, those older properties will expose tenants to much higher energy costs and those expenses are only set to rise. Consequently, tenants in those homes could see their real incomes eroded faster so they are likely to have less to spend on rental payments. That could mean less potential for longer term rental increases and a higher risk of defaults on payment. As an investment class, newer property therefore looks set to offer better and more dependable returns.

Tenant Incomes and Property Choices

Many commentators have remarked that many more families will fall into poverty in the years ahead as a result of rising energy costs and inflation more generally. That could well translate into a rise in defaults, particularly on the part of lower income tenants. It could also mean an increase in average void periods if, for example, non-paying tenants have to move out and replacement tenants have to be found.

To insulate themselves against such risks, many investors may choose to focus on properties aimed at higher-earning tenants or higher-yielding markets. One example might be higher quality properties in city centres that may well appeal to people in better-paid professional roles; often young graduates who are progressing quickly up the career ladder and who may be better placed to absorb any increases in energy or rental costs.

Another option would be to choose property that appeals to the profitable short-stay market: holiday-makers, conference delegates and so on. Here, particularly where property is let as serviced accommodation, energy costs are not the primary concern for visiting tenants. Location, amenities and visual appeal tend to be more important criteria.

Moreover, as real incomes fall across the UK, demand for expensive foreign holidays is likely to dwindle and Britons may be more likely to opt for a cheaper UK staycation. Suitably equipped properties in popular cities, coastal resorts and other tourist hotspots could therefore prove to be a reliable and profitable choice.

Energy Efficiency and Investment Costs

So far, we have looked at what rising energy costs are doing to the tenant demand side of the equation. However, there is another important reason why investors might increasingly favour newer, more energy efficient properties and that’s a simple question of legal compliance and the associated maintenance costs.

Currently, in order to be let out, a property must have an EPC rating of E or better. However, that’s a low standard and by 2025 the threshold will be raised to a rating of C. That should present a challenge because, according to many media reports, only “a third of rental properties currently have an EPC rating of C or above.” That means that in just the next three years, thousands of landlords who own older properties will be forced either to sell up or to make potentially expensive energy efficiency improvements.

If landlords sell large numbers of inefficient properties, the resulting increase in supply could tend to drive their average capital values down, which could erode total returns for those who buy them or for those who hold on to similar, older properties of their own. By contrast, more energy efficient homes should hold their values better and see continuing appreciation.

The alternative is to pay for energy efficiency retrofit work. The Chancellor’s decision to remove VAT from energy efficiency measures will help to reduce the costs somewhat, but such projects can still prove very expensive.

According to a March report by Shawbrook Bank, landlords with older properties have tended to underestimate the costs of bringing them up to new minimum EPC standards. The bank writes: “When asked how much they believe they would need to spend on making the necessary improvements, landlords estimated that it would cost £5,900 on average to improve their properties. This figure, however, could be significantly underestimated as landlords who have already made improvements to their properties have spent £8,900 on average to date.”

These are costs that would quickly erode net yields on an older rental property. Crucially, however, they would not be incurred at all by investors who have focused on newer A to C-rated properties. Typically, these will include new-builds, modern residential conversions, purpose-build student accommodation and higher quality tourist apartments.

Summary

With energy costs rising fast, and showing no signs of abating in the coming months, public awareness of energy efficiency has never been higher. In the coming months, this is likely to manifest as rising demand for more efficient properties – typically new-builds and new conversions – and a corresponding reluctance to rent older, colder properties.

The sheer scale of rental demand and the lack of housing stock should mean that older properties still find tenants, but their potential to deliver rising rents will probably diminish and they could potentially expose investors to higher risks of voids and payment defaults. As an asset class, their popularity is likely to decline over time and this is likely to be a long-term trend, not simply a short-term dip.

By contrast, modern rented accommodation should fare considerably better. The great imbalance between supply and demand should continue to drive capital values higher and if the cost-of-living crisis leads to more mortgage defaults and repossessions, demand in the private rental sector could gradually increase.

There are no real winners during a cost-of-living crisis and no one will take pleasure from the current situation. However, those investors wishing to best protect their financial interests might now be looking towards more modern properties, particularly those aimed at higher-earning workers and the buoyant short-stay market.

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To find out more about investing in modern residential property and short-stay accommodation, please call our advisory team on 01244 343 355