New UK PM Truss Set To Cap Energy Prices And Avoid Ticking Time Bomb For Commercial Property

UPDATE, SEPT. 6, 4:55 P.M. GMT New UK Prime Minister Liz Truss is set to cap the price of energy for businesses to avoid the huge rises many commercial property owners and tenants are currently facing.

The new PM's team is considering two strategies to limit the price rises being faced by businesses, Bloomberg reported. One is a cap on energy prices for businesses, similar to that currently in place for households. Prices for businesses are currently uncapped.

The other measure would see energy companies forced to offer businesses a price reduction. Under both plans the government would reimburse energy suppliers for income not generated, and that would cost the Treasury between £21B and £42B over a six-month period, Bloomberg said.

Households across Britain are set to be hit hard by the upcoming hike in the cost of energy — but the surge will create a giant problem for the commercial property sector as well. 

Both commercial tenants and landlords are facing a huge financial hit from price rises that will initially be higher than those faced by individual consumers because rises for businesses are not capped. 

The plight of pub owners, cafés and restaurants has already hit the headlines, with predictions that thousands of small businesses might need to close as bills rise by up to 1,000%. Retailer Iceland said it would halt store expansion because of the increase in cost of operating new stores.

But the rises will hit every sector of commercial real estate, and not just the already-struggling retail and leisure sector: Booming sectors, like light industrial and BTR, and those in flux, like traditional and flexible offices, will also be affected.

There are some positives from the crisis: Strategies to mitigate price rises will encourage people to think about and reduce the energy they use, as well as invest in green technology. The situation will provide a case study in just how much less it costs to operate and occupy a green building. 

But on a wider level, the commercial property sector is poised to serve as a microcosm of just how detrimental these price rises will be for the UK economy as a whole. 

“The whole industry has been holding off dealing with this issue, hoping it would get better and prices would come down,” Workman ESG Director Vicky Cotton said.

As a property management specialist, Workman is responsible for procuring energy contracts for landlords and tenants, and liaising between the parties on issues like energy costs.

“It’s just amazing where pricing has gone," Cotton said. "We’re seeing increases of 1,000% being quoted on contracts coming for renewal where the price was fixed two years ago.”

The way energy is procured and paid for in commercial property means landlords are facing financial pain from the spike in energy prices even if it is the tenant using the energy. Just as during the pandemic, landlords might need to financially support some tenants, while cost increases being faced by tenants could put a dampener on taking more space, forcing them to choose between paying for heating, light or people. 

If a building has a single occupier, a big office or logistics asset, for example, that occupier will probably procure their own energy directly from a supplier. In a multi-let building — say an office, industrial estate or shopping centre — a landlord will procure the energy and then charge the tenant through the building’s service charge. 

In all cases, businesses tend to have a contract of a fixed length with a fixed price. Unlike for individual households, that price is not capped, so when that contract ends, companies pay the going market rate. The recent surge in global prices, caused by factors like the Russia-Ukraine War and supply chain snarls, is leading to huge rises when those contracts come to an end. 

There’s a looming crunch point for landlords and tenants: 1 October. When the UK energy market was deregulated in the early 1990s, privatisation began on 1 October. For that slightly arbitrary reason, Cotton said, a huge number of energy contracts are coming up for renewal on the first day of next month.

“Not much has been said about the typical Joe Bloggs small industrial occupier, but they will be absolutely crippled,” Cotton said. “I wouldn’t be surprised if tenants in all sectors weren’t starting to have conversations with landlords about financial support.”

In spite of the scale of the problem, it is one that the property industry, both landlords and their tenants, hasn’t fully appreciated. 

“Communications have been key,” BNP Paribas Real Estate Head of ESG and Sustainability, Property Management Ailsa Shaylor said. “The rises don’t hit home until people see it in their service charge. Compared to 24 months ago, people are getting some shocking bills, and tenants are only just waking up to this.”

In the past few weeks, the pressure has cranked up on landlords and tenants even further. Energy suppliers are providing quotes at massively increased rates to businesses, owners and occupiers looking to renew contracts.

But not every business can even get a new contract.

“Suppliers are getting pickier about who they are offering quotes to, and procurement is getting harder,” Cotton said. “It’s a seller’s market.”

Smaller businesses, which often tend to have worse credit ratings than bigger ones, are finding it difficult to renew contracts, she said. Sectors like hospitality, where income is less secure, are being charged more or not offered new contracts at all because they are seen as riskier and potentially unable to pay their bills.

In that sense the media focus on hospitality, while well-meaning, has been unhelpful.

“In the last week or so we’ve seen suppliers saying, 'The pub sector looks dicey,' and raising their prices even more,” Cotton said. “They’re risk-averse, so they’re applying a risk premium.”

It is not just tenants suffering from energy suppliers being picky.

Energy suppliers are also wary of landlords based offshore, Cotton said, because of fears they might not be able to pursue debts. With many property funds based offshore in jurisdictions like Jersey or Guernsey, this is leaving large property funds unable to find new energy contracts, she added. 

The power won’t be turned off in the buildings owned by these funds; suppliers have a legal obligation to keep providing energy after a contract has finished. But the price can rise at any time if wholesale prices continue to rise, payment times are shorter, and there is no obligation to provide renewable energy, a problem if a fund has any aspiration to green credentials.

Another problem for landlords, particularly in sectors like office and shopping centres, is that some leases allow service charges to be capped, meaning that no matter how high energy prices go, there’s a limit to how much the landlord can recoup from the tenant.

“In those cases the landlord will end up sharing the burden with the tenant,” BNP Director of Property Management Sam Lawrence said.

There are also some sectors of commercial real estate where utility bills are included in the rent tenants pay landlords, like flexible offices, co-living and some build-to-rent schemes.

In normal times, offering tenants an all-in cost is appealing for landlords and tenants, as it provides a single figure for total occupancy cost. In some cases, landlords can actually make a small profit by charging the tenants slightly more for energy than they are paying themselves.

“At the moment, if you are charging an all-inclusive rate, you can become quite stretched,” Grainger CEO Helen Gordon said.

The same goes for flex office, according to Clockwise Offices Chief Operating Officer Alexandra Brunner.

“So far, us and our competitors have absorbed the rise in costs," Brunner said. "But how long can we afford to do that?”

Brunner said the company wanted to help its tenants out in a time of need by not passing on the costs. With most of Clockwise Offices' customers on rolling one-month leases, it could pass on increased costs fairly quickly, but it wants to build loyalty among customers. It is, however, constantly reviewing whether this policy is financially viable, she said. 

Such rolling one-month leases allowed tenants to flex up or down in terms of the amount of space they take, and this is where the knock-on implications for growth of the office sector come through. Some might downsize or choose not to expand as revenue that might otherwise be spent on people is diverted to other costs.

“It is not just energy, but other suppliers are increasing their costs, too, and wages are also rising to keep up with inflation,” Brunner said, adding there is going to be less money available for new hires that lead to growth in space and increased rents. 

Making the case for BTR, Grainger’s Gordon pointed out the newer, more energy-efficient buildings being developed by the sector are far cheaper for tenants to heat than the average home rented from a private landlord.

Citing JLL data, she said the cost of heating an apartment with an Energy Performance Certificate rating of A-C was less than half that of heating a lower-rated building. About 87% of Grainger's apartments are rated A-C compared to less than 42% of those owned by smaller private landlords, Gordon said.

New-build BTR, often seen as a more expensive option by consumers, will actually start to look cheaper as a result, with a lower total cost of occupancy, she said. That means that although consumers might be more stretched, rental growth in the most energy-efficient buildings shouldn’t necessarily be tempered, especially if inflation causes wages to grow.

And more broadly, the energy price hikes will bring home the benefits of energy-efficient buildings in all real estate sectors in a tangible way.

“We’ve been waiting for 15 to 20 years to quantify once and for all how much difference an energy-efficient building makes,” Gordon said. “Now it will be there in the bills.”

In terms of mitigating cost rises for landlords and tenants, some of the quick wins are the same as “what I bang on to my children about, making sure the lights are turned off,” Workman’s Cotton said. 

A more long-term, slightly more sophisticated version of that is to install building management software to control when heating, lighting, and other plant and machinery in a building are being used, Cotton said. A building’s heating might turn itself off at 10pm and come back on at 2 o'clock the next morning, meaning the building is being heated for a large portion of the day when no one is using it. 

Landlords and tenants could cut down the hours buildings are heated and lit, but this could be a tricky subject in a multi-let building.

“Operating hours can be an emotive topic,” BNP’s Shaylor said. “If you have one company that works late into the night and another where everyone goes home at 5, then you get into the question of how costs should be apportioned between those companies.”

One positive to be taken from the crisis, BNP’s Lawrence said, is that nothing sharpens the mind like a cost increase.

“It’s forcing people to think about things they weren’t going to think about for five years,” he said. “In that way, it accelerates the green agenda.”

Lawrence said enquiries about installing solar panels on buildings, particularly industrial buildings, had increased dramatically in the past few weeks. There has also been an uptick of interest in other energy-saving technology, like building management systems.

Landlords and tenants need to work out who is going to pay for the capital expenditure, but the systems can be operational and saving money in around six months or less.

With prices predicted to be elevated for at least a year and possibly two, the financial benefit is evident. 

“We’ve been saying for a long time that using carbon needs to be more accurately priced,” Cotton said. “This is going from one extreme to the other.”