REFIRE Interview: Sonar Real Estate

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Interviews

The issues surrounding ESG are gradually becoming mainstream themes within real estate. One company that has put ESG front and foremost in its corporate strategy is investment and asset manager and co-investor Sonar Real Estate.

REFIRE talked recently with Sonar CEO Christoph Wittkop, along with Managing Partner and Co-Head Transaction & Asset Management Holger Hosang, and Director for Strategy & Operations Paul Mossler, to get a better understanding of how important the integration of ESG is to the company’s DNA.

Some excerpts from our discussion:

REFIRE: You’ve promoted ESG to be a central component of your asset management approach to real estate. What have you learned since starting Sonar in 2020?

Sonar Real Estate: We’ve come a long way in our understanding of ESG over the last three and a half years, since we founded Sonar. Back then people were talking about ESG, but it was largely underestimated and not fully understood. Now we’re much further along the line. For us, the issue now is always to ask, what catalogue of measures is the right one for a particular building in terms of getting the best results? What advantages, cost-effectiveness and practical feasibility can we achieve here? That’s a process which requires pretty deep analysis. It’s a discovery process, with a lot of trial and error to get it right. There is no one-size-fits-all tool box for every property.

What we’ve learned is to look at things from an investor’s perspectives and not obsess about the technical aspects, which of course are important, but not as important as really getting a good handle on the investor’s viewpoint. We’ve gained some real-life experience in several situations where we’ve built an optimal case and shown what is possible. We’re happy to try to do the same for other investors, many of whom tend not to focus enough on practical, hands-on tools at management level. This doesn’t always have to mean big up-front investment. The art is in integrating many of the tools we’ve mastered, and skillfully omitting and optimising where appropriate.

What has changed in this period?

Back then the banks and other lenders weren’t touching anything that wasn’t ESG-compliant. And everybody, including us, wanted Article-9 funds. But then, increasingly, there was pushback - not a bad thing - while everyone took a step back, looked more closely at it, and then started asking themselves - what does ESG actually mean? Of course it’s important, and of course for institutional investors there’s no way around it. Bank lenders always pay close attention to it. But that was the high point, the peak of the buzzwords. Thankfully, we don’t see that anymore, now everybody is focused on thinking more commercially about their ESG and sustainability goals.

Our bottom line at Sonar has always been sustainability management that doesn’t implement stand-alone measures just for the sake of ESG marketing, but that genuinely contributes to the health of the building long-term.  

- Sonar Real Estate

Is the whole industry moving in step with your understanding?

Our bottom line at Sonar has always been sustainability management that doesn’t implement stand-alone measures just for the sake of ESG marketing, but that genuinely contributes to the health of the building long-term. That means that sustainability leads to energy efficiency and hence to savings both for the tenants in terms of energy consumption, and on the cost side in terms of CO2 emissions. This has always been our goal. We’ve said we have to see it as part of our integrated planning, including all management and Capex projections.

I think we’ve used this time to test, and find partners and tools and solutions, that help us to create this transparency. We’ve got very good at something about which not many people know a lot, and we can use this to advise our partners and investors on developing their own strategy, and help them get where they want to go.

What makes you think your approach leads to better results?

We’ve switched to coming up with an appropriate strategy at the level of the building itself. What does this property need, and what can it handle? What level of rent can be expected, even if we refurbish the asset? Where can we take it and how can we then implement these measures as sustainably as possible so that it works in and of itself? Only then, I believe, will we have created a product which can hold its own in the market, and will hopefully do so. We can’t say 100% yet that it will, but the corresponding premium - or at least avoiding a mark-down - should be achievable, which wouldn’t be the case without it. These are the things we’ve really learned over the past four years.

The current goal in the market, which is transparent and which everybody understands, is CO2 and energy efficiency. These are what banks, investors, and all market participants measure. They might measure it a little differently, but it’s what we do. We wouldn’t buy any asset today without transparency as to how far this asset might be to becoming ‘stranded’, meaning that it falls short of being compatible with the goals of the Paris Climate Agreement for 2050.

How aware are most players of their obligations to comply with these goals?

We are definitely noticing that pressure on ESG reporting is increasing, and it’s international. That means almost all investors in Germany with a three-digit million asset volume and more will have to include ESG and sustainability reporting for some of their buildings from next year. Some investors may not have fully grasped what’s involved, because of still hazy understanding about the issue. We’re in a good position to provide support and point to the right areas that need to be tackled, and what steps to you need to take today in order to be able to report next year.

While pioneering US and UK investors may have shown rapid flexibility in dealing with other areas, it will be difficult for them to implement these ESG solutions in Germany without a strong local partner. Anglo-Saxon solutions that haven’t yet been tested here could run into problems that can only be solved with a lot of effort. Learning now about what these reporting requirements are all about is a prudent approach.

The majority of existing office buildings in Germany that are older than 20 years all have a big problem. That doesn’t mean they’re all lost causes - in fact, inspired by our motto “Leave No Asset Behind”, we know there are strategies and action plans that could rescue a large number of these properties and make them ESG-compliant.

- Sonar Real Estate

As Sonar, you invest yourselves, so you have plenty of ‘skin in the game’. Do you practice what you preach on ESG?

Historically, we at Sonar are a value-add investor, so we’re very much at home in this area. If we find a property where we know we could convert and revitalise it without tearing it down and re-building it, then this could be a sustainable investment. If, by implementing small innovative measures, we can reduce the energy consumption and the CO2 emissions by enough to get it back on the path to Paris Agreement compliance, then that’s a worthwhile investment.

The majority of existing office buildings in Germany that are older than 20 years all have a big problem. That doesn’t mean they’re all lost causes - in fact, inspired by our motto “Leave No Asset Behind”, we know there are strategies and action plans that could rescue a large number of these properties and make them ESG-compliant. That’s assuming the location is basically sound. Assets that already weren’t working because of poor location, poor rents, poor tenant structure, or whatever - they can’t be saved with ESG. Nor will ESG save buildings that in a good phase were simply wrongly positioned. We’ll just have to accept this.

Are all investors equally affected by ESG regulations?

The ESG assessment criteria have now not only been tightened, but are being imposed more firmly. Remember, some fund investors are only permitted to buy green products as they are part of a portfolio and will be held for several years. This is where really close scrutiny is required, and a lot of energy goes into examining the asset. We, as Sonar, sometimes see that a property is sometimes not suitable for long-term institutional portfolio holders. But as a value-add proposition, we may be able to use our strategies and experience to make a good product out of it, while doing the right thing ecologically and adding extra value.

But where almost every investor will sooner or later encounter ESG regulations is in the coordination with potential financing partners. All banks have to pass on the ESG regulations based on their own allocation of capital in very different ways. This is where it helps to be aware of one’s own figures and at Sonar we help with this preparation.

What concrete examples can you offer of how this works in practice?

Our landmark property Prisma in Frankfurt Niederrad is a good example. We’re seeing strong rental demand from potential tenants who are specifically looking for defined ESG characteristics such as low emissions and low energy consumption. Typically the only properties meeting such high requirements would be new builds. But our Prisma building, an existing building, but benefiting from a full refurbishment with brand new technical components and a full suite of building control tools, can meet these demanding specifications. We actually have a building in our portfolio that is cheaper in terms of costs but can meet the same requirements as a new building. This is what people are seeking to emulate, and whose ideas and blueprints we’re happy to share.

This has been a hugely important project for us. From the beginning we said, if we’re going to do this, we’re going to do it right. And on so many levels we’re doing just that. For example, the amount of existing material which we’ve been able to recycle and which will be re-used elsewhere, thanks to our partnership with circular real estate specialist Concular. And what we’re doing now in really CO2 balancing, determining how much grey energy is tied up in the whole building, in operations and the site itself. We have seen how we can re-use and recycle climbing walls, so that we now have 20-year-old walls that look like new. It’s like looking at the inside of a building, and then instead of demolishing it, looking at it again and again to find a way of making the best possible use of it.

Prisma is a major redevelopment project for any company to take on...

We’re lucky we have an investor on board – a fund advised by Patron Capital - who understood our motivations from the beginning and is fully committed to our strategy, of speculatively upgrading the building as we’ve done, without an existing pre-letting. It’s a great vote of confidence. It’s why we can justifiably claim that when we look at new buildings, we’re now on a different path, we can be confident that we have a better, more transparent, look at what we can make of it. Our assessment is much more tangible, much more realistic for a business plan for a building. Which ultimately makes the asset much more marketable.

Sonar is the asset manager for THE SQUAIRE at Frankfurt Airport, the largest commercial property in Germany. ESG is doubtless a big theme there too?

We’ve recently achieved a BREEAM Excellence certification for THE SQUAIRE for the first time. (THE SQUAIRE, for which Sonar is the asset manager, has a total lettable area of 140,000 sqm. The property, 660 metres long, 65 metres wide and 45 metres high, houses offices, shops, hotels and event venues, all areas with different functions and spacial climate requirements.)

Our recent co-operation with MeteoViva at THE SQUAIRE means we can intelligently and predictively control our building technology. The MeteoViva tools use the predictions of weather forecasts or collected knowledge about occupancy on certain days of the week, and then use this data intelligently to control the heating, ventilation and cooling to minimise consumption. This promises average savings of between 15% and 30%.

There’s more to come for the majority of our assets under management, as we work with additional partners such as Aedifion, to achieve intelligent control and efficiency gains.

How has Sonar’s strategy shifted over the past few years in its focus on asset classes?

There has been no particular change to our strategy - we’re staying true to offices. The strategy has become somewhat narrower, obviously, but with common sense and a halfway normal market, we expect that offices in good and very good locations will still be needed, and rents will still probably rise. Of course, you won’t be able to buy cheap offices, rent, and hope to sell on. Even if an office building is mainly or even fully-let, selling on is difficult in the current market.

Yes, the office market is changing, but it is far from dead. Our view is that people are looking for quality offices in better locations at higher rents. Yes, liquidity in the office market has decreased, and at the moment interest in offices has declined. So yes, we’re giving additional thought to residential - we can see that demand from private equity is also moving in this direction, so we’ll be positioning ourselves also in this area.

Transaction volumes in Germany are way down on previous years. Are investors hoarding their capital to invest in other markets or asset classes?

Lack of capital is not the problem. There is enough private equity capital for real estate in Europe. But what is it actually available for within the sector? Much of it is targeted at the debt sector. So there is concern about going in with equity on a big scale. Why? Because from capital’s point of view prices haven’t fallen yet to a level that will reward opportunistic investing. At the same time, borrowing costs have risen significantly. So, whether I act as a lender or a preferred equity provider - basically a type of debt capital within the framework of equity - the question is, can I get the same return with lower risk? Clearly, yes. That’s what we’re seeing happening a lot at the moment.

But the proof of the pudding is in the eating. Are there really enough deals on the debt side that are so attractive? We’ll see - at least the expectation is there that debt is the better approach, at least for offices. Again, have prices fallen sufficiently? Germany had become so expensive, that quantifying the extent of the drop is difficult. There’s just so many questions about the office user market. There’s plenty of capital too for the logistics and residential asset classes, where there’s no uncertainty about the user markets.

On another question - Sonar has experience with office conversions. How realistic is it to expect a surge in the sector?

The number of offices that are suitable for conversion to residential is very small, a rule of thumb puts it at about 10% at best. A conversion remains the exception rather than the rule - at least, given our existing planning laws and regulations. It could be more if we had more flexibility in our planning regulations.

So far the main debate has been about converting offices into residential housing, given the housing shortage. But we’re now starting to look more closely at other uses, such as converting offices into schools or other public uses that people are always looking for in downtown areas. Many city centre offices are emptying, and may never be used as offices again. But they can’t all remain ruins or vacant buildings forever.

There are of course much better prospects for the conversion of say, old hotels into small apartments or micro-apartments. The structures are already in place and adapting the interior architecture is often feasible. We’re seeing several successful projects of this sort.