The environment factor
Nina Röhrbein reports on the progress of sustainable real estate
Earlier this year, a report published by Dutch institutional investors APG and PGGM and the UK’s Universities Superannuation Scheme (USS) revealed that, although energy-saving investments can create value for property investors, the majority of the 700 listed property companies and fund managers surveyed were not yet actively managing environmental issues in their portfolios. Nevertheless, sustainable real estate seems to have come a long way.
Research undertaken by Russell investments ‘Themes on ESG in current practice: US and pan-European core real estate open-end fund managers’ found that sustainability initiatives sought by property fund managers have gained momentum over the last two years. “The fund managers in the survey were seeking to balance their fiduciary responsibility with the desire to pursue sustainability initiatives,” says Tamara Larsen, senior research analyst at Russell Investments.
“They are currently working on identifying or developing a benchmarking framework for sustainability performance across property types and countries that can be consistently applied across their portfolios, including new and existing buildings.”
“While environmental issues are not as yet critical factors in property management, particularly at a time when rents and yields are under intense pressure, they undoubtedly represent a significant long-term risk,” says Tatiana Bosteels, head of responsible property investment at Hermes Real Estate. “The impact on the bottom line of failing to adopt such practices for real estate companies and their institutional investors is minimal and difficult to measure in the current market environment. However, we believe that the combination of government action and market-led forces could lead to a tipping point in as little as five years.”
The exponential growth in ESG or sustainability in real estate in recent years has been driven mainly by legislative pressures arising from the EU’s Energy Performance of Buildings Directive (EPBD) or the UK’s CRC Energy Efficiency Scheme. However, while the EPBD has led to a lot of discussions about design versus energy performance, it is still debatable how much of an impact it has had in practice. A large number of property transactions are still being undertaken without the UK’s Energy Performance Certificates (EPCs), which continues to undermine the system, believes Andy Schofield, head of responsible property investment at Henderson Global.
“EPCs are inadequate to assess the energy performance of a building because they only look at the design stage and not at the actual performance,” adds Rob Watts, director at UK real estate developer Stanhope, which runs the Low Carbon Workplace Trust with Threadneedle and the Carbon Trust. “But while on the surface a building can look good in terms of energy use, it may be occupied quite sparsely. That is why the Carbon Trust is trying to calculate the actual carbon emissions per person at work because it is just as important to know how intensively a building is being used.”
USS has been working on integrating sustainable real estate since 2001. At present, 85% of its real estate portfolio is direct property in the UK, while the other 15% has recently been invested in non-listed property funds.
According to David Russell, co-head of responsible investment at USS, the property investment sector has lagged behind public equities with regard to sustainability or environmental, social and governance (ESG) issues. “However, it is catching up quickly,” he says. “The advantage is that we own only a small fraction of shares, usually less than 1% of the listed companies in which we invest, whereas we are the owners of our properties, leaving us with a higher level of control.”
The Dutch pension asset manager APG, which has real estate assets of €16bn under management, started implementing ESG criteria in real estate in early 2009 based on its own research study. Sander Paul van Tongeren, APG’s senior sustainability specialist for global real estate, does not believe the integration of sustainability to be any easier or more difficult than for other asset classes. However, he says, the global spectrum of investment opportunities of approximately 700 companies is more easy to assess for institutional investors than the equity universe. “For real estate we do the ESG assessment ourselves, while for equities we have to employ the help of ESG rating providers to supplement our in-house resources,” Van Tongeren comments.
Efforts to raise sustainability issues have so far focused on new construction, and improvements for older building stock are more elusive. This is a significant issue because 80% of existing buildings will still be standing when the UK’s carbon reduction target expires in 10 years, warns Bosteels. “Higher environmental standards will be required when refurbishing existing assets in the coming years as new regulations and taxes are applied. In anticipation of this, some owners have adopted a smart management approach, whereby they make low-cost improvements that have a tangible effect on their carbon footprint.”
On an existing vacant building, costs of retrofitting to the highest energy efficiency quartile are slightly higher than on new developments, according to Tim Mockett, partner at Climate Change Capital. “We do not know what the costs are going to be of non-compliant buildings in a couple of years’ time but by undertaking retrofits we are ensuring competitive positioning within the market place in the medium to long term,” he says. “Energy inefficient buildings will ultimately be less attractive to occupiers and investors and cost more to hold.”
“Some of our most sustainable buildings have been where we have provided a new lease of life to a tired, existing building because the embodied carbon alone could be worth between 10-20 years of energy consumption,” adds Watts.
Institutional investors also manage and monitor the energy efficiency, waste reduction and water usage of their properties. Location-specific criteria such as floodplain risk and accessibility to public transport also play an important role.
“We, for example, do not take market risk so will not buy empty buildings for our fund,” says Mockett. “For us as fund managers two things are crucial: does the existing occupier share our ESG goals and ambitions and is therefore willing to share the costs and do the physical attributes of the building enable us to get a good return.”
“We look at the low-hanging fruit first,” says Russell. “In other words, how do we make the changes where low investment actually leads to a high return so the tenants do not have to pay extra costs for additional energy efficiency. We concentrate on properties where we have control over large areas of space to enable USS to pick up the savings in energy and waste. But property owners investing money for tenants to reap the benefits or how those benefits should be split remain issues.”
Respondents to the Russell Investments survey do not think there is a green premium today but believe that sustainability contributes to tenant retention, reduced operating expenses and the strengthening of building occupancy. They also believe that, within the next five or 10 years, forces such as regulation, tenant interest and future buyer demand are going to increasingly reward high-performance buildings. In other words, they believe in the idea of future proofing for enhanced competitive positioning and valuation over the longer term.
“The green premium is the holy grail, which is very difficult to assess at this stage,” says Mockett who pegs the return from sustainable real estate at around 15%, with half coming from income and about half from capital gain.
But for now, the collection of sustainable real estate data seems to be the most difficult challenge the sector faces. “The sector is only beginning to collect systematically ESG information on properties,” says Russell. “There is still a long way to go in terms of appropriate data collection.”
“We found that existing data from listed real estate companies was outdated, unclear and coverage was listed to a maximum of 40% of the full listed universe,” adds Van Tongeren. “That is why we undertook the data collection with Maastricht University and asked USS and PGGM to join the research initiative as well.”
One thing is clear though: sustainability in real estate is dominated by the ‘E’, or environment, factor. The social aspect is more difficult to assess. “USS has looked at how some of its larger assets, usually shopping centres, interact with the local community, so there are ways of addressing the social aspects of running a large property portfolio,” says Russell. “Nevertheless, the real drivers for change are environmental such as the cost of carbon and energy efficiency.”