The long road to green growth

Sustainability measures have taken a backseat for real estate funds with investors split on their importance.

As a consequence, sustainability advocates are working hard to quantify the benefits. Sustainable investing is a multi-trillion dollar business worldwide. In Europe alone, so-called ‘green’ investments hit €5.2 trillion in 2014.

Yet, the private real estate market currently lacks the pulling power of other asset classes when it comes to sustainable investing. In 2014, European sustainably designed and managed real estate funds solicited only €495 million of backing, according to Catella, the Stockholm-based financial advisory and asset management firm.

Interest in green property is growing, however, and Catella expects that by mid-2016 some €850 million will be allocated to dedicated green real estate funds in Europe.

Commentators say that holding back the sector is firstly, a lack of new real estate in Europe and secondly, the difficulty in refurbishing existing assets to a uniform standard. “There is neither a universal seal of approval for sustainable real estate funds, nor a benchmark for peergroup comparisons, which are absolute prerequisites to kindle the competition,” says Thomas Beyerle, head of group research at Catella.

However, there is a plethora of sustainability labels that property fund managers can use to showcase their environmentally-friendly investing. AXA Investment Managers – Real Assets, formerly known as AXA Real Estate, last month announced it is targeting 75 percent of its direct property portfolio to be certified with such labels by 2030.

The real estate arm of the French insurance giant already incorporates sustainability certifications in acquisitions, new developments and refurbishments of existing assets and currently has 21 percent of assets under management certified including offices, residential, retail, hotels and logistics assets. “Our overriding aim is to create better environments for people to live and work in, and through reducing environmental impacts, improving social practices and setting clear goals, we believe we can achieve this,” says Anne Kavanagh, global head of asset management & transactions, real assets at AXA. “Our target of 75 percent of assets to be certified by 2030 not only meets these goals, but also creates long term value for our clients and investors by enhancing existing assets.”

For the wider real estate industry there is the Global Real Estate Sustainability Benchmark (GRESB), an industry-driven organization that assesses the sustainability performance of real estate portfolios (public, private and direct). AXA is one of the longest standing members and submits around 60 percent of its €49 billion real estate portfolio for GRESB to benchmark.

The benchmark is used by institutional investors to engage with their investments with the aim to improve the sustainability performance of their portfolio, and the global property sector at large. Yet, despite having more than 100 institutional investor and fund manager members there are those that question its current reliability in showing the entire green property universe.

“We have seen funds being quite selective about what portfolios they submit to it and ducking and diving to produce the desired outcomes,” according to one London-based real estate fund manager.

However, Esme Lowe, managing director at Impax Asset Management, an investment manager dedicated to responsible investing, is quick to point out that the benchmark is a credible test and that as more fund managers and investors join the party the GRESB benchmark will improve.

“It is a good thing and is gaining traction but at the moment it is often regarded as something that you must be seen to be doing.” Window dressing Not everyone is yet convinced that a focus on sustainability while property investing is of great importance.

Hermes Investment Management, the £29.8 billion (€42 billion; $45 billion) investment management business of the BT Pension Scheme, published its Responsible Capitalism and Sustainability survey last month which revealed that of 109 UK and European institutional investors surveyed, only 48 percent believe environmental, social and governance (ESG) factors are not important when assessing direct property investments. A mere 19 percent consider them vitally important.

“Given all the information available to these investors, the results here are astounding. Even in an area where there is a regulatory imperative, such as energy efficiency, the response is alarmingly dismissive,” says Chris Taylor, head of private markets at Hermes. “Nearly half the investors believe energy efficiency is, by and large, unimportant, and yet it is easy to demonstrate financial savings from best practice here and reckless to ignore the red tape.”

Taylor says that these survey results suggest that such investors are short-sighted or unduly influenced by short termism. Possibly both. That may be acceptable for an opportunity fund but problematic for a pension fund, he says.

“I have some sympathy for the investors who say that ESG is not important, because from a classic landlord’s perspective they look at it like they are just being forced to spend money. It’s a tax on a building,” adds Basil Demeroutis, managing partner of London-based family office investment firm FORE Partnership. Demeroutis is committed to making sustainability part of FORE’s asset management and the firm was recently awarded a ‘Gold’ sustainability certificate at the EXPO REAL conference in Munich for its Geisberg Berlin project by the German Sustainable Building Council (DGNB).

“Cynics think it’s just putting on a few solar panels and potted plants out front and collecting a bit of recycling. They [investors] ask themselves whether for all this extra effort and cost and compliance associated with sustainability they are really changing the world? The answer in fairness is probably not. I guess that’s why people just roll their eyes and see it as another tax or compliance burden. When you have a highly-regulated asset class like real estate, people are very cynical about adding even more regulation,” says Demeroutis. “Someone who is predisposed to think this way will probably look at firms announcing sustainability initiatives and say it is window dressing and wonder how it is any different.”

Property has traditionally been considered a high carbon asset class and therefore it has been inevitable that the ever tightening ratchet and subsequent implementation of global environmental policy is impacting the sector.

The UK is one jurisdiction which has some of the strictest property environmental regulations in the world. While Energy Performance Certificates (EPCs) were introduced in the EU in 2007 and are now mandatory for all new commercial buildings, in 2008 the UK went a step further with a requirement for all public sector buildings to have Display Energy Certificates (DECs) to demonstrate real operational data. Additional proof of the UK Government’s commitment to improving the sustainability credentials of the property sector was the adoption of the Energy Efficiency Regulations 2015. Under these regulations, all non-domestic rental properties will be required to have a minimum EPC of “E” by April 1, 2018. It is estimated that a fifth of all EPC rated buildings in the UK may not meet the standard and risk becoming unlettable in 2018. This legislation poses a considerable threat to the value of many commercial property portfolios.

“There are certain properties out there, probably more tertiary than secondary locations that you aren’t going to even be able to let and that may not have been fully focused on by the market,” says Paul Hastings corporate real estate partner, David Ryland.

Quantifying the value

It is not merely the box-ticking nature of regulations that cause some to doubt the benefits of going green. As the success or cost of many sustainability initiatives have not typically been quantifiable when a fund manager has exited an investment, some investors shrug their shoulders as they cannot be presented with hard numbers.

Past research that has attempted to prove the pros of green property investing has only been applicable at portfolio level and using a generalized sustainability benchmark that does not link environmental performance with value.

However, Impax Asset Management is trying to change that via a new approach which aims to generate a robust quantification of green alpha at the individual asset level using actual benchmarked financial data.
This work highlights how green alpha is created predominantly through active energy management. The remainder of the excess returns are generated by other positive externalities which are more likely to occur with more sustainable properties. For example, greener buildings are more attractive from a Corporate and Social Responsibility (CSR) perspective and so will attract and retain stronger covenants and ultimately stave off rental depreciation and obsolescence.

However, proving to what extent these factors have contributed to the excess or overall alpha remains a work in progress, says Lowe. But for now, energy cost reductions are quantifiable and can be expressed as a percentage of the ungeared net differential total return.

Also attempting to showcase that the greenest buildings are the best performers are Dr Nils Kok of Maastricht University in The Netherlands and Dr Avis Devine of the University of Guelph in Canada. The pair analyzed 10 years of financial performance data across a Bentall Kennedy-managed office portfolio totaling 58 million square feet. The results evidence that buildings with sustainable certification outperform similar non-green certified buildings in terms of rental rates, occupancy levels, tenant satisfaction scores, and the probability of lease renewals.

Net effective rents, including the cost of tenant incentives, average 3.7 percent higher in Leadership in Energy & Environmental Design (LEED) certified properties in the US than in similar non-certified buildings. Rent concessions, for LEED and Canadian certified BOMA BEST buildings are on average 4 percent lower than in similar non-certified buildings. Occupancy rates during the period were 18.7 percent higher in Canadian buildings having both LEED and BOMA BEST certification, and 9.5 percent higher in US buildings with ENERGY STAR certification, than in buildings without certifications. Tenant renewal rates were 5.6 percent higher in Canadian buildings with BOMA BEST Level 3 certification than in buildings with no BOMA BEST certification.

By documenting significantly higher levels of tenant satisfaction, increased probability of lease renewals, and decreased tenant rent concessions for certified buildings, these results are able to provide insight into the non-financial implications of constructing and adopting more sustainable space. “Previous studies have suggested similar correlations but none of these looked at in-depth, diverse metrics across a large portfolio for as long as 10 years,” says Giselle Gagnon, senior vice president of the strategic resources group at Bentall Kennedy. “Investors want evidence to support the economic merits of investing in sustainable buildings, and this new academic research provides exactly that.”

Yet, Impax’s Lowe says that you’ll never be able to financially quantify directly some of the soft tangible issues. “A simple analogy is do you like working for your current employer? There are things there that make it a more attractive environment so it attracts and retains good quality people and the same is true of buildings.”

And Mathieu Elshout, director in the private real estate team at Dutch pension fund manager PGGM, agrees that investors can be skeptical of the soft issues because overall they feel sustainable initiatives will cost them money. “There is a leap of faith that investors have to take. It helps if you have someone focused on sustainability, not everyone does and that will make it harder for it to be at the forefront of their thoughts.” FORE’s Demeroutis agrees and adds that to get investor and tenant buy-in for sustainable initiatives the focus must be on showcasing how it is also a cost saver.

“We need to change the conversation. It has to be less about carbon reduction or how much CO2 a single tree saves,” says Demeroutis. “We have to talk first and foremost about cost savings for tenants. When we integrate carbon reduction strategies in our buildings we talk to our tenants about how they are saving on service charge, as carbon efficient buildings are cheaper to run.”

But, with the Hermes survey revealing that nearly half of investors are not interested in taking that leap of faith, green property advocates still have an education job on their hands. And as Elshout says: “It [ESG criteria] is a very important, but of course one of more factors we take into account when choosing a fund manager, and we don’t feel we have to give in on the return to integrate sustainability into the strategy.” Impax’s Lowe also says that lines can be blurred for investors as a lot of fund managers will say they are using sustainable property initiatives. But to what extent is it fundamentally part of their DNA and are they really committed to it? “Our sense and experience is that a lot of people still see this as a tick-box issue to show to investors as opposed to something that goes to enhancing value.”

More available data to back the hypotheses that sustainable initiatives aid returns from green property would likely see sustainability practices become more mainstream. But for now, the prevailing sentiment from the private real estate sector is that it is a different kind of ‘green’ that investors truly value.

Hermes: What investors want

48% – Institutional investors surveyed by Hermes believe ESG factors are not important when assessing direct property investments
19% – Consider them vitally important
37% – Institutional investors surveyed felt pension funds should give greater consideration to whether their
investments will improve or detract from the overall quality of life experienced by beneficiaries when they retire
60% – Institutional investors surveyed want their fund managers to be more transparent and share their ESG analysis on at least a quarterly basis

Case study in corporate values

FORE’s exit of a speculative office development at 58 Victoria Embankment for £51 million shows how proactive sustainable design can generate greater returns.

One of the main benefits extolled by sustainable property advocates is that tenants prefer to occupy green buildings. If this holds true either rental growth increases or asset depreciation lessens. It also means shorter interruptions to cash-flow.

But why do tenants want green buildings? In many instances it can be due to a company’s Corporate and Social Responsibility (CSR) charter as well as fulfilling a wider strategic purpose, says FORE’s Demeroutis. “We are in a part of the business cycle where there is a lot of competition for staff as well as clients. There is a war on talent and companies need to attract and retain staff and foster creativity in their business. You can use these sustainability tools as a means of doing that. Who wants to work in a clean and healthy building, flooded with natural sunlight where there is a cool place to hang out when you need a break? The answer is everyone.”

He says that sustainable property is not exclusively the domain of energy, water and waste, the holy trinity of carbon reduction.

“We have recently sold our building at 58 Victoria Embankment in London. We sold it to an owner-occupier, Nesta, a year before it has been completed. They had a lot of choice for 50,000 square foot of space for their office in London. But our building was one of the very few they felt really fulfilled their strategic purpose, because it not only has green features but the whole ethos behind it is in keeping with the company’s values. They identified with the building.”

Alongside joint venture partners Kier Property, the pan-European real estate investment club for family offices and private investors sold ‘VIEW 58’ to Nesta for £50.95 million (€72.4 million; $77.5 million). “It resulted in a great exit for us and was ahead of where we thought our returns were going to be. We shortened the void period after construction to zero, we got a great price for it, a happy buyer and hopefully happy staff.”

The development, designed by architect TP Bennett, has each floor opening into a central atrium and has exposed lifts and walkways. Nesta was attracted to the building’s fully-integrated vision on sustainability, which encompasses design, place-making and community engagement, as well as traditional carbon reduction features.

“VIEW 58 is a rare find; a building that is not only a perfect fit with our ambition, but also one which embodies our values, and represents a solid investment for the future,” says Nesta chief executive Geoff Mulgan.

Designed to exceed BREEAM’s Excellent sustainability rating, VIEW 58 incorporates a number of ‘green’ technologies, including solar photovoltaic panels that generate power from both the top and underside. In addition, during the demolition process, 99 percent of waste was diverted from landfill and recycled.

Calculating green returns

Advances in technology allow for detailed environmental performance measurement and mean fund managers can isolate the impact of sustainability led capital expenditure on returns through Impax Asset Management’s ‘Green Alpha’ methodology. Here is a step-by-step guide to the process.

Step 1 – Data collection

Energy data collection can begin when an asset is acquired and continue until exit offering the opportunity to identify and isolate where capital expenditure on sustainability re-fits has led to tangible operational savings. Active energy management means that buildings are equipped or retrofitted with sub-metering and half
hourly data loggers. Further data can be collected from the property’s continuous monitoring and subsequent Energy Performance Certificates (EPC) and Display Energy Certificates (DEC) and relevant benchmarking and re-rating, corroborating any energy efficiency improvements and associated carbon

Step 2 – Investment performance analysis

In order to isolate the impact of sustainability led capital expenditure on income, capital or total returns it is first necessary to account for the impact of macro and microeconomic cycles. With respect to the achievable price on any given asset, there is also the need to check for special purchasers (which may be inclined to pay a premium for a specific reason), competitive bidding and other market factors.

Using databases of local rental and capital growth and yield movements over a 20 year to 30 year period (Impax uses data from JLL), it is possible to account for the impacts of potential variability within the market up until the asset disposal. Using a discounted cash flow valuation model, together with rent and yield forecasts at the date of acquisition for the local market, it is possible to use Monte Carlo simulation to identify the most likely or median exit value for the asset at any given date.

This analysis can then be adjusted for the many other possible factors that could impact returns; the greatest of which is usually inflation. To address this, both the nominal delivered returns from the asset are adjusted for Consumer Price Inflation (CPI) as are the results of the Investment Property Databank Index (IPD) over the hold period. This isolates the ‘real’ performance differential of the asset against the market otherwise known as ‘alpha’.

Step 3 – Attributing green alpha

Green alpha can then finally be estimated using future tangible cost savings accruing from the point of exit for a five-year period, using a Net Present Value (NPV) calculation. This NPV figure is then expressed as a proportion of the total alpha described above.