Greening up: Some value-added investors find an advantage in ESG
As socially responsible investing evolves, investment managers are increasingly looking at returns through a more holistic lens, padding their portfolios with assets that are more congruent with their values.
Given the mobility in the movement, the market has seen a significant surge in managers that are keen on greening up. About 42 percent of U.S. institutional investors have incorporated environmental, social and governance (ESG) factors into their investment decision-making process, according to Callan’s seventh annual ESG Survey. GRESB, an ESG benchmarking group launched by a handful of large pension funds in 2009, also found more than 90 percent of participants benchmarked in 2019 have multiple ESG objectives that are fully integrated into their business strategies. Currently, GRESB participants total 1,005 private equity funds and listed real estate firms spanning 64 countries, representing $4.1 trillion in gross assets.
But greening up is one thing; reflecting those initiatives in a portfolio is another, particularly in a short-term hold scenario. Due to its buy-rehabilitate-sell strategy, the noncore real estate sector is perceived as having more difficulty establishing its credibility in the sustainable-investing space than the core sector does. Supporters of this supposition say the costs outweigh the returns for investments with a shorter holding period, shackling green potential in red tape. Others argue this sector is, by nature, primed for ESG but gets less credit for its initiatives because of a lack of data coverage.
Terrell Gates, founder and CEO of Virtus Real Estate, is in the former camp. He published a white paper in June that argued the three- to five-year holding periods typical of value-added or opportunistic assets render it economically unviable in the short-term to refurbish existing properties to make them greener. According to the paper, managers are often discouraged from retrofitting existing systems unless there is a requisite economic benefit during the intended holding period. Others do so with the help of governmental subsidies to reduce out-of-pocket costs, but without those, often the payback for such efforts can be more than 10 years — longer than the typical holding period.
“The reality is that the capital cost can often outweigh the benefit that you get in both op-ex savings as well as the improvement to the net operating income, which ultimately impacts the value of the property in the short term,” says Gates. “Where the magic starts to happen is in longer-term buy-and-hold assets with a longer runway for value creation.”
Industry participants such as Brad Dockser, CEO and co-founder of Green Generation, disagree with that premise, however. Dockser believes all assets stand to benefit from greening up, both in the short term and long term, regardless of sector.
“Whether you’re selling or refinancing, you get that financial pickup immediately,” says Dockser. “In addition, if you’re a core or long-term holder, you’re getting that dollar of increased cash flow all the time, and your asset value has gone up. I think whether or not you’re opportunistic with a short-term horizon, or core or open-end fund or REIT with a long-term perspective, there’s a strong financial case for this in all cases.”
Eric Rothman, portfolio manager for CenterSquare Investment Management’s real estate securities group, also subscribes to the belief value-added real estate investors do not face more challenges in pursuit of greener portfolios — in fact, he posits brownfield and greenfield rehabilitations offer more opportunities to demonstrate greenness than ground-up developments because the before-and-after costs of running the building can be more easily measured.
“I think, in many ways, when you’re doing a rehabilitation, you actually have a big opportunity to make a very big impact,” says Rothman. “It’s more in that steady-state portfolio where everything is kind of clicking along, there’s not any real active need to get into a building to add whatever it might be to change the mechanicals of it.”
Dan Winters, head of Americas for GRESB, also believes value-added funds are uniquely positioned for ESG. “Value-add funds, by their very nature and strategy, are most primed to deliver operational improvements, energy- and water-saving retrofits, and overall asset upgrades,” says Winters. Indeed, value-added funds outscored the average in a recent analysis by GRESB, which assessed 1,000 funds regarding their ESG policies. The 184 value-added and opportunistic funds scored an average of 74, exceeding the overall GRESB benchmark average of 72.
Benchmarking has created market dynamics akin to a “race to the top,” Winters says, whereby companies without a comprehensive ESG program see others score high, creating competitive dynamics that force greater attention on providing investors with structured, nonfinancial data to better inform investment risks and returns. Dockser, whose clients include LaSalle Investment Management and Clarion Partners, has observed a similar mobility in the market. “Until people see it happen in their portfolio — in other words, the money that’s saved is not in a case study for someone else but is their own — that’s what really gets people motivated,” says Dockser. “It almost always takes a pilot project.” As a result, more real estate fund managers are ordering energy, water and waste audits, while adding detailed floodplain analyses and physical asset resiliency assessments, according to GRESB. But even when pursuing a solid ESG strategy, the noncore sector still struggles with obtaining basic consumption data and with an overall lack of direction. According to GRESB, 21 percent of all 2019 participants report no formal energy-reduction targets, while value-added funds lag the broader peer group in asset-level consumption data coverage.
A broader understanding of ESG
Other aspects of ESG are much harder to measure, such as tenant experience or the benefits associated with upgrading energy sources that power soft-infrastructure assets, such as hospitals. That seems to be the direction ESG investing is headed, and it transcends light fixtures, LEED-certified buildings and other measurable upgrades, going beyond the green to fill a societal need. These need to be synergistic endeavors, not mutually exclusive, explains Gates.
“We think of it way beyond the green factor. I think that’s really what it’s about, is finding the balance of these different objectives and trying to create an optimal balance, or good harmony, between those,” he says.
Virtus’ strategy was built on providing real estate services that meet enduring societal needs, such as education, healthcare and affordable housing.
“You’re either having social impact or not, and if you are having social impact, the ideal scenario is where you can create a triple-bottom-line outcome,” says Gates.
The notion of a multi-bottom line is one Dockser says forms the pillars of the company he started, Green Generation. Green Generation was founded on the notion of a double bottom line — or greening up in a manner that increases cash flows and asset values, while lowering carbon footprints. He calls it “operating in the green,” which veers away from the traditional approach to real estate, where people were asked to invest in sustainability without a clear return on investment.
“By definition, reducing energy demand has to reduce your carbon footprint,” says Dockser. “You didn’t allocate money to reducing carbon; you invested to drive the value of your assets. Now you have a double bottom line, and you can prove sustainability in some way, giving you a sustainability and resiliency impact without explicitly allocating money to doing so.”
The idea that investors do not have to trade ROI for ESG is gaining traction, unlocking potential for all real estate sectors for more holistic investing. “There’s pockets of capital out there that are much more concerned about having a sustainable investment than having necessarily the highest single yielding investment or highest single returning investment,” says Rothman.
Even in the past five years, sustainable investing has undergone a significant evolution, bringing some growing pains along with it. But as ESG principles become more of a must-have than a nice-to-have, an ESG story is more important than ever. With this in place, real estate investment — and investment in the noncore segment specifically — shows great promise in carving a niche for itself.
Kali Persall is a reporter with Institutional Real Estate, Inc. and editor of iREOC Connect.