With buildings accounting for 40% of greenhouse gas emissions and the way environmental, social impact and governance issues have become a driving force in global business, the intersection between sustainability and real estate is an inevitable reality. Far less predictable, though, are its implications. In a sector where participants range from architects and developers to institutional investors and fund managers, there are plenty of interested parties before even considering the millions of employees who work in office buildings.
In practice, most of the ESG implications for commercial real estate fall into one or more of three categories: the construction of the building itself (the environmental aspect), the experience of occupiers (social impact and governance), and the financial instruments and regulations involved in funding it.
Bricks, mortar and energy
Inevitably, much of the attention focuses on energy and water efficiency, given their potential for reducing a building’s operating costs and carbon emissions, as well as increasing its rental yield, tenant occupancy rate, and asset value. A 2020 ESG report by Nareit, the US real estate investment trust trade body, puts numbers on the benefits of green buildings - 23% higher occupancy rates, 8% higher rental income and up to 31% higher sale premiums than traditional assets without sustainability characteristics.
Clearly, the appeal of a modern, green building for tenants and leaseholders is more than a question of mere aesthetics. In an era when companies are reporting on their carbon footprint and commitment to combating climate change, many see an opportunity to burnish their credentials by reducing their scope 1 and 2 emissions (emissions directly produced by a company or resulting from its consumption) as too good to miss.
Delivering on emission-reduction objectives and meeting the performance expectations of owners, tenants and financiers can be a challenging task, however. In many cases, the solution lies in obtaining certification such as BREEAM in the UK and LEED in the US, which are becoming increasingly common for commercial new-builds and renovations.
A survey of global trends by the commercial real estate and investment firm CBRE from November 2022 identified the three leading building features that impact a real estate transaction as reduction in energy consumption, green building certification, and on-site energy generation. Significantly, nearly half of the 500 respondents said they would seek a discount or simply walk away from a deal for a building with poor energy efficiency.
Given that the estimated increase in capital costs for a BREEAM-certified office building ranges from 0.2% for a ‘very good’ rating to 0.8% for ‘excellent’, the case for investment appears easily made. A gap analysis assessment regarding the EU Taxonomy is not just an efficient way to check whether a building should be considered green and estimate further capital expenditure required for renovation, but it is also essential before taking old building stock to market.
Social impact and governance factors
Broader in scope, but often less tangible in terms of metrics, the ‘S’ in real estate ESG starts with an obligation for asset owners to carry out due diligence on their building contractors. The treatment of on-site workers and sub-contractors is a potential source of reputational damage that can be avoided by careful selection and ongoing oversight. This type of analysis will in future become a core aspect of value chain due diligence, if it is not already.
Social impact should also feature in a building’s design and the facilities available, specifically promoting the health and wellbeing of occupants. Like the environmental aspects, the social contribution of a building can be officially certified, courtesy of the WELL standard, which assesses seven key factors: air, water, nourishment, light, fitness, comfort and mind. Such elements are often the objective for impact funds categorized under article 9 of the EU’s Sustainable Finance Disclosure Regulation (SFDR).
Studies by the Massachusetts Institute of Technology indicate that certified buildings offer a 7.7% rental premium per square foot, while average leases last more than a year longer, at 88.3 months compared to 75.3 for uncertified buildings. Improvements in employee mental health, wellbeing and productivity were also identified in a separate peer-reviewed study.
Wellbeing at work is not a particularly new idea, but its relevance has grown in a post-Covid world where the importance of good mental health is moving up the agenda. In the CBRE study, “features that improve physical and mental health of building users” were the most frequently cited by respondents for having a positive impact on a transaction.
Layout and facilities aside, the social aspect of ESG in real estate also involves responsible behavior on the part of landlords, sensitivity to the need for diversity and inclusion, and a positive relationship with the local community.
The governance aspect of ESG is less prominent, but the SFDR imposes a mandatory good governance check as part of compliance. Meanwhile, institutional investors are increasingly opposing the disposal of assets that do not meet sustainability standards and instead calling on investment managers to finance their transformation to meet ESG requirements.
Finance and ESG, a work in progress
When it comes to finance, real estate faces the same opportunities and challenges as many other sectors. Money has poured into ESG investments in recent years, leading to predictions that ESG assets under management could reach $50 trillion by 2025, representing one-third of the world’s total projected invested assets.
However, investors and asset managers are highly reliant on third-party rating agencies for assessing the ESG credentials of a company or fund – and not all of those experiences are positive. There is considerable variation in the metrics, weightings and investment scopes used by different agencies, inevitably leading to differences between their ESG scores.
Separately, real estate is not immune to the risk of ‘greenwashing’, in which the sustainability claims and objectives of companies, funds or projects are deliberately – or negligently – overstated, exposing them to potential legal action and/or reputational damage.
In the EU, introduction of the SFDR’s detailed technical standards in January 2023, which tighten the rules on the description and ESG reporting of funds, has led to a precautionary downgrading of some funds from the highest sustainability category, article 9, to the less demanding article 8 classification, and from article 8 to article 6.
It has also made asset managers wary about launching new article 9 funds, since they are uncomfortable about becoming first movers in what is seen as a gray area. At the same time, the European Securities and Markets Authority has proposed new guidelines imposing quantitative thresholds for eligible or sustainable assets for funds whose names include ‘ESG’, ‘sustainability’, ‘impact’ or related terms.
Rise of real estate green bonds
Although the principle of greater investment clarity is broadly welcomed, the SFDR’s detailed requirements are seen as problematic by some industry members. INREV, the association for investors in non-listed real estate vehicles, argues that the legislation fails to offer incentives for the transformation of existing properties.
The industry will also have to deal with forthcoming tax-related rules, notably the EU’s Carbon Border Adjustment Mechanism. This will impact the real estate sector through tariffs on imports of carbon-intensive cement, iron and steel, aluminum, fertilizer, electricity and hydrogen. Reporting will start on October 1, 2023, and the mechanism is due to take effect at the beginning of 2026.
In terms of instruments, along with the many exchange-traded and other funds available for investment in property portfolios, the market for real estate green bonds is enjoying rapid growth. Green bond issuance by members of the European Public Real Estate Association totaled €40bn between 2013 and April 2022, of which more than 50% was issued in 2021-22 alone. A similar story is playing out in the US, where green bond issuance by REITs rose from $8.4bn in 2020 to nearly $12bn the following year, according to S&P Global.
Sustainability is clearly an opportunity to boost growth in the real estate sector. The environmental and social benefits of a sustainable building are a sound basis for leveraging the finance needed for development and delivering a broad range of benefits and returns. The challenge lies in managing the various stakeholders involved in that process.