Real Estate 2.0: Tesla-style buildings, used “Uber-style”

Wednesday, September 2, 2015

While the financial industry is still reeling from and reflecting on last week’s stock market gyrations, wondering whether China’s growth will (finally) go below 7%, and whether the Fed will be deterred from (finally) raising interest rates from their current rock-bottom level, it is tempting to forget about lingering long-term issues, such as the impact of extreme weather events that take place increasingly frequently, the slow rise of sea levels that threaten economies and entire societies, and the impact of changing demographics (i.e., aging populations) and health trends such as obesity and chronic diseases on our healthcare systems. It’s short-termism versus long-term thinking in its purest form. And it’s human. After all, we evaluate the performance of the financial industry on a yearly, quarterly or even more frequent basis, and as the saying goes, in the long run…we’re all dead.

But even amidst the current turmoil, there seems to be a sea of change in investment beliefs that is becoming ever more prominent, and ever more articulate; the belief that for long-term investors, long-term trends can have real implications for capital values and income returns. Whether it is the current drought in western North America and in Australia, flooding in Chinese cities, or the rise of renewable energy, some of the “long-term” trends are starting to become real, happening every day, at many different places in the world.

While long-term trends affect all industries, they are particularly relevant for the real estate sector, where assets are long-lived and…typically cannot be moved to another place. Buildings are basically sitting ducks, waiting for urban form and consumer preferences to change. In the real estate sector, attention to non-financial information that may affect financial performance has traditionally focused on governance – deal terms, fees, alignment, transparency, and reputation. But over the past ten years, buildings have become a focal point in the debate about broader, global sustainability issues. In the face of climate risk and resilience, buildings are a big problem, consuming over 40% of energy globally. In the face of water scarcity, buildings are a big problem, both as significant consumers of water and for example as the cause of drainage flooding. In the face of rapidly increasing healthcare costs, buildings are again a big part of the problem, with people on average spending 90% of time indoors, subject to often-suboptimal workplace quality that lacks any stimulus to move.

These issues all have regulatory relevance, and in many regions, countries and jurisdictions, building-specific regulation is introduced to address the impact of buildings on energy, water and health. Such regulation ranges from general sustainability disclosure requirements on stock exchanges to energy performance disclosure requirements at the asset level, and from mandatory water savings in buildings to mandatory improvement of buildings energy efficiency. For investors in real estate, this nascent growth of regulation adds to the real implications of environmental and social trends on the buildings that they own and manage, as well as the changing preferences of their consumers (or: tenants, in real estate language). Think for example about the changing role of the workplace, from place to work to place to meet, with flexible seating arrangement and more attention to desirable common areas. Think about the evolution of retail, from places to buy to places to experience. And of course, the “überization” of the real estate sector through platforms such as AirBnB and (perhaps not so well-known) WeArePopUp.

It is an interesting analogy to compare the real estate industry with the automobile industry. Fuel economy standards are common practice in the automobile industry, increasing in both Europe and Japan from 37MPG in 2002 to 50MPG in 2015 – that’s a 30% increase in efficiency over a bit more than a decade. In the U.S. and Canada, fuel economy requirements increased from 25MPG in 2009 to 35MPG in 2015 – a 40% increase in 6 years. Regulation is paired with increasing consumer awareness through standardized information provision, such as energy labels and MPG stickers. What’s more, the industry has innovated to mass-produce hybrid and electric-powered vehicles, ranging from the now-common Prius to the highly desirable Tesla. These innovations have not just led to more efficient cars, but also to a new generation of vehicles that no longer require a dealer network, do not need the same level of maintenance, and can be updated and checked remotely, uprooting a century-old industry. Given that the average buildings lasts for decades, buildings are less sensitive to such rapid technological development, but one needs just a little imagination to envision how a new generation of Tesla-style buildings, used “Uber-style,” could similarly uproot the real estate industry.

Ultimately, it is the capital market that will both benefit and suffer from regulations, environmental and social changes, and societal trends. As in any business, for investors to understand and act upon new information, they need just that – data. Information transparency enables better investment, empowering decision makers to manage risk and find superior returns. Smarter investment will reward innovation, ultimately driving market transformation. The buzzword to measure the ability of companies to respond to long-term trends is “ESG” or sustainability performance – encompassing environmental, social and governance factors. In fact, those companies that better understand the implications of ESG trends on their business can be better positioned to generate higher, more stable returns in the short run, as ESG management is very often a useful proxy for superior management. It turns out that very few poorly run companies can effectively manage complex issues like energy, water, waste, and health.

Comparable to cars, there is a plethora of “nutrition labels” available for individual buildings and assets – globally there are over 200 energy and sustainability labels that provide market participants with information about the energy performance of an asset, and often much more than that. Leading labels such as BREEAM, Green Star and LEED include factors such as climate change resilience, water efficiency, location relative to public transport and other factors into their assessment. But buildings are often part of larger portfolios, owned and managed by developers, listed property companies (REITs) or private equity funds. Many investors, such as pension funds, mutual funds, bank insurance companies, endowments, etc., never touch individual properties, preferring to invest indirectly through property companies and funds. GRESB provides these investors with a systematic, annual assessment of portfolio ESG performance – a “nutrition label” for real estate companies and funds, comparable to what Morningstar provides on the financial performance of thousands of mutual funds, or to what Moody’s and S&P provide on the credit score of tens of thousands of countries, companies, and financial products. Or, back to the automobile analogy: the rating that the Consumer Reports provides to Teslas, and virtually every other car.

The GRESB ESG “label” enables large investors to be smart shoppers. But rather than spending USD30, 000 on a car, institutional investors are allocating tens of millions, sometimes billions of dollars to real estate. Today, most of these decisions are made without regard to health, safety, energy, water, etc. – not with malice, just ignorance. This means that there is a significant opportunity for investors just by asking for basic information and by beginning to consider the most important issues. Over time, the market will respond to their interests. Their attention will help drive performance. Over the past six years, GRESB has assessed and evaluated the sustainability performance of nearly 1,000 companies and funds operating in the commercial real estate sector. Perhaps that's not the thousands of Morningstar ratings, but consider that the real estate sector is still much less institutionalized (or: securitized) than most other sectors, and globally there are “just” 330 property companies in the main real estate index (the FTSE EPRA/NAREIT index), on aggregate representing USD 1.2 trillion. On the private equity side of the commercial real estate sector, numbers are much harder to come by (it is “private” after all), but estimates put the size of the sector at about USD 750 billion, and there is much more commercial real estate owned directly by sovereign wealth funds, pension funds, and corporates.

In 2015, 707 unique property companies and funds have been rated by GRESB, representing USD 2.3 trillion in commercial real estate and some 61,000 assets. The data is summarized in the 2015 GRESB Report, which provides new insights showing that the global real estate sector is increasingly integrating environmental, social and governance considerations into corporate policies and business strategy. Critically, the data also shows that policy and strategy are backed by actual implementation of energy and water efficiency programs, and demonstrable improvements in sustainability performance. On aggregate, the sector reported huge energy consumption of 109TWh in 2014, but it notably reduced its consumption by 2.87% since 2013. That’s the equivalent of taking 105,000 U.S. cars off the road. Greenhouse gas emissions decreased by a similar amount: 3.04% or 533,000 metric tons, the equivalent of nearly 50,000 U.S. homes. While these percentage reductions may feel small, they are beyond what policy makers and climate negotiators are typically aiming for when setting long-term reductions goals (such goals are a hot topic in advance of the Paris climate negotiations). Water consumption in the commercial real estate sector also decreased significantly, by almost 2% or 6.6 million cubic meters, the equivalent of nearly 3,000 Olympic-sized swimming pools. There is also a significant uptake in renewable energy with on-site renewable energy generation increasing to 445GWh in 2015 from 296GWh in 2014, equivalent to a quarter million barrels of oil.

The global sustainability performance of the real estate sector also improved across other areas of environmental, social, and governance performance. Trends in GRESB data show that sustainability goals and ESG disclosure are now firmly part of mainstream business practices: 93% of property companies and funds incorporate sustainability into business objectives. With extreme weather events and shifting weather patterns threatening economies and the built environment, 54% of all property companies and funds have policies in place that consider climate risks. In addition, the real estate sector increasingly recognizes the health, safety and well-being of occupants, the community, and the supply chain as sources of both risk and opportunity.

GRESB considers all this information and much more, churning the numbers through comparative calculations, and ultimately producing a single measure of overall ESG performance. This simple number has power. It provides a measure of something that was once invisible, a company or fund’s overall effort and success in addressing critical long-term global challenges associated with environmental, social, and governance issues. In the hands of a savvy investor, this score can nudge risk ratings up or down; affect discount or growth rates; inform a choice on investment manager or operator; or simply assist real estate investor in better understanding the sustainability risks and opportunities intrinsic to the portfolios they invest in.

This score also allows us to take the pulse of the real estate industry. In 2015, we found that this pulse is strong and steady. It seems that our patient has been working out a bit. The average GRESB Score improved to 56, a significant boost compared to 46 in 2014. Another vital sign, the number of GRESB “Green Stars”, also improved, with over 350 companies and funds receiving this mark of distinction based on their combination of superior management and on-the-ground action.

Notwithstanding the outsized role of the property industry in the current debate on resilience, climate change and public health, the 2015 GRESB data, representing a significant part of the industry, suggests that the commercial real estate sector is “getting to grips” with sustainability as a business consideration, not just as a mere afterthought.

Analogous to the automobile industry, the commercial real estate sector has the capital, power, and innovative capacity to provide solutions to the problem of which it is an inextricable part. Regulation and changing consumer preferences will spur the need for these solutions. Our collective capital, managed by pension funds, insurance companies, banks and other financial institutions will be an important part of the transformation to a more efficient, more sustainable built environment. Not for reasons of philanthropy, but for reasons that the financial industry understands best: improving returns and reducing risk, both in the short term and in the long term.

Read more about the GRESB and the 2015 data in the GRESB Report.