SUMMARY

Investors and their stakeholders are increasing the use of environmental, social and governance (ESG) criteria to screen investments, causing private equity real estate investment managers to place more focus on measuring their portfolios against environmental sustainability benchmarks ("environment" being the most prominent component of ESG in the real estate space). This stems from factors including the financial risks attributable to climate change, the potential enhanced reputational and financial benefits associated with sustainable assets and increasing government support for green assets reflected through fiscal spending and regulations. Prudent private equity investment managers are exploring the application of strategic ESG initiatives in their investments, not only to address requirements from investors and regulators but also to enjoy some of the enhanced returns that are associated with green portfolios.

GROWING INVESTOR FOCUS

More and more investors are using ESG principles as part of their risk management calculations, and private equity investment managers that are raising capital should be prepared to present these increasingly socially conscious investors with the ESG initiatives that they plan to employ. According to the 2019 PERE ESG Investor Survey (PERE Survey), 70% of institutional real estate investors have explicit ESG policies in place, and nearly all respondents reported that ESG principles have a role in shaping their investment decisions. The PERE Survey reported that 35% of such real estate investors already expect their investment managers to implement ESG initiatives, with a further 13% stating that they would require such initiatives within the next three to five years. Investors are also appointing in-house ESG experts and are insisting on compliance with global ESG benchmarks. Such benchmarks include the Global Real Estate Sustainability Benchmark (GRESB), which saw participation in adoption of the benchmark grow by 18% in 2020 amid the COVID-19 pandemic and now represents over US$5.3 trillion in assets under management, and the United Nations Principles for Responsible Investment (UN PRI) which has more than 1,100 signatories and represents US$70 trillion in assets under management. Benchmarks such as GRESB and UN PRI allow organizations to aggregate a vast amount of data and better understand the economic consequences of maintaining increasingly larger green portfolios over time. In addition, many real estate investment managers and developers are obtaining green building certifications (such as the LEED and BREEAM certifications) to reflect environmental accountability to both investors and tenants.

Investors (and their stakeholders) not only expect ESG initiatives from their investment managers, but are migrating capital to achieve this objective. An example of this can be seen in BlackRock's annual letter to chief executives for 2020, in which Larry Fink, chairman and chief executive of BlackRock, stated that it would be "exiting investments that present a high sustainability-related risk." ESG-focused investing has grown to over US$30 trillion in assets and many market analysts are convinced that there is no end in sight for this booming trend. It is now commonplace to see the launch of a multi-billion dollar capitalized fund with the explicit goal of deploying capital in sustainable investments – a recent example being the Morgan Stanley-managed US$4 billion Global ESG High Quality Growth Equity Fund, which was formed to invest in ESG-focused companies. Investment managers that do not incorporate ESG considerations may find themselves at a disadvantage if investor appetite for assets without an ESG focus dries up.

FINANCIAL RISKS OF BROWN ASSETS

A recurring cause of the increased financial risks associated with "brown assets" (i.e. assets without sustainability elements) are the widely perceived effects of climate change. In its 2019 annual "Weather, Climate & Catastrophe Insight" report, Aon estimated that the global economic loss related to weather and natural events was US$232 billion, making 2010-2019 the costliest decade ever as it relates to natural disasters. According to the report, 2019 was the second warmest year on record for land and ocean temperatures since 1851. Further, the World Economic Forum's "Global Risk Landscape Report" listed seven of the top 10 risks for businesses as climate related, with factors connected to the environment and climate change representing all five of the top risks for the first time.

Regardless of the ongoing debate on the effects of climate change, investors are taking note of the economic risks associated with natural disasters and are asking questions such as (in the words of Larry Fink) "what will happen to the 30-year mortgage – a key building block of finance – if lenders can't estimate the impact of climate risk over such a long timeline, and if there is no viable market for flood or fire insurance in impacted areas?" According to news reports, investors are already feeling the economic consequences of natural disasters in the form of rising insurance premiums in regions that experience increased threats of recurring natural disasters, and the insurance industry is contemplating what the future of coverage in some of these areas will look like. Even if there are arguments that concerns such as these are theoretical in nature at the moment, real estate investment managers should be prepared to show the steps that they are taking to address these concerns and mitigate any financial loss that may arise in a worst case scenario. As environment-related losses and/or costs continue to climb, investment managers can expect continued pressure from investors who may end up finding investments in brown assets too risky or expensive.

FINANCIAL BENEFITS OF GREEN ASSETS

The employment of strategic ESG initiatives may not only decrease the financial risks associated with environmental disasters, it may also enhance the financial performance of a real estate asset resulting in higher distributions to investors. Recent studies indicate an increasing amount of data that suggests that real estate managers should embrace ESG initiatives from an enhanced-profit perspective, with sustainable properties being shown to outperform less sustainable-focused assets in a number of areas.1

  • Asset Valuation – Evidence suggests that environmentally certified buildings attract a premium to asset value. Furthermore, REITs with a larger share of sustainable properties in their portfolios compared to their peers enjoy higher equity market valuations relative to the net asset value of their portfolio. Such valuations exceed any improvements in the underlying market value of the properties as a result of high cash flows or lower risk and is attributable to an enhanced corporate reputation.
  • Rental Revenue, Tenant Satisfaction and Sale Price – "Green" buildings are perceived as being able to achieve higher rental revenue by attracting and retaining lucrative tenants. Findings also show that modern and efficient sustainable properties are associated with higher tenant satisfaction, which could result in lower tenant incentives and re-leasing costs over a period of time. Furthermore, fund managers have reported green premiums on the sale price of assets as a result of improvements to the ESG credentials of such assets. On the contrary, just as there may be a premium on the value of a green asset, the value of a brown asset may be discounted due to additional upgrades and maintenance that will be required by a buyer in order to maintain its portfolio risk levels.
  • Obsolescence and Enhanced Financing Terms – A more efficient building will also help to reduce the risk of obsolescence. Also, lower interest expenses are associated with sustainable properties, and research shows that green buildings carry a 34% lower default risk as a result of a favorable loan-to-value ratio where risk is lowered by a green price premium. According to PERE, major real estate market players, such as Savills, have stated that lenders are currently awarding green premiums to borrowers whose assets have sustainability elements by imposing stricter borrowing terms on projects with fewer ESG attributes rather than rewarding those that offer them.

GOVERNMENTAL REGULATIONS

In addition, governments are shaping behavior in the real estate industry as it relates to ESG initiatives through a combination of regulation and fiscal spending. According to the Wall Street Journal, as of July 2020, the world's top 50 economies were putting US$583 billion into boosting green efforts. Europe leads the way in terms of ESG-related governmental regulations. For example, according to research services provider Infomineo, France requires asset managers and institutional investors to report how ESG considerations are incorporated in their investment and risk management processes, and the Netherlands requires pension funds to disclose in their annual reports whether their investments incorporate any ESG considerations. Furthermore, the European Union has laid out an Action Plan on Sustainable Growth to direct capital flows toward sustainable investment. Asia is not far behind as it relates to government incentives to adopt ESG initiatives. The Monetary Authority of Singapore published plans in November 2019 to deploy US$2 billion to develop Singapore into a green financial hub, and Japan's Government Pension Investment Fund, the world's largest pension fund, is a very vocal proponent of responsible investing. Over time, as more government agencies enact ESG-related regulations and/or set aside capital specifically for ESG-related objectives, an investment manager that has not already employed ESG initiatives may have no choice but to do so. Investment managers that already have embraced ESG initiatives will enjoy the benefit of not having to immediately take on the educational hurdles and economic costs associated with modernizing their investments and risk management processes.

CONCLUSION

If the incentives and pressure from investors and governments further intensify (as they are expected to), ESG-focused investments will transform from a sub-class of investments to the expected norm, and the greening of real estate portfolios will move from a nice-to-have reputational booster to a vital component to fight off discounts on "riskier" assets, putting at a disadvantage investment managers that do not employ ESG initiatives. In the immediate term, a manager that is waiting to see if the ESG trend bottoms out would be excluding itself from the opportunity to raise capital from investors looking to participate in a class of investments that is already valued at US$30 trillion. While weighing other factors, such as the transition costs of implementing ESG initiatives across a portfolio, the financial consequences as well as the implications to investor and government agency relationships should be considered by managers in their assessment of whether ESG initiatives fit in their business model.

Footnotes

1. "Green Building Valuations; from a Valuers' Perspective", L. Abdullah, T. Mohd, S.F.C. Pin and N. Ahmad, 2018

"Decomposing the Value Effects of Sustainable Real Estate Investment: International Evidence", A. Devine, E. Steiner and E. Yonder, 2017

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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