Why Real Estate Finance Needs to Build in Sustainability

January 22, 2020

The real estate sector affects – and is affected by – climate change.

We must identify solutions to reduce emissions and mitigate climate impacts.

This approach can reap financial as well as moral dividends.

The real estate sector has a serious impact on climate change. Buildings account for around one-third of global greenhouse gas emissions and consume 40% of the world’s energy.

Furthermore, as a result of climate change we are experiencing more frequent extreme weather events, which in turn have a huge impact on real estate prices. In the US, homes exposed to rising sea levels sell for around 7% less than observably equivalent unexposed properties at a distance from the beach. In Europe, commercial, residential and office buildings are exposed to floods and high winds more and more often – such as the winter storms of 2015-2016 in the UK, which resulted in around £900 million ($1.18 billion) of property-related economic damage.

Altogether, this demands an immediate intervention from global-level governing authorities, who must now define potential solutions to manage the impact of real estate on climate change.

As part of wider efforts to implement the Paris Agreement, in 2016 the United Nations Environment Programme Finance Initiative (UNEP FI) and its collaborators produced a document called Sustainable Real Estate Investment – Implementing the Paris Climate Agreement, which is the first framework to directly support the real estate sector in meeting its low-carbon goals. It was a turning point; real estate asset owners, investors and stakeholders must now recognise they have a clear fiduciary duty to understand and actively manage environmental, social, governance (ESG) and climate-related risks as a routine component of their business-thinking, practices and management processes.

Nowadays, many investors recognise that ESG information is crucial to understanding the mission, strategy and management quality of real estate companies. Rather than only preventing climate-related losses, real estate professionals are now shifting their focus onto how to generate profit using a more responsible approach. Indeed, ESG covers a wide spectrum of issues that, while not traditionally part of financial analysis, may yet have financial relevance.

Notwithstanding the importance of lowering the impact of this sector on the climate, it is still important to maintain the profitability of the sector as well as ensuring fair returns for investors. There are several elements supporting the idea that implementing the ESG investment scheme can preserve, if not improve, the sector’s financial performance:

1. Resilience as the driver of risk management. The sector is keen to understand how to build climate resilience into investment decisions. One recent report estimated that around 35% of REIT properties are exposed to climate hazards. The risks associated with climate change go beyond direct physical damage to buildings, however; they include insurance premium repricing, economic and demographic damage, and abandonment of the riskiest locations. Therefore, resilience becomes a factor in assessing investment risk. According to a 2017 CFA Institute survey, 65% of investors were moved to take ESG issues into consideration. Governments are also adapting regulations in areas such as as energy and water benchmarking requirements, to help counter energy consumption and climate change challenges. Portfolios with an ESG strategy and data management platform are positioned to be ahead of the market, and will be able to identify properties in safe areas or to meet local environmental regulatory compliance standards, informing investment decisions accordingly.

2. Investors are looking for transparency. It is common for investors to require an ESG assessment — or a commitment to undertake one in the future — in order to allocate capital in a real estate fund or investment trust. The Principles for Responsible Investment, a signatory programme and annual survey that ranks companies based on their ESG performance, now has over 1,900 signatories with more than $81.7 trillion in assets under management. CDP, an annual survey that allows companies to report on greenhouse gas emissions and climate change mitigation strategies, has seen a 33% increase in participation since 2013, and the companies reporting to CDP now represent 56% of global market capitalization. The number of participants in the Global Real Estate Sustainability Benchmark – one of the sector’s most important ESG assessments – has increased steadily since its inception in 2010; in 2018, 903 entities managing over 79,000 assets and $3.6 trillion in gross asset value took part (see figure below).

3. Financial performance and market allocation forecasts. In the real estate sector, financial performance and sustainability seem to have found the right balance. According to MSCI’s World SRI Index, socially responsible investments funds have achieved annualized gross returns of 6.27% since 2007, against 5.56% by funds with collateral carrying negative social or environment impact. Additionally, green-certified buildings generally have positive sale and rental premiums compared to non-green buildings, as well as operating costs up to 14% lower and 9% higher occupancy rates. It also appears that sustainable housing retrofits can maximize financial returns. Looking beyond investor demand, environmental performance can help real estate companies attract lucrative tenants who are increasingly seeking efficient, healthy and green-certified buildings. Incorporating these factors can lead to increased profitability through higher property values, tenant attraction and retention and improved returns on investment. The trend is going to increase; 95% of millennial investors surveyed in a recent study are interested in sustainable investing.

The mix of market demand, climate change, increasing urbanization and financial performance requirements supports a good correlation between ESG investment and real estate. These new investing formats are either chasing or driving the growing demand for quality-based solutions. Various ESG analyses can be incorporated in the investment as part of the risk-return calculation and diversification considerations, making the battle against global change both a moral duty and a financial pillar of real estate investing for the years to come.

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