ESG Investor Survey: A question of value

ESG is now so much more than a ‘nice to have,’ but establishing a direct link to improved investment returns remains a challenge, says INREV’s CEO Lonneke Löwik.

ESG is firmly on the agenda for INREV members. The topic receives plenty of airtime at our events, and members are now quick to express their commitment to it. A straw poll conducted at our annual conference in Venice in April reflects this mood with 45 percent of delegates believing that the industry could reduce its contribution to greenhouse gases by 50 percent over the next decade.

External pressure
Market dynamics, regulation and the drive for greater transparency across the board – from investors to occupiers – are fueling the momentum for ESG principles. The Paris Agreement on climate change and the UN Sustainable Development Goals, for example, have added pressure on the private real estate industry to act. The Paris Agreement has set a target for the rise in global temperatures to stay below 2C (or preferably 1.5C) for the remainder of this century.

Ignoring these targets could have profound consequences, especially given the fact that a considerable percentage of the value of global investment portfolios is vulnerable to climate-related risks. Making things even more difficult, banks are refusing to lend against assets that do not comply with the Paris Agreement or the UN SDGs.

Across Europe, at a national level, regulations are already in place with very direct consequences for the real estate industry. In the Netherlands, all commercial property will need to meet a minimum energy efficiency rating of ‘C’ by 2030. Buildings without this certification will be unrentable. By 2020, all new buildings (commercial and residential) in the country will need to be gas neutral. Similar restrictions were imposed in 2018 in England and Wales, stopping owners from leasing commercial buildings without an energy rating of ‘E’ or above.

“There is an apparent correlation between ESG and the ability to attract and retain lucrative tenants, and, in some instances, to increase rental values”

INREV is aligned to both the Paris Accord and the UN SDGs. In Brussels, we have been a conduit for a two-way information exchange: interpreting and sharing insights from EU regulators with members, and relaying members’ ideas and experiences to the European Commission. INREV’s professional standards committees, including our dedicated ESG committee, have made sure ESG is incorporated in key documents, such as the INREV guidelines, global definitions database and due diligence questionnaire. And ESG is broadly embedded across all our services from training, to research, to events.

Elsewhere in the industry, the Global Real Estate Sustainability Benchmark has played a key role in establishing a high bar for the sustainable performance of real estate funds.
These initiatives have changed attitudes. ESG best practice is now more broadly adopted in the sector. And there is now compelling anecdotal evidence that it is increasingly seen as an integral element of the risk assessment and investment decision-making process because it is perceived to contribute to real estate investment returns.

Proof of value
The extent to which ESG adds to property values – and by extension, internal rates of return and yields on real estate portfolios and investment vehicles – remains difficult to prove, however. The ongoing debate about cashflow valuations at the individual asset level, for example, means the industry has yet to reach a consensus on how to quantify the financial advantages of ESG.

Since 2015, INREV has been collating and curating a global ESG library, which documents case studies from members. The good news is that a growing number of these stories are pointing to a clear link between the adoption of ESG principles and demonstrable financial benefit.

There are common threads that show how ESG plays an important part in helping to reduce onerous costs – specifically those associated with the development and life cycle management of individual buildings. There is an apparent correlation between ESG and the ability to attract and retain lucrative tenants, and, in some instances, to increase rental values. From the point of view of investor and tenant-driven demand, programs enable real estate entities to optimize operational performance, and to identify and mitigate risks.

An independent academic study carried out in 2017* makes for interesting reading, too. The report compared GRESB scores between 2011 and 2015 with returns performance data from the INREV Annual Index covering the same period. One of three key conclusions stated: “…the GRESB score itself can help us to understand the observed cross-sectional variation of non-listed fund returns. High total GRESB scores are associated with higher excess returns, a result which is important in a market in which information is harder to find.”

“We must maintain the pressure for full industry adoption of ESG principles because the level of external scrutiny will only intensify in the future”

If not entirely conclusive – and taking account of the obvious caveats about potential sample size, timing and coincidence anomalies – this finding is instructive. Work is still required, but perhaps the industry is edging closer to an agreed metric for proof of value.

No time to rest on laurels
As a whole, the non-listed real estate industry is making solid progress on ESG, but there is no room for complacency.

We must maintain the pressure for full industry adoption of ESG principles because the level of external scrutiny will only intensify in the future. Investors, industry bodies, policymakers and regulators will insist that buildings conform to energy-efficient standards, that occupiers’ health and wellbeing are optimized, and that the industry upholds the highest standards of ethics and transparency.

ESG is evolving all the time and we are already reaching the next frontier. The focus is shifting beyond economic, social and governance considerations to the more stretching target of impact investing, with its much more deliberate attempt to generate a broader social or community dividend. Specific funds, such as those focused solely on affordable housing, are a good example. The principle is that delivering investment returns is no longer the only important output and the creation of a bigger positive impact on society, such as decent, affordable homes, is also a must-have.

It remains to be seen where this particular conversation lands, but impact investing is firmly on the agenda for INREV’s ESG committee because it is creeping ever closer to the mainstream. The task is to rapidly interrogate the facts and relate them to the wider real estate market, with supporting guidance and direction. Then, of course, we will be back to the thorny issue of establishing meaningful industry-wide standards of measurement.

*Sustainable Insights in Private Equity Performance: Evidence from the European Non-listed Real Estate Fund Market, Dirk Brounen and Maarten van der Spek, July 2017