No three letters have appeared more often in the real estate press over the last 12 months than ESG. In light of the Greta effect, social movements such as Black Lives Matter, and the innumerable implications of the ongoing pandemic, how the real estate industry interacts with the world around it has increasingly been at the forefront of our consciences. This can be seen not only in the materials we use in construction and the retrofitting of older buildings but also in the diversity of the talent we hire and the quality of the relations we have with our existing employees. We invited an international group of ESG experts and leaders in real estate investment and development to a virtual roundtable in order to discuss this wide-ranging topic further.

Environmental and social returns – a must have or a nice to have?

In the past, a company’s green credentials and wider commitment to social responsibility have been tucked away in the small print on their website. However, it was agreed by our panel that ESG credentials and the associated returns are becoming increasingly important.

One investment consultant commented that ESG is seen as being integral to achieving a long-term sustainable performance, reducing risk and/or enhancing returns, with investors increasingly seeing ESG as broader than three letters – ‘it’s about doing the job properly’. This means investors increasingly expect us to show respect for our impact on the built environment and operate our businesses as well as our assets in a sustainable way. According to one fund manager, the shift in the mindset of institutional investors, particularly Europeans, is a mostly recent phenomenon; they were surprised to discover that investors were willing to sacrifice just under 2% of their annual dividend distribution if it meant reaching ESG objectives. This, they commented, was surprising: everyone wants to do good but they don’t always make good on this when they are the ones to carry the cost.

To this end, environmental and social returns are no longer viewed as something businesses ought to aim for but rather, they are increasingly becoming a necessity. According to one panellist from the retail sector, the pressure on assets is becoming extremely challenging with the transition to a zero carbon economy; short-term questions regarding capex quickly become irrelevant if the assets would otherwise be unsellable and gains cannot be realised. Investors are becoming increasingly anxious about making assets fit for the zero carbon economy now, rather than waiting until 2030 or 2040.

The climate crisis isn’t the only issue weighing on investors’ minds, however. The need to generate social returns is also crucial. One panellist from the affordable living sector in the UK gave a startling statistic: a 13-year-old will go to school for 52 days more per year if they are in a permanent home rather than temporary accommodation or a hotel. They calculated that this generated a social benefit of at least £15,000 per home, which, given the average cost of building a house is £250,000, produces a ‘social return’ of 6%. Investors have seized on this as an opportunity to deliver a reasonable economic return as well as a phenomenal ESG return.

However, ESG returns do not come without their challenges. One participant from the private equity world pointed out that current benchmarks such as GRESB aren’t appropriate to a value add/opportunistic strategy as they don’t hold the asset for long enough. For longer term core/core+ strategies, where there is a focus on monitoring improvement, it is harder to justify falling short. Nonetheless, private equity funds can still do their bit, as the panellist noted, for example by adding an energy efficiency programme to capex measures or adopting responsible contractor programmes.

Investor returns – short-term sacrifice for a long-term gain?

However, despite the huge shift in investor thinking towards diversity and inclusion, sustainability and improvements in corporate governance, are returns being sacrificed at the expense of ESG? Are investors willing to pay for a higher level of ESG performance with yield? The picture is perhaps more complicated than it may first appear. According to one investment manager, whilst 92% of their investors (typically insurance companies and pension funds) are planning to commit to net zero, 80% said that ESG objectives should not be at the expense of returns. There are therefore instances where investors are not ready to pay. The manager needs to be able to show that they can still achieve the target returns.

However, another fund manager commented that there are several elements at play in investors’ thinking and that ESG performance should be viewed as a long-term goal: the shorter one’s time horizon, the more likely it is that ESG will be viewed as a cost as the majority of the financial benefit of futureproofing buildings can’t be realised immediately. A different panellist felt that the question of sacrificing yield for ESG performance was somewhat outdated as ESG is not something investment managers can avoid. ‘It would be like not doing due diligence on an asset prior to the acquisition’.

Investors are, however, keen to see the impact that their investments have from an ESG perspective, which can occasionally be hard to quantify. One of our group indicated that there is not an agreed way to measure ESG performance, which means people can claim things that others may think are spurious. Consequently, they are looking to create an ESG framework and partnership in Europe to set a standard, against which ESG performance can be measured.

Views on whether ESG performance is a short-term sacrifice or a long-term gain differ depending on the investor. As the consultant at our panel pointed out, Europe has taken a progressive approach in this regard, though there are differences between countries, with environmentally conscious Scandinavians being different from their counterparts in other parts of the continent. Some parts of Asia and North America are well behind in their understanding of the necessity of ESG performance. However, the overwhelming trend remains: investors want to see their capital invested in ESG compliant assets.

Making an impact

Whilst generating environmental and social returns appears to be high on the agenda of some investors, there has also been increasing appetite for dedicated real estate impact funds, with the likes of Cheyne Capital and Germany’s Commerz Real having recently launched funds. One of our panellists commented that megatrends such as an aging population, the pandemic and increased awareness of the effects of climate change have created ‘not a perfect storm’ but rather ‘a perfect summer’ for such funds. Another pointed out that institutional capital is increasingly taking a hard line in other sectors, notably in oil and gas, and it is likely that this will be the case in real estate over time.

In order to make good on these commitments, investors are therefore increasingly looking towards impact funds. One participant from an investment manager stated that their aim is to grow their impact investing business to 15% of AUM and that now is the time to do so. But what makes for a good impact fund? The investment manager in question believed that it is important to ‘add’ something, creating new product in sectors such as social housing rather than merely acquiring existing stock. It is therefore important to avoid greenwashing when it comes to impact funds, making sure that the impact of these funds is genuine and not just a PR exercise to highlight a few green credentials. As a result, it is important that investment managers spend time getting the correct framework for these funds in place, whereby their ecological and social impact can be measured.

Offsetting – how to do it effectively

Regardless of how sustainably a property is constructed and operated, there will always be some form of emissions. One way of combatting this is through offsetting, though our panel’s opinions differed as to how best to achieve this.

There was widespread consensus that the old-fashioned way of simply buying a section of forest in the Amazon is not sufficient. Some commented that the industry should aim, wherever possible, to construct and operate sustainably, lowering the need for offset as reducing carbon footprint can often be expensive and, in any case, the same amount of energy is being used in constructing and operating the asset, regardless of attempts to offset.
One panellist from the ESG advisory space pointed out that offsetting should take place close to where the investment is happening, for example by retrofitting assets close to the development site, or by investing in green space nearby. This would create a double gain as it also improves the infrastructure and environment of the local area. It is also important to push for the use of green energy when constructing or developing assets, as one participant from the investment world noted, with ‘build back better’ initiatives encouraged by the UK government being a great way of incentivising the real estate industry to decarbonise.

Nevertheless, our panel were united in their belief that offsetting is not an easy task but it is important to do everything you absolutely can without needlessly sacrificing returns or greenwashing.

Occupier opposition and the challenges of data gathering

However, regardless of the best efforts of investors, fund managers and developers, several of our panellists pointed out that one reason these ESG strategies aren’t being executed is the reluctance of occupiers to adapt to the zero carbon economy.

Our participant from the retail world explained that retailers are dragging their feet, and won’t share data around their energy usage and waste disposal, meaning that opportunities that greener ways of operating are being missed. In some cases, tenants are either unwilling to share their data or will not pay for the technology needed to track their energy usage.

Countering this, one sustainability expert believed that there has, in fact, been a seismic shift on the occupier side. Occupiers want a net zero building with incredibly good data around wastewater and energy usage, enabling them to lock in the environmental and social benefits – the sophisticated thinking among occupiers is there. The real issue is the lack of product: in order to reach net zero, one panellist commented, they would be required to repurposing and retrofitting 5% of their buildings each year.

Even where occupiers are receptive to more energy efficient buildings and their data being used to track their sustainability, this also brings challenges. It comes with a lot of investments in technology as well as lots of intervention: putting monitors into a few assets is quite straightforward for smaller companies, less so for major corporates. As one panellist pointed out, managers may soon have no choice but to adapt, with new legislation in France (to be implemented in September 2021) requiring businesses and their landlords to provide information on energy usage to a centralised database with fines in place for those who do not comply. Managers need to adapt to this and implement technology driven solutions to track energy usage. ESG-friendly legislation around reporting, whilst seeming onerous, seems to be doing the trick, however. One American investment manager informed us that, in the case of California, their industrial portfolio went from capturing 10% of energy data to 90%, allowing them to identify how to decarbonise their assets.

In some sectors, notably social housing in the UK, there is no choice about building sustainably or capturing usage. Here, regulators expect developers to deliver carbon neutral homes by 2025, including retrofitting existing stock. As our expert in the sector commented, this means across all UK residential there are 28 million homes that will require some form of retrofitting in order to become carbon neutral. Funds are often unable to monetise this with all of the immediate benefits of carbon neutral homes, such as reduced energy bills and dampproof homes, going to the customer. The challenge, therefore, is to convince asset managers not to go for the fast and commercial wins but instead focus on the long-term benefits of carbon neutral buildings, which means that the asset does not become stranded.

Action on existing buildings is therefore key, as one fund manager noted. However, decarbonisation of the portfolio isn’t just about focusing on ‘operational carbon’ such as lighting and heating. Half of the emissions associated with the real estate industry are to do with the construction and demolition of buildings, as well as the extraction of raw materials. It is therefore no longer sufficient to just make buildings slightly more sustainable. This requires action from all parties, occupiers, developers and asset managers. Our ESG expert summarised the situation, ‘all parties are waiting for one another to act and take a risk together’. The path to net zero requires collaboration and trust.

To net zero and beyond

The coming years look set to be decisive from a climate change perspective, with a crucial climate change conference in the form of COP26 taking place in Glasgow later this year, as well as increased pressure to ‘build back better’ in the (hopefully) post-pandemic era. We asked our panel what they are looking to do in order to improve their ESG credentials in the coming years.

A common trend was the embedding of ESG in all parts of the business, with one private equity leader commenting that the job of ESG experts is ‘to be out of a job in 5-10 years’. Sustainability should be part of everyone’s role, not just a special team within the fund. There was a feeling among one participant that we are entering a crucial, albeit delicate, phase of ESG. Designers, owners, contractors and project managers have to buy in to it and all parties in the real estate industry need to not only act with consciousness of their environmental and social impact, but also leverage the benefits of technology, data and platforms, in order to meet the challenges of net zero. This means sweeping changes, not just putting in a new boiler and saying you’ve cut your energy bill.

Whilst buildings need to be upgraded and our industry needs to become more sustainable, ESG brings with it excellent business opportunities, such as in retrofitting flats on behalf of local authorities. As one panellist from the advisory side commented, ‘the pioneers will set a way that will leave others stranded behind’.

The target of reaching net zero by 2050, increasing diversity in our sector, as well as acting in a socially responsible way, pose challenges for our industry as well as exceptional possibilities. We look forward to seeing what happens next. We would like to thank our panellists for taking part in this insightful and lively discussion.