Whether or not investment in sustainable buildings is currently profitable, green fund managers argue it is best to begin making changes now.
Wildfires in California, floods in Germany, drought in Australia. Channel surf the news on any given day and you are likely to see evidence that climate change is beginning to affect the lives of people all over the world.
Obviously, something needs to be done to lower the production of greenhouse gases believed to be causing this extreme weather—and just as obviously, part of the solution will involve the buildings in which people spend as much as 90 percent of their time. What is less obvious is that many developers say all the retrofitting and rethinking they need to do will present a profitable business opportunity.
The Case for Green Profit
Often, proponents claim, a green building is cheaper to operate, less financially risky, and—depending on the sector—more attractive to prospective tenants. In some European cities, for example, office buildings that have earned the highest ratings for sustainability now enjoy a 10 to 20 percent rental premium over ordinary buildings, says Abigail Dean, global head of strategic insights for global investment manager Nuveen Real Estate.
Real estate also has an advantage in that the story is easier to tell, says Sam Adams, chief executive officer of Vert Asset Management, which markets a green real estate investment trust (REIT) index fund. “When you start talking about sustainability and you explain how a company is more sustainable, using real estate as an example, people can grasp that quickly because they’ve changed the light bulb, they’ve paid a utility bill, they’ve had materials in their building that they like and some that they don’t like,” he says. “And so it’s very tangible, very real for investors.”
Once he tells people, for example, that the Empire State Building recently had an energy retrofit and its energy bills are now 40 percent lower, they can see the opportunity very clearly. “I think real estate has a huge role to play in getting investors excited about sustainability because it’s so tangible and the solutions are so readily available and understandable,” he says.
Investors have taken note, and many asset managers have reshaped their portfolios to meet the demand. Major developers such as Hines are luring investors into property funds that earn high marks for environmental, sustainability, and governance (ESG) factors, and a large number of REITs are also going green. Retail investors, too, are being given access to exchange-traded property funds with a green tilt, such as the offerings of Vert and BNP Paribas.
And bond buyers are not being left out: demand is strong enough that some green property bonds now trade at a lower cap rate than ordinary bonds. One property manager says that right now this field offers easy money. “To be honest, they just fill out a form that says it’s ‘green,’ and that’s it.”
“Investors like the green touch,” says Claus Hecher, head of business development exchange-traded funds and index solutions for BNP Paribas in Munich.
But are green investors right to be bullish?
Often, the value of green improvements outruns cost. Simple measures such as installing insulation can reduce energy needs and cut power bills at the same time. Hans Vrensen, head of research and strategy for investment manager AEW Europe, estimates in the firm’s 2022 global outlook that it will cost just below 50 basis point in annual returns over the next five years for investors across 100-plus global markets to align themselves with the carbon emission reduction pathways agreed to in the Paris Accord by applying the Carbon Risk Real Estate Monitor, a global carbon benchmarking tool.
Advances in technology are also expanding the boundaries of what is economically feasible for asset managers. Artificial intelligence–controlled heating, lighting, and cooling of the kind featured in Nuveen’s Cube, a 175,000-square-foot (16,300 sq m) office building is making it easier to be efficient.
Solar panels, too, are over 80 percent cheaper than they were in 2010, facilitating new business models. One California startup, ZNE Capital, takes master-metered class B and C apartments in the Sun Belt, improves their energy efficiency, then installs solar panels—moves that shrink the building’s carbon footprint while increasing operating income and therefore the building’s value. “Clean technology doesn’t make bad real estate deals good, but it always makes good real estate deals better,” says Owen Barrett, founder and president of ZNE Capital.
Not only can solar installations reduce electricity costs, but also some buildings can even produce more power than they consume. For energy-efficient, low-rise buildings with large roofs or surrounding land that can be given over to solar panels, “it absolutely should be feasible to have them generating more energy than they’re using,” says Dean.
But it is not all easy. Though the first stages of reducing energy use and a building’s emissions—such as installing insulation and double-glazed windows—tend to be fairly inexpensive and the costs recouped fairly quickly, subsequent projects can be more expensive. Also, it is more challenging to reduce emissions in some sectors than others. For instance, a class A downtown office building will be less costly to retrofit as a percentage of value than a suburban distribution center, analysts say.
And as in all things connected with property, location matters—and not only in terms of how sunny it may be. For example, some countries use more fossil fuels than do others. In France, the country’s reliance on nuclear power makes French assets inherently lower carbon than those in coal-burning Poland.
In most sectors, there is also a lag between investors’ appetite for green properties and the enthusiasm of tenants for them. Outside of prime office stock in major cities, Dean says, there is less enthusiasm among tenants for green property. “I think that’s a real challenge for asset managers—that slight disconnect between investors and customers.”
The human side of the energy transition is another challenge as well. “We’ve spent quite a lot of time up-skilling our investment committee, for example, to ensure that they have a good understanding of what the different ESG strategies of our different products are so that they can ask questions about whether an acquisition fits in that,” she says, “because what might work for one strategy may not work for another.”
Property managers, too, are learning new tricks. “Traditionally, property managers are focused on collecting the rent and ensuring that the buildings are being cleaned and they’re insured,” Dean says. Now, they also need to understand a lot about what a sustainable building looks like and how it is operated. They also need to know how to work closely with tenants, she adds, “because the reality is that it’s the occupiers in the building that are actually using the energy, and we need to be able to work in collaboration with them.”
Other asset managers agree that tenant behavior will play a crucial role in the success of efforts to reduce emissions.
“As a landlord we have control over a lot of the building’s performance. . . . but we don’t have control over the way tenants use their own space. . . So to maximize performance, we have to work with tenants to influence their use of the building and to help them to be more efficient,” says Simone Pozzato, manager of the Hines European Core Fund, which has won awards for its ESG performance.
At Hines, managers try to emphasize their shared interest in reducing energy consumption, Pozzato says. “The way we do this is by bringing our tenants in on a common interest we have. For example, we monitor the consumption data for our own buildings,” he says. “Now we don’t just keep this for our own use. We share the findings with the tenants, and we say, ‘Well, look at your consumption curve. Could we bring this down? Do you really need to have the lights on from 7 p.m. ’til 10 p.m.? How many people do you have in the office at that time? If you turn the lights down or off where they are not needed, maybe you can reduce your energy consumption.’ Most tenants have their own net zero objectives, and so they are very receptive to these suggestions.”
But even getting the data needed to make that nudge is not automatic. Tenants’ lawyers can still sometimes strike out Nuveen’s green lease clauses, which guarantee access to energy use data, not understanding why the property managers need it, Dean says.
New Year, New Rules
Another challenge is that although the goalposts have not moved, the scoreboards and the rules keep changing. Every year, the number of ESG benchmarks grows and the benchmarks themselves become more nuanced, complex, and sometimes more complete, market watchers say.
“There are a lot of numbers and scores, and they are not all correlated,” says Fulya Kocak, senior vice president in charge of ESG issues for the National Association of Real Estate Investment Trusts (NAREIT).
“It’s our impression that many investors are still uncertain about what it all means to implement a holistic ESG approach,” says Peter Epping, global head of ESG for Hines.
Vrensen argues that it is time to take stock of existing benchmarks. “It’s madness and counter-productive to just keep adding new measures. Let’s consolidate and focus on what’s most important,”
Most of these shortcomings seem to be the result of growing pains related to the limited amount of data available.
“The market is still struggling to get tenant data,” says Julia Wein, an associate at the Institute of Real Estate Economics in Austria and a director of the Carbon Risk Real Estate Monitor (CRREM).
Eventually, however, analysts and executives seem confident that more detailed, granular, and consistent information will become available. Hines’s Epping predicts that in five years, much more ESG data will be available and it all will be better organized. “I’m pretty sure that we’ll have something that is a lot more transparent, and a lot more data will be stored and benchmarked,” he says.
The benchmarks are still missing things, too. Leakage of refrigerants—gases 10,000 times worse for the atmosphere than carbon dioxide—are often not yet included. Wein estimates that this could reduce the scores of some buildings dramatically, particularly in retail, an already lagging sector, by 20 to 30 percent.
Embodied carbon is also often not yet incorporated into benchmarks, although it is an important element: the amount of carbon that goes into the construction of a building typically is equal to the first 25 to 50 years of carbon emissions for a building, Wein says.
“The next frontier in ESG with regards to climate change is embodied carbon,” says Adams. “It’s a big deal for the developers, the homebuilders, those guys; less so for the REITs because they tend to be more landlords rather than developers. But it’s an issue for everyone in terms of renovations and retrofits and things like that.”
In the end, Vrensen argues, concerns about embodied carbon will lead people to place more value on retrofitting buildings. As he heard the chief executive officer of one German office company say, the best green building is the building you do not build. “If you think about the logic of that, it makes sense because we already have a lot of buildings. Why do we need new buildings?”
Net (Zero) Present Value
Investors support may also falter if returns fall, as some analysts now forecast. Analysts at Green Street, for example, argue that achieving net zero carbon emissions will reduce the long-term value of eight of 17 main property sectors by at least 2 percent, and the value of lodging, data centers, and cold storage facilities by more than 5 percent.
But Adams argues that it is too early to tell. “Other types of factors—like small cap and value and those types of things—we have 100 years of data on, so academics and asset-pricing scientists can say, here’s the significance of that and what we can expect going forward,” he says. “With ESG, we have 15 years’ data total, and not very much of that is very good, so it’s hard to come up with definitive answers on how it’s going to improve returns or lower risk, or both, or what it’s going to do.
“But from a theoretical perspective, it’s pretty clear a company that’s using less inputs and creating more outputs, a company that has less risk in its supply chain, a company that has better risk management in its governance is going to be a better-run company.”
But profitable or not, at present, green fund managers argue that it is best to begin making changes now. “You’re clearly exposing yourself to the risk of capital market repricing or of future significant capex if you don’t approach it early on,” says Epping. “But equally, if you manage to move early and build up a reputation and strong branding for having assets that perform very strongly in this field, then clearly it’s an opportunity to be seen as a leader and someone who understands these types of assets really well.”
Either way, time is not on the industry’s side. “Our analyses indicate that climate-change transition is a manageable problem for real estate, but we do need to get started and scale up on the available solutions,” Vrensen says.