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25 Nov Responsible Investment: How Real Estate Investors Manage ESG Issues
Transition to net-zero carbon and climate resilience has already become mainstream for all sectors in the world. As for the real estate industry, buildings account for nearly 40% of global greenhouse gas (GHG) emissions, 50% of the world’s energy consumption, and 40% of raw materials usage, so ESG management and responsible investment are vital. Responsible investment, defined by the UN PRI as a strategy and practice to incorporate ESG factors in investment decisions and ownership engagement, becomes a trend in real estate investments.
Compared to other asset classes, investing in real estate has its characteristics. First, the investment horizon is long, which is attributed to the long construction periods of ESG properties as well as real estate properties. Second, many ESG issues mainly matter at a regional level. For example, extreme weather and water security are linked to geographic locations. A company in other sectors usually could move its operations or source alternative materials, while real estate projects do not have such flexibility. So, for investors, a systematic and informed approach to identify and manage ESG issues across the portfolio is very important.
How does ESG fit into real estate investing?
Obviously, not all ESG criteria could be applied to every type of real estate investment. For instance, an individual does not need to worry about governance concerns when he/she just simply buys a single-family rental property. In view of this, there are several possible ways to make sure different types of real estate investments ESG integrated.
REITs. Since most REITs are traded just like stocks, the criteria for ESG investing are similar to those used by stock investors. A company that invests in renewable energy infrastructure is more popular than the other that invests in traditional energy equipment. Or, if a company has committed to achieving 100% net-zero emission will attract more investors.
Funds. As an indirect real estate investment method, investing in funds requires a different approach to responsible investment. Though investors cannot make specific investment decisions, they can still influence the decision-making process. These indirect investors could monitor and engage an investment manager in need about the policies, systems, data used related to the funds.
Investment properties. Regarding this type, investors have quite more control over the ESG-focused nature of properties. Many investors are formally stating that they will include carbon neutrality objectives in strategies. As investors are drawn to properties that are more sustainable, these assets will be worth more.
Four steps to manage direct investments in real estate suggested by PRI
There are four steps to implement responsible investment for direct real estate investors, according to PRI:
Deal Sourcing. Before making an investment decision, investors have lots of work to do. The first thing is screening, which is made to see if any serious ESG problems could ruin the deal directly. For example, fines and remediation costs on contaminated land are common items that could bring financial risk. Second, due diligence is needed, especially for the environmental component. ESG due diligence work requires lots of information, which comes from a variety of sources. The sources are mainly in three types: 1) Raw data, including utility bills, building management system, and existing environmental management system; 2) Third-party reports, such as energy audit reports and certifications; 3) Independent database, like flood and earthquake records.
The output of ESG due diligence could include both risk alerts and lists of improvements with costs and estimated savings. For new constructions, it is more effective to integrate ESG factors as early in the process as possible. During the design phase, investors can request better ESG performances, such as rainwater harvesting and renewable energy installation.
Investment Decision. The ESG performances identified during due diligence should be logged into the investment memorandum to make the investment committee understand them accurately. It is suggested that a responsible investment staff should join the investment committee meeting to communicate material issues and answer questions. The investment committee also needs to note that ESG issues could affect the valuation in several ways, including but not limited to the following: 1) Additional capital expenditure, e.g. upgrading costs of a drinking water system; 2) Future income uncertainty, e.g. buildings that do not meet minimum energy performance standards set by governments; 3) Obsolescence risk, e.g. low-quality materials that shorten the building’s using life; 4) Risks identified during due diligence, e.g. high likelihood of natural disaster. Afterward, the investment committee should collect as much information as they can, then choose the material issues, and finally make the decision.
Ownership. In the ownership phase, investors have a lot to do to create value through responsible investment. As an example of managing real estate assets, investors could keep the property energy-efficient by installing sustainable equipment to reduce costs. Second, gaining a better knowledge of a building’s environmental condition could reduce uncertain risks. Also, certifications can be used in asset management, which is useful for attracting tenants and buyers. Leadership in Energy and Environmental Design (LEED) is a well-known green building certification used worldwide. In 2019, Shanghai Tower became the tallest LEED Platinum-certified building in the world. In the same year, Beijing Daxing International Airport Economic Zone was certified under LEED for Cities as Plan and Design Platnum project. Other certifications include Energy Star, BREEAM, Green Globes, Living Building Challenge, etc.
Investors sometimes have no experience of property management in the ownership phase, as they often outsourced the day-to-day management to an external property manager. The external property manager could also help with the engagement of tenants. However, when investors decide to seek external management sources, the successful management of ESG issues will rely on selecting a good external property manager and working with them effectively.
Sale. In the sale phase, investors also need to identify and manage material ESG issues to avoid unforeseen risks that could be used by a buyer to negotiate a lower price. Considering this, evidence should be provided to support claims that ESG issues are well managed. ESG management and improving performance during the previous step will be realized on the asset’s sale. As asset valuation differs in countries and regions, it is important to know more about the local regulatory environment and policies. Investors can consider as many factors as possible to make a successful deal.