Retail buildings are typically the largest consumers of energy in the property industry. The Carbon Trust recently stated that the 40 largest shopping centres in the UK consume £40 million worth of energy per year and that for most retailers reducing energy consumption by 20% would have an effect on the bottom line equivalent to a 5% increase in sales. [Read more…]
Over the past three months, I’ve been speaking with real estate debt fund managers about the new GRESB Debt Survey, an assessment designed to evaluate and benchmark, but also, to guide, the sustainability engagement and performance of real estate lenders. Recognized as “at least a decade behind the equity side of real estate,” sustainability integration in real estate debt (aka lending, finance or credit), still seems to be an emerging concept. Furthermore, given the multitude of regulations and parameters lenders already face (and often respond to with great innovation), the prospect of another looming externality, like sustainability, doesn’t exactly give lenders a warm feeling.
During the Debt Survey engagement process, reactions have run the gamut, from, “though we haven’t begun implementing all areas addressed in the Survey, we are moving in the right direction and plan to participate,” to “we’re far removed from the property and we’re not going to tell our borrowers what to do, is that what you’re asking of us?”
By far the most common reaction, in one form or another, has been: As a lender, we have less control over properties than do borrowers/asset owners. Furthermore, we realize no upside as a result of energy efficiency or other cost cutting, sustainability-related property features and improvements. Why should we consider environmental, social and governance (ESG) issues relative to our lending platform and processes?
Here’s my response on why ESG matters for lenders – whether traditional balance sheet lenders or alternative lenders:
At best, lenders get their principal returned along with the spread they priced during loan underwriting. Because there is indeed no upside, risk management is the name of the game.
Financial/Credit Risk – Managing downside risk is critical to delivering a risk-adjusted return. Sustainability risks can adversely impact collateral value and a borrower’s ability to fully repay their obligations. A recent study conducted on 80,000 CMBS loans found 20-30% lower default rates associated with Energy Star labeled and LEED certified buildings. This study is supported by a growing body of academic literature that indicates green buildings have better rental rates, better quality tenant attraction and retention, and higher resale values compared to their non-green counterparts. Furthermore, as extreme weather events increasingly impact buildings, and tenant and investor preferences evolve, there is the risk of stranded assets (those unable to retain their value, resulting in unexpected write-offs).
This information may be compelling, but it only addresses a lender’s security or collateral. What about the sustainability risk associated with a sponsor (borrower or guarantor)? If the sponsor has environmental fines outstanding, these may be sizable and ultimately impede their ability to pay off, pay down or otherwise make whole their lender. Knowing the sustainability track record of a sponsor could provide valuable insight, not only with regard to how responsibly and efficiently that sponsor will operate and manage its properties, but also how likely the lender is to end up inheriting an under-performing asset or potential liability.
Whether collateral-level or sponsor-level, sustainability data and analysis can serve as a competitive edge if properly integrated into loan structuring, underwriting, due diligence and ongoing monitoring. How would pricing be impacted if sustainability risks were incorporated into probability of default (PD) and loss given default (LGD) models? Perhaps lenders would make many of the same decisions they do today, but with sustainability risks fully priced, it might mean fewer losses during downturns, more consistent lending operations and more stable returns to investors.
Compliance Risk – Staying ahead of evolving climate change regulation. While legislation varies across regions, global portfolio diversification is becoming a more common debt strategy. In some countries, there may be direct negative consequences for ignoring the environmental impact of collateral. For example, in the UK, the Minimum Energy Performance Standards (MEPS) regulation, calls for the unlawful leasing of properties with energy ratings below a defined minimum threshold, thereby impacting affected property cash flows and values.
Strategic risk – The capital to lend doesn’t exist in a vacuum. Whether delivered through the capital markets, via shareholders and bondholders, or collected as life insurance premiums, investor accountability is implicit. In the case of private debt funds, the relationship between lender and investor is even more intimate. Real estate debt funds are dependent upon private equity fundraising. 46% of institutions include real estate debt as part of their real estate allocation. Institutional investors have long-term investment horizons and are increasingly interested in seeing ESG integration extended beyond their equity investments, to debt and fixed income as well. Integrating sustainability into a commercial real estate lending philosophy and processes allows a debt fund to create a portfolio aligned with its investor’s values.
Reputational risk – The real estate sector contributes one-third of global energy consumption and greenhouse gas emissions. As financiers to building owners and operators, lenders provide the capital that makes positive or negative environmental outcomes a reality. It’s unclear whether lender liability will eventually extend to climate change risks associated with buildings (e.g. carbon emissions). But becoming the lender of choice to a market transformation by financing green rehabs, retrofits, and repositionings, as well as green development, can’t hurt.
The GRESB Debt Survey examines the ESG issues embedded in commercial real estate lending. I say embedded, because these issues already impact lenders and investors. The question is how aware they are and how they can begin to use sustainability data to their own advantage.
Thinking about disasters is a hard sell. But whether we think about them or not, we pay for them. According to the 2015 UNISDR Global Assessment Report, expected annual global losses are estimated to reach $314 billion in the built environment alone. All indicators suggest that the frequency and intensity of disasters will increase, meaning that this cost will go up. Disruptions—natural, human-caused, or a combination of the two—are inevitable.
In this new reality, organizations that are able to manage risk will be better prepared to withstand disruptions and to capitalize on opportunities as they arise. Building owners are well positioned to take a leadership role and to benefit by going beyond preparedness to resilience.
Green building strategies can play a role in risk mitigation, but by themselves, they do not position organizations to respond to a dynamic environment. By building on sustainability efforts and tools, however, it is possible to prepare for disasters in ways that make organizations stronger today and that pay off whether disaster strikes or not. This is what Judith Rodin, President of the Rockefeller Foundation, calls the “resilience dividend,”—the return on investment that organizations (both public and private) can achieve by investing in resilience strategies.
Resilience can be defined as the capacity of individuals, organizations and communities to adapt and thrive in the face of stressors and shocks. Shocks are the big events that keep emergency managers awake at night—major storms, earthquakes, tsunamis and other headline-grabbers. The stressors are what make us vulnerable to those shocks—crumbling infrastructure, degraded environments, public health issues, chronic unemployment, poverty.
The ability to weather the proverbial (and literal) storms will require new levels of creativity. The resources simply don’t exist to solve one problem at a time. The threats we face are interrelated, and the solutions must be as well. Systemic approaches are our best hope.
Many studies of disasters reveal how addressing underlying vulnerabilities can limit the impact of events and speed the recovery (for example, see Social Capital and Community Resilience by Daniel P. Aldrich and Michelle A. Meyer). The places, people and organizations that fare best are not necessarily those that are the strongest per se—strength without flexibility creates rigidity. Instead, resilience lies in the multiple points of connection—between people and communities; between sources of critical resources like energy, water and food and their destinations; across modes of transportation and communication; across segments of society.
Resilience is not an end state—it is a practice. Those points of connection are not created overnight. They require on-going maintenance and development. Local governments are gearing up to tackle many of the issues, but their efforts cannot do everything. Every sector of society has a part to play.
Building and property owners are well-positioned to take a leadership role at a finer grain in the built environment. Buildings serve as a nexus of the physical environment and human interaction. The way buildings are designed, managed and operated matters on a daily basis as well as during disruptions.
Resilient operations require assessing risk not only at the building and operational scales, but also at community scales. The vulnerabilities of the communities that intersect with a building have a direct connection to resilience of organizations themselves. Imagine, for example, that in a disaster your facility remains intact, but that the neighborhood around you is in chaos. You may not in fact be able to resume full operations in a meaningful way.
But what if you have existing relationships with your community and already know who will need help and who will be able to provide it? What if you are able to offer shelter, energy, water or food to your neighbors? What if you have invested in making sure your maintenance staff is trained to act as first responders?
Suddenly you are no longer a victim of the disaster. You are the hero.
This means broadening your understanding of your community to include your workers, contractors, visitors and suppliers. It requires thinking beyond your span of control and considering your span of influence and connection. It requires talking to your neighbors.
But the potential rewards are substantial and go far beyond those of corporate altruism. By incorporating social vulnerability assessments, direct community engagement processes and programs that promote social equity into your risk management program, you can generate measurable value. By making your physical assets as well as the people in and around them more resilient, you open the door to mutually beneficial opportunities.
The business case for an integrative approach to resilience is strong, as organizations can capture direct and indirect benefits such as:
- Reduced uncertainty
- Improved business continuity, including reduced losses and faster recovery
- Improved financing terms and insurance rates associated with risk reduction
- Reduced operating costs associated with simple, local or passive strategies
- Improved ability to leverage new opportunities
- Improved community relations
- Improved brand association
- Improved quality of life and public health for both building occupants and the surrounding community
With new tools and programs currently under development, what sound like lofty goals on first blush can become realistic, cost-effective measures that can be implemented at the building scale. For example, on a global level, the R!SE initiative, an international effort being led by the United Nations Office for Disaster Risk Reduction, PricewaterhouseCoopers and other partners, is developing a framework to make all investments, private and public, risk-sensitive. The program will engage with business, the public sector, education, civil society, insurance and investors.
At a local level, the USGBC Los Angeles Chapter is developing a Building Resilience rating system to work seamlessly with LEED for existing buildings that includes metrics and processes for risk management and resilient operations of both physical assets and social capital. While the program will focus initially on Southern California, it will serve as a template for a broader national/international program.
FEMA estimates that $1 in preparedness is worth $4 in recovery. Others put that ratio closer to 1:20 or more. The goal now is to activate investment of that first dollar in resilience and to leverage as far as it will go.
There is consensus among leading industry bodies that an assessment of materiality in the context of financial information, involves a qualitative assessment that takes into account context and surrounding circumstances. In the case of non-financial data, as well as defining the scope of what is material, the challenges in collecting robust and rigorous ESG data means that context and surrounding circumstances are also crucial to understanding a lot of the information that is collected. For example, an environment in which energy prices are rising and resources are becoming scarcer is relevant context for assessing the materiality of energy consumption data as a material ESG issue. The ability for a building owner to collect energy consumption data for a building depends on who occupies the building, the legal and business relationship with that occupier and on regulatory requirements that may require specific action by owner or occupier or grant specific powers to them.
If context and surrounding circumstances are so crucial to understanding the data, doesn’t that undermine its robustness and return us to the point where it cannot be material because it cannot tell us anything concrete without supporting qualitative analysis? There are people that consider that however you might define materiality of financial data, the discussion stops there – any non-financial data (a term which, for these purposes I use synonymously with ESG and sustainability data) cannot be relied on and/or is irrelevant. However, this view is quickly starting to look old fashioned.
PwC UK’s corporate sustainability strategy seeks to address total impact, incorporating measurement but also a holistic approach to measuring performance that goes beyond simple financial metrics and which considers outcomes and impacts from business activities. PwC talks to its stakeholders including clients, staff and recruits and maps its impact and areas of focus based on their feedback. The broader reporting frameworks promoted by the Global Reporting Initiative (GRI) and the International Integrated Reporting Council (IIRC) take into account not only financial but also manufactured, intellectual, human, social and relationship and natural capital. The IIRC’s draft framework has some high profile advocates that are starting to implement the framework in their annual reporting cycles.
That said, a tension exists between this pragmatic approach and the long-term view. International environmental law and policy experts debate the extent of our legal obligations to future generations. Local and national governments wrestle with long-term environmental risks that need to be addressed now. An example is the Thames Barrier, London’s protection against tidal surges from the sea. In the 1980s there were four closures of the barrier, in the 1990s 35 and, so far in the 2010s, there have been 65 closures. The UK government has a Thames Estuary 2100 plan in place to prepare for changes in flood risk levels over the next 70 years. The Environment Agency, the body responsible for implementing the plan, estimates that while in the short term the Thames Barrier does not need to be replaced, London’s current defence system will need to be upgraded from around 2035.
Local and national governments and the NGO community are ideally placed to take a longer-term view The World Economic Forum’s annual Risk Report adopts a 10-year horizon for measuring long-term, systemic risk. The IIRC’s draft reporting framework recommends disclosure of information that “substantively affects the organization’s ability to create value over the short, medium and long term.” The European Commission has set energy reduction targets far into the future.
Is the commercial real estate sector so busy thinking about targets for the coming twelve months that it completely ignores crucial but impossible to quantify, longer-term information? Possibly in some cases that is true. I was in a meeting recently where I was informed that flood risk assessment in London was pointless because of the existence of the Thames Barrier. The speaker did not know much more about the Barrier other than that it crossed the Thames and protected the Thames from flooding. He made no mention of groundwater flooding and, if you are going to rely on the Thames Barrier to explain why you are not concerned about flooding, it makes sense to at least know some basic facts about what the Barrier does and its projected life time.
However, the increase in uptake in ESG reporting frameworks and benchmarking schemes (including GRESB) suggests that investors and managers are aware of the longer-term horizon. In the real estate sector, investors and their managers must integrate their sustainability performance assessment into an annual cycle. Clearly, for the year-on-year operation of the asset, its energy performance and its ability to comply with existing environmental regulations (for example the obligations in the re-cast European Commission Energy Performance of Buildings Directive) is key. So, what are context and surrounding circumstances in the context of sustainability information?
The horizons in the real estate investment community are not narrow. However, companies, investment managers and capital providers are all under significant obligations to report at a minimum annually, on a wide variety of metrics both financial and non-financial. For example, a UK-based REIT GRESB participant is subject to multiple mandatory and voluntary reporting obligations including the Carbon Reduction Commitment (CRC), Carbon Disclosure Project (CDP), and the Principles for Responsible Investment and GRESB. Realistically, you are going to struggle to convince these groups of the materiality of topics that do not impact on these cyclical reporting obligations. However, depending on their investment strategy, owners may hold properties for only a few months. Certainly, the lifetime of the investment will often be far shorter than the lifetime of the asset.
Norges Bank Investment Management (NBIM), in charge of the USD 900 billion Norwegian global government pension fund, has recently called for more rationality in the sustainable investment debate. Speaking at the Geneva Summit on Sustainable Finance, NBIM’s Chief Executive called for rationality around the responsible investment and sustainable finance discussion and said that it was for politicians to address questions of ethics. In other words, focus on information and activities that improve the rigor of the information that you are collecting.
Evidence from the GRESB benchmark indicates that this is the real estate market’s approach. Initially participants’ focus is on collecting data on the performance of real estate assets and qualitative information that supports the interpretation of the data. In 2014, 310 participants included sustainability disclosures in their Annual Report, 321 prepared standalone sustainability reports. In both cases, about half do some kind of third-party check on the data in their reports, in some cases using recognized reporting, verification and assurance standards. In 2014, a participant Survey participant explained to me that efforts are first concentrated on getting hold of data and then on checking it. The approach is realistic and pragmatic.
In a commercial environment, time is best spent, showing investors and their managers the links between what they do now to measure their sustainability performance and the longer-term risk and opportunity horizon. Realistically, responsibility to future generations is not likely to top the materiality priority list for most investors and managers. However, real estate is that most tangible of assets, a piece of land. You can see it, inspect it and observe its operation over time. Not to do so, is to ignore the context and the surrounding circumstances that make an assessment of materiality possible.
On Friday June 19, NASDAQ, the world’s second largest electronic stock exchange, hosted an audience hungry for the best. I’m not talking about Fogo de Chao’s ringing of the closing bell after their successful IPO rose nearly 30% on that day’s market debut – this group expected much more.
This audience of nearly 200 capital market experts, institutional shareholders, and company professionals descended on NASDAQ for Skytop’s inaugural ESG Summit that included a series of expert panels discussing methodologies for assessing and presenting ESG performance to the capital markets.
NASDAQ’s Director of Corporate Responsibility, Evan Harvey, welcomed the group by highlighting NASDAQ’s 40 year record of efficiency and transparency as the foundation of a brand that drives their current business strategy.
Jose Maria Figueres, the former President of Costa Rica and Chairman of the Board at both RMI and the Carbon War Room followed by announcing the release of a comprehensive financial study of the REIT market revealing a significant link between portfolio sustainability indicators and REIT stock market outperformance including ROA and ROE measures when adjusted for risk.
The Carbon War Room commissioned this robust academic research by the University of Cambridge, which used GRESB data to analyze ESG performance metrics by individual REITs and their stock market performance. I encourage you to check it out: The Financial Rewards of Sustainability: A Global Performance Study of Real Estate Investment Trusts.
The Carbon War Room report highlights findings including that an increased level of transparency coupled with lower exposure to environmental, energy, and regulatory risk should alter the risk-return profiles of participating REITs over time. This is in line with my personal observations from meetings with REITs who choose to use the GRESB benchmark assessment as a serious internal engagement tool for management introspection, business planning and priority setting, and ongoing implementation of industry best practices.
The bottom line is REITs with higher GRESB ratings could be expected to achieve higher financial return metrics per unit of risk — interesting stuff. With GRESB on track to welcome a strong group of 2015 benchmark participants, there are additional opportunities to assess financial return measures based on 1) longevity of GRESB engagement, 2) year-over-year improvements, and 3) a breakdown of performance on specific Aspects.
The University of Cambridge study is just the latest in a long line of solid evidence reflecting the business case of engaging ESG-based best practices. Comments from research analysts at State Street Global, Morningstar and Moody’s at today’s Summit reinforced how ESG is quietly penetrating company analysis. My overall takeaway from today’s event is that I’m highly confident similar evidence will continue to surface.
In the meantime, don’t let out the secret that well-managed REITs with high ESG engagement show market outperformance. Financial markets can be hyper-efficient and I would hate for some hedge fund to seize a market opportunity…!
The property sector appears to be warming up to green bonds. Over the last year, we have seen a series of offerings from Vornado Realty Trust, Regency Centers, Unibail-Rodamco, Vasakronan, and Stockland.
A new, $500 million green bond issued by Digital Realty Trust, Inc. (NYSE ticker DLR, more on GBIG) marks an important step forward for property-based bonds. Digital’s new bond is distinguished by several important aspects of its specifications for “Eligible Green Projects”, including support for multiple outcomes, provisions for lifecycle thinking, and global scope.
Outcomes. Some organizations have argued for thematically narrow or “boutique” green bonds, such as those focused only on exceptionally aggressive levels of greenhouse gas emission reduction. Digital’s list of eligible projects emphasizes the use of integrative, multi-criteria green building rating systems, while mentioning the potential to pursue savings through energy efficiency, water conservation, or clean energy supply. Consideration for water savings is particularly notable, and it appears to be first for the property sector. This is useful as property managers seek to address risks associated with severe drought in areas such as California and the Western United States.
Lifecycle. Most earlier property bonds have focused on whole building performance, for example, Regency Center’s $250M offering. Digital’s eligible projects include the option to address each of the major phases in the lifecycle of commercial property: new or re-development, renovation, tenant improvement, and system-level upgrades. This practical approach makes it possible to use proceeds for work across the asset lifecycle and demonstrate compliance with widely used schemes, such as LEED for New Construction, LEED for Existing Buildings, LEED for Commercial Interiors, and ASHRAE audits for system improvements.
Scope. Most previous bonds, such as those offered by Vornado or Stockland, have clearly been regional in scope. Digital breaks the trend, and its list of eligible projects clearly suggests the potential for using proceeds for projects around the world. The bond calls out high-quality national rating systems in the US (LEED), UK (BREEAM), and Singapore (Green Mark). Interestingly, it also highlights a fully audited, property type specific rating system, Certified Energy Efficient Datacenter Award (CEEDA).
Digital’s clear and practical guidelines for demonstrating achievements in each of these areas are well aligned with GRESB’s new Green Bond Principles for the Real Estate Sector. The Guidelines provide a practical, sector-specific framework aligned with the widely adopted Green Bonds Principles. The goal is to maximize the use of established industry tools to communicate and document the use of proceeds to support a range of green projects. Ultimately, the objective is to accelerate the use of innovative financing to accelerate market transformation.
Great to see Digital’s leadership role in accessing this important new source of capital. We’re looking forward to seeing results on the ground.