Property is often overlooked in climate change debates, but its role in saving the planet is huge. Mark Dunne reports.
No other asset signifies how difficult the war on climate change is than property. Oil, gas and transport typically dominate environmental conversations between institutional investors and their portfolio companies, but the built environment produced 38% of the world’s harmful gas emissions in 2018, the United Nations (UN) says.
Yet despite the huge focus on reducing carbon, the problem is getting worse. Indeed, harmful gases linked to the built environment increased by 2% globally during 2018, according to the UN.
Most of the built environment’s pollution – 28% of the world’s greenhouse gas emissions – was caused by powering, heating and cooling buildings, while 11% was generated during the construction phase, which includes the carbon footprint of any steel and concrete used.
“We cannot reach net zero without tackling the problems that buildings present,” says Regan Smith, head of real estate sustainability and a managing director at Manulife Investment Management.
It is a big problem. Indeed, in the UK, only a quarter of the built environment is energy efficient, the Loan Markets Association says. So, the scale of the problem is huge, but replacing older, energy inefficient buildings with modern institutional-quality assets is not a quick fix. “Around 50% of a property’s carbon footprint over its lifetime comes from building it. That is the difficulty to overcome,” says Oliver Hamilton, a partner at The Townsend Group, a real assets adviser which is part of Aon.
So, only building operationally carbon neutral assets will not immediately decarbonise portfolios. “Carbon neutral from a construction perspective is a long way out into the future,” Hamilton adds. “It is not a realistic 2030 target.”
New construction methods and standards are needed if the World Green Building Counsel’s target of embodied carbon – associated with steel and concrete – shrinking by 40% in the next nine years is to be achieved.
Carrot and stick
It is clear property owners face a huge task in reducing their negative impact on our climate, but this is likely to be less of a challenge in the institutional space, Hamilton says, where funds in the UK are working to be operationally carbon neutral within 10 to 15 years. “For some managers their plans to do this are quite advanced,” he adds.
Hamilton is not the only one to have noticed this trend. Today, investors understand that they have to fight climate change through their portfolios, Smith says. “Investors have a role to play in engaging with their property companies to achieve these net-zero results,” she adds.
Many commercial real estate landlords have started to invest “heavily” in sustainability, Smith says, due to rising demand to demonstrate climate action. Such demand accelerated in 2015, which was around the time that the UN Paris Agreement, an international treaty on tackling climate change, was first agreed and today has the backing of almost 200 governments. Regulation is also a driver.
British pension schemes must now show how they are protecting their members against climate risk, while new energy efficiency requirements will arrive in the UK in 2023 meaning that landlords face fines if they let uncertified properties.
This is an issue that is being tackled on both sides of the Atlantic. In New York City, if a property’s greenhouse gas emissions exceed a certain level from 2024 there will be a price to pay. “It is effectively a carbon tax for those properties,” Smith says. These initiatives show that although ESG has been a factor in investment decision-making for some time, alternative assets, such as property, have not traditionally featured, but that is changing.
“The direction of travel for pension schemes for quite a number of years has been a greater focus on ESG, but real assets, such as property, are taking longer to be looked at given the challenges,” Hamilton says. “Bonds and listed equity are the lower hanging fruit and it made sense to start there.”
But the authorities are realising that asset owners need to be motivated to climb higher up the tree if portfolios are to be truly carbon neutral.
“There is a carrot and stick approach from the governance coming in, but the direction of travel has been taken for a few years now,” Hamilton says.
Around 50% of a property’s carbon footprint over its lifetime comes from building it. That is the difficulty to overcome.
Oliver Hamilton, Townsend Group, part of Aon
Other risks
Sustainability in the built environment is not just about reducing bad gas emissions. Other risks include biodiversity loss, water usage and waste disposal.
Then there are the many future risks that properties need to be built or upgraded to withstand. “ESG considerations are not just about energy efficiency,” Hamilton says. “There is a risk at the property level if we are going to have extreme climate change related weather events. A building may not be in a flood zone today, but it could be a different story in 10 to 15 years’ time.”
Are the properties you own ready to handle that? “We are also seeing political risk, such as legislation and regulatory risk,” he adds. “If you have a property portfolio which is not up to scratch, you may be caught out if there are changes to tighten current or proposed regulation.”
Then there is the trend towards wellness, which was happening before Covid, Smith says, but the pandemic has elevated expectations for healthy indoor environments.
“Having a healthy building where we work or where we live is no longer optional. When buildings operate correctly, they can positively influence our wellbeing. Studies show that they may increase cognitive function scores,” she adds.
In this area, Manulife Investment Management has achieved Fitwel Viral Response module certification at the entity level to demonstrate its commitment to the health and wellbeing of its spaces. These risks need to be tackled or commercial property landlords could face heightened liquidity risk, especially if they have ESG-unfriendly tenants, such as oil or tobacco companies. “Fund managers and other property owners are paying more attention to who their tenants are with a closer eye on how the type of tenant might cause a property’s liquidity to change in the future,” Hamilton says.
“Having a property that does not hit the right ESG credentials is not going to be desirable to many occupiers or buyers in the future,” he adds.
The more established fund managers will be addressing ESG risk and have frameworks to help them. “Managers who are not on top of these issues run the risk of underperformance in the future because they have not understood or appreciated the ESG risks in their portfolios,” Hamilton says.
Research from one asset manager points to climate analysis of a property manager’s assets will be “essential” for spotting funds that will outperform their peers.
Premium assets
Such outperformance should command higher rents. And demand for sustainable property is rising. Most (55%) commercial property companies have seen a rise in tenants or potential tenants asking for green or sustainable properties, according to a survey by the Royal Institution of Chartered Surveyors and the World Built Environment Forum. And it appears that corporates and other organisations are willing to pay a premium for such a property.
“We are starting to see a trend for charging higher rents for sustainable properties,” Smith says, adding that rents for green certified buildings in the US averaged about 11% higher than for non-certified buildings. She points out that office rents in London with high sustainability ratings are commanding premiums of more than 12%.
“In a post pandemic world, we expect to see this trend continue as occupiers have greenhouse gas reduction targets and are looking for landlords who will help them achieve their low carbon plans,” Smith says.
Hamilton has read reports that rental premiums of between 6% and 10% are being achieved for owning sustainable buildings, but for now he believes it is not as clear-cut as that. “So many factors effect what rent you can charge –specification, location, demand – so it is not clear that these premiums exist solely due to sustainability.”
But, he adds, corporates and other organisations are looking for offices with better environmental credentials and may pay a premium for it. “The managers we cover believe there is clearer evidence for a premium on price in terms of the yield an investor is willing to pay.”
The rents landlords are charging is only one part of the return from such an asset. There is another side to increasing return. “Using energy and water more efficiently will likely lower your operational costs and make the property more attractive,” Smith says.
New buildings that are more sustainable have lower running costs over the long term, says Hamilton, but it is a different story for older properties, which need investment. “There is an upfront cost, so someone has to put the capital up to improve that building,” he adds.
Yet an investment in improving older properties to “institutional quality” for investors with a suitable risk profile could be a better option than rebuilding them. “The carbon footprint of knocking down a property and rebuilding it is huge, so taking an office or industrial site, etc, and improving its environmental credentials can help improve its value as well as its operational carbon footprint,” Hamilton says.
Property is the future
Despite the huge task outlined in the paragraphs above, it appears that a clean and green property portfolio can be achieved. For example, at the end of 2020, Kilroy, a US office real estate investment trust (REIT), reported that its operations were carbon neutral. This was achieved by reducing energy usage across the portfolio by 18.5% since 2010 by installing solar panels on 15 properties, using energy supplied from off-site solar parks for others and buying carbon offset verified emission reduction credits.
Manulife Investment Management’s real estate group sets a carbon emission target for all properties it manages, which is an intensity-based reduction of Scope 1 and 2 emissions.1 Such a target is generally set by assessing how the emissions in its existing portfolio will be projected into the future. Capital costs and market developments that could influence that target are also factored in.
It is clear that the built environment is a huge barrier to creating net-zero economies, but it can be achieved. Investors may have to play the long game to own the assets they need to meet their ESG targets. It is a big task, but it could be worth it as we may not have a future until we clean up the built environment. “Property is a key element in trying to achieve low-carbon economies,” Smith says.
Note
1) Scope 1 includes emissions from natural gas, diesel, and refrigerants. Scope 2 includes emissions from purchased electricity and steam.
