Environmental, social and governance (ESG) factors are becoming increasingly important investment considerations across the entire investment management landscape. But within the real estate sector, the level of ESG incorporation, and its degree of influence, remains patchy.
The latest report from the UN Principles for Responsible Investment (PRI) notes that the buildings sector contributes up to 30 percent of annual global greenhouse gas emissions . Yet despite property investors showing “a sophisticated use of ESG indicators in their investment strategies,” the proportion that systematically factor ESG issues throughout their investment processes remains relatively low.
“To date, responsible property investment has mainly been the remit of advanced institutional investors and large funds, leaving behind a large group of other investors with less advanced ESG practices,” says the report.
Measuring ESG impact
The challenge to further uptake lies in demonstrating a clear benefit to investors of incorporating ESG considerations into their real estate investments.
There are multiple supporting arguments for targeting ‘greener’ buildings, says Matthew Clifford, JLL’s Head of Energy and Sustainability Services in APAC. Energy efficiency is the primary one, as it offers the most tangible, and often rapid, return on investment. “Green buildings are more cost effective typically, which means more money going to the bottom line. Theoretically, a more efficient building has greater appeal to tenants as well, so it might be possible to lease faster, or for higher rents. That can also help reduce the risk of obsolescence.”
The PRI report observes that, of 114 investors surveyed, 85 percent state ESG factors helped them identify risks and opportunities. In addition, 60 percent said ESG considerations had an impact on the prices paid or offered for property, including premiums for buildings with high sustainability standards and discounts for ones with poor credentials.
Yet with so many disparate and often subjective factors determining an individual property’s value – most notably location, but also multiple other variables, such as quality, occupancy, discounts offered to tenants to fill vacancies, etc. – undertaking an apples to apples comparison to prove a causal, quantitative link between ESG and asset performance can be difficult. So while being green may add value, pinpointing that exact value can be obscured in a sea of noise from other variables.
As JLL’s Global Capital Markets Research Director David Green-Morgan observes, there is scant conclusive evidence at the moment that green buildings directly produce higher rents or values – especially as most new construction in developed markets is required to have a certain level of sustainability built in. “In fact, in this cycle older, refurbished buildings in some fringe markets – such as Shoreditch in London, Greenwich Village in New York and SOMA in San Francisco – have outperformed traditional central business districts.”
Comparing fund performance
At a fund level though, comparisons become easier to measure and track, says Clifford. For example, a fund with 50 buildings can measure how each building performs in terms of kilowatt-hour per square foot or tons of CO2 per dollar of revenue it generates, and track that over time to demonstrate aggregate improvements. The financial performance of a fund can also be compared against other funds, adds Clifford. Using these data points can then help managers position their funds competitively against rival ones.
“For years now, we have seen superannuation funds and other large investors direct their money into funds with strong green credentials,” notes Clifford. “Property is a long-term investment, so orienting those investments in a more sustainable direction makes good economic sense.”
Growing adoption pressure
Employing rigorous fund benchmarking will be key to promoting further ESG adoption in the sector, with peer pressure likely to play an important role in driving change. For instance, the Global Real Estate Sustainability Benchmarking (GRESB) initiative collects information from property owners and ranks the sustainability performance of their buildings, which investors can use to inform their investment decisions. From a standing start five years ago, GRESB now has more than 250 members, with pension fund signatories acting as a spur to real estate funds to participate and report on their sustainability performance, says Clifford.
Reporting by participants also generates more competition. “No one wants to report bad results or be at the bottom of the table,” notes Clifford. “So you can see the GRESB scores improving over time, as the transparency driven by investor pressure drives better performance.”
Moreover, the growth of GRESB in both mature and non-mature markets is helping foster more globalized standards, awareness and uptake. “GRESB is leveling the playing field, by making it easier for investors to compare performance of funds in the US or UK, against a fund operating in, say, China or Malaysia,” says Clifford. “So if investors have come to expect certain levels of sustainability performance in one location, why should they accept a different standard in another market?”
The National Australian Built Environment Rating System (NABERS) plays a similar benchmarking role. “Most funds have a NABERS rating target for their portfolio,” says Clifford. “And they are all competing to outdo one another, because by adding specific, tangible targets for energy performance they can attract investment.”
For such benchmarking tools to be truly effective though there is a need to drive more transparency and widen the participant pool, since those funds that are willing to disclose at present are probably already the best performers. “But if you can force or encourage more disclosure, there will be a natural tendency for companies to perform better to demonstrate a competitive advantage,” notes Clifford.
The carrot and stick
That said, ESG adoption will depend to a large extent on the alignment of investors’ sustainability and investment strategies. For instance, opportunity funds that buy and sell buildings quickly – such as in China and India, where a lot of new development is taking place – will not be as interested in spending resources on improving the sustainability of their properties to guard against depreciation.
By contrast, long-term investors with a 10 to 20 year investment horizon will not want to pay a high price for a building designed or constructed on the cheap, and without a long-term vision around sustainability, since they will need to invest considerable time, effort and money in upgrading the property to maintain its competitiveness. Instead, such investors are more likely to incorporate a sustainability focus into their investment strategy from the outset.
Regulation may have a role to play here. For instance, China has been rolling out real estate emissions regulations. Shanghai and Beijing both have schemes covering building energy performance, which is forcing properties to reduce their emissions. More long-term incentive programs that spur investments in green buildings, and that are not subject to government caprice, could further foster sustainability practices.
While traditional factors such as location and quality remain the main force driving property values, environmental performance is an increasingly nuanced field, offering different drivers and benefits for different stakeholders. Understanding and capitalizing on these opportunities can create a source of differentiation for properties and funds, helping tip the investment decision balance.
And that will only continue, reckons Clifford. “People are trying to do more, not less. Regulation is trying to enforce more, not less. So improved sustainability is the direction of travel for the real estate industry.”
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