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The challenges of building a sustainable real estate portfolio

20 July 2022

With most risk assets performing poorly and offering little protection against rising inflation, investors are increasingly turning to real estate to hedge the negative effects of rising prices on portfolio returns. Over a third (35%) of global investors recently surveyed[1] cited inflation as the most compelling driver for listed property while European real estate mutual funds received the second largest inflows of all asset types in the first quarter, according to Refinitiv[2].

ESG is a longer-term driver of real estate investment and has been one of SKAGEN m²'s portfolio themes for several years. It is also accompanied by a set of unique challenges. For those who can navigate its complexities to create a sustainable and attractively valued portfolio, the opportunities are clear.

Ratings riddle

In keeping with the development of the broader sustainability 'industry', the number of ratings available to assess the green credentials of real estate assets has exploded in recent years. There are currently around 600 global systems for investors to navigate, as well as an alphabet soup of abbreviations and acronyms that has similarly spread across the broader ESG landscape.

The world's first was BREEAM (Building Research Establishment's Environmental Assessment Method), which has been used since 1990 to measure the operational energy, water, waste and air quality of commercial properties. NABERS (National Australian Built Environment Rating System) launched eight years later and is now used globally to assess the efficiency of offices, shopping centres, hotels and data centres. Another widely used is GRESB (Global Real Estate Sustainability Benchmark) which provides a top-down view of portfolio ESG metrics.

A further challenge is that ratings can be highly subjective and should be treated with caution. Like any third-party analysis, it is important to understand the methodology and data quality – there's no substitute for doing your own research.

More welcome for investors and the environment is the growing number of real estate companies adopting science-based, independently-verified targets to reduce their carbon emissions. 160 firms are now signed-up to the Science-Based Targets Initiative (SBTi), more than double the figure 12 months ago.

Cost pressures

Alongside investor attention, real estate companies face ever-increasing scrutiny from regulators, particularly relating to environmental disclosures. The SEC recently proposed rule changes requiring US companies to report on climate-related risks and emissions. The new legislation could even cover scope 3 emissions which would include the activities of builders, tenants, and others across the value chain, which would be particularly onerous for real estate companies.

Buildings currently contribute 37% of global CO₂ emissions[3] and the costs of making them greener to meet the demands of regulators, investors and tenants are often huge. Decarbonising commercial real estate requires significant investment, particularly in older buildings where retrofitting more sustainable materials and designs can be highly complicated, convoluted, and disruptive.

A recent report by Oxford Economics[4] estimated that renovating a property to extend its economic life by only 10-15 years cost between 7-30% of its capital value, depending on sub-sector (see chart). Portfolios that are overweight hotels – often older buildings in prime locations with high levels of energy intensity – face the steepest decarbonisation costs to be compliant with more stringent energy performance standards. Conversely, portfolios tilted towards industrial and retail assets would incur relatively smaller costs. On a country level, investors in the UK – where minimum EPC standards are set to rise from 2027 – are expected to bear the highest renovation costs due to labour market inflation. Nordic countries on the other hand will require the smallest investment given their lower obsolescence risk and capex ratios.  

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These costs are becoming increasingly embedded in real estate valuations with brown discounts for properties facing physical or transition risks. If banks begin restricting credit to brown buildings with inadequate plans or capital to decarbonise, investors could face additional financial and liquidity risks that cause further discounts to asset values.

Green premiums

The opposite is also true with green buildings unsurprisingly commanding premium prices. Research[5] last year found sale prices were 8-18% higher in the UK and Australia for BREEAM and NABERS-rated buildings. There are also significant income benefits; another 2021 study[6] concluded that London office buildings with the greenest ratings received rental premiums of 3-13% over the past decade.

The link between sustainability and profitability, which is perhaps stronger for real estate than any other asset class, also holds for equity performance. A 2015 study[7] of global REITs found that higher GRESB scores correlated with better returns on assets and equity as well as a significant link between sustainability and risk-adjusted stock market performance.

Finding the right companies at the right prices is the greatest challenge for building a sustainable real estate portfolio, particularly as the risks for those who fall short on ESG – and their investors – will only increase.

With valuations generally attractive (and likely to continue receiving support from inflation-hedging investors), the opportunities are also real. The keys to unlock the best portfolio returns are stock selection, diversification (across sub-sectors and geographies) and active engagement to help companies crystalise their ESG value and contribute to a greener planet.


References:

[1] Source: 2022 UBS Investor Survey, March 2022
[2] Source: Refinitiv, April 2022
[3] Source: Science Based Targets Initiative
[4] Source: Oxford Economic, The renovation race to net-zero, April 2022
[5] Source: Knight Frank, Active Capital Report 2021, September 2021
[6] Source: Knight Frank, The Sustainability Series, September 2021
[7] Source: Franz Fuerst, The Financial Rewards of Sustainability: A Global Performance Study of Real Estate Investment Trusts, June 2015

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