01 May 2017

Six trends driving sustainability in commercial real estate

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The following article was originally published in NAREIM Dialogues, Spring 2017 

"What can we expect in the next several years with regards to sustainability and commercial real estate?” “What cultural, economic, and technological forces should we look to understand in order to shape our investment strategies in 2017?” Recently at Principal Real Estate Investors, portfolio managers, asset managers, operations managers, appraisers, and engineers gathered to explore these questions and assess the implications for the commercial real estate sector. We focused on the following six trends that represent large, global changes displaying many signs of acceleration in the industry:

1. MATERIALITY

Moving from reporting to meaning

Over the past several years, there has been a rapid growth in sustainability and corporate responsibility reporting. For example, the Global Real Estate Sustainability Benchmark (GRESB) now includes data from 66,000 assets representing over $2.8 trillion in asset value. The United Nations Principles of Responsible Investment (UN PRI) annual survey represents over $59 trillion in assets. The Carbon Disclosure Project (CDP), the National Association of Real Estate Investment Trusts (NAREIT), the U.S. Green Building Council (USGBC), and many other organizations collect, analyze, and aggregate data on sustainability and corporate responsibility issues in commercial real estate.

The industry has rapidly progressed from having too little information regarding sustainability and real estate to information overload. That said, the focus has now turned to determining what information is vital and is key in investment decision making. Moreover, what specific data benchmarks help identify risk, or highlight new opportunities? In addition, how can investment managers zero in on what is most important?

It is a growing belief among investors that good sustainability performance is a proxy for good investment management and raises awareness on what is material in commercial real estate. For instance, recent efforts initiated by policy and financial organizations have been seeking to identify what materiality means to the investment community. One definition worked on by the Sustainability Accounting Standards Board (SASB) defines materiality for a variety of commercial sectors, with the intention of requiring disclosure of material sustainability information in future 10-K and other financial filings. Findings from McKinsley & Company1, MIT Sloan Management Review2, BlackRock3, and Mercer4 highlight the discussion on portfolio exposure to “climate risk” and the meaning to investment managers.

2. RESILIENCE

Managing real estate in an increasingly volatile environment

The concept of resilience is gaining more attention among investors of all asset classes. For real estate, the term resilience represents a mindset that examines how to mitigate risk, anticipate issues, and protect investments from negative impacts due to climate change, natural disasters, and “black swan” events. The Urban Land Institute (ULI), American Planning Association, and USGBC5 have jointly defined resiliency as “the ability to prepare and plan for, absorb, recover from, and successfully adapt to adverse events.” They also examine the economic imperative to successful resilience strategies, stating, “the promotion of resilience will improve the economic competitiveness of the United States.”

The increasing attention to resiliency strategies is also apparent in public policy initiatives and private sector research. For example, significant efforts are emerging particularly at the city level and discussions on resilience as part of public policy have been accelerating. The importance of resilience is also reaching the private sector, major insurance, re-insurance, and risk companies. These entities are leading research and analysis on the impacts of climate change, and updating their models to incorporate climate risk. The World Economic Forum’s “Global Risks Report”6 identifies “failure of climate change adaption and mitigation” as one of the most concerning risks for its members. Considering these developments, resilience strategies should integrate with investment management practices, necessitating improvements in underwriting and managing real estate, and mitigating risks across geographic, market, end ecosystem perspectives.

3. PERFORMANCE RESULTS

Greater expectations to achieve and evaluate

A variety of factors are now driving increased market expectations for performance. However, the most important is the signing of the Paris Climate Accord.7 Signed in 2015, this watershed event brought significant implications for real estate. Almost 200 countries signed the Paris Accord in an effort to accelerate and intensify a “transition to a near-zero carbon global economy in this century.” Because buildings account for about one-third of global carbon dioxide emissions, real estate will be at the center of these policy activities, with many initiatives expected to target buildings and urban developments.

Setting “science-based targets” has become a growing effort in corporate sustainability programs. This methodology creates enterprise carbon-reduction targets in a manner consistent with meeting the two degree global maximum. More than 200 companies are participating in the Science Based Targets initiative.

It is also worth noting that property performance is the last frontier on the Global Real Estate Sustainability Benchmark (GRESB) assessment, and the primary way for real estate investors to continue to demonstrate leadership in sustainability. As more companies begin to implement policies and management strategies for environmental, social, and governance factors, the green certification and actual energy, water, and waste performance of properties will define the true leaders in our field.

4. INTELLIGENCE

Harnessing data, analytics, and new technology in real estate

The abundance of operational, financial, and environmental data is reshaping building management and analysis. The increase in building intelligence is transforming how and who operates the buildings, and this has added complexities to landlord and tenant relationships. The rapid growth of this industry has made it difficult to stay up to date on the new technology available. By 2021, it is expected that over 3.6 billion connected devices will be installed in commercial buildings. These devices could come in many forms lighting sensors that personalize control of individual fixtures, occupancy and temperature sensors, access control, etc.

However, the explosion of data brings challenges for investment managers. Having thousands of data points within a building provides no value if the data is not being used to make informed operational and business decisions. In the coming years, the industry will need to work towards turning this new data into intelligence, making it digestible, actionable, and useful.

5. EXPERIENCE

Navigating new tenant expectations and tools for engagement

The occupant experience has been emerging as a major industry focus and highlighting the importance of blending sustainability, intelligence, and experience. It is worth noting that 90% of the costs associated with running a building come from employee salaries and benefits. Just 10% is attributed to the building’s operating costs, including energy, maintenance, and mortgage/rent, among other things.

Worker health and productivity are emerging as strategic priorities among corporate real estate leaders, and the industry continues to innovate on space design and the resulting impacts of how people interact with each other. Health design trends include integrating amenities and features such as access to daylight, quality of lighting, acoustics, ventilation, and thermal comfort into typical building designs. A study by Harvard8 found the increase in ventilation resulted in a significant improvement in cognition. This trend is leading to a shift in mentality from leasing square footage, to leasing an experience.

6. RESEARCH

Growing body of research by real estate and leading academics

There is an increasing amount of research being conducted by some of the leading names in real estate and academia. Recent studies have focused on the linkage between sustainability and financial performances, as well as on improved productivity, occupant experience, and health and wellness. Even with this expanding body of research, barriers exist that hinder progress. For example, real estate is intrinsically illiquid limiting sample sizes of transactions and comparables. Financial data is also held closely and is considered proprietary and confidential.

To address some of these barriers, Principal Real Estate Investors participated in a pilot Financial Research Study with the Department of Energy to study over 130 office properties. Building, leasing, and financial information were analyzed to determine if there were correlations between green certification and financial performance. Full results of the DOE analysis are now available, and we hope to release further analysis done on tenant satisfaction data in the fall of 2017.

 

In summary, each of these six trends are interrelated and influence each other. Data and intelligence enable new sustainability and engagement strategies. Environmental performance is tied to financial performance, and overlaps with the health and productivity of building occupants. Understanding the impact of climate change influences how real estate investments need to adapt and prepare for adverse events. Each of these trends represents new market realities in the new competitive landscape. In short, real estate now needs to be sustainable, resilient, smart, and engaging. Fiduciaries and investors need to understand what the main issues are and develop strategies accordingly.

Portions of this paper were previously released at the  Principal Real Estate Investors Blog.

 

Disclosure

1 Sustaining Sustainability: What Institutional Investors Should Do Next on ESG. McKinsey & Company, Private Equity and Principal Investors

2 Investing for a Sustainable Future – Investors Care More About Sustainability Than Many Executives Believe. MIT Sloan Management Review

3 Adapting Portfolios to Climate Change – Implications and Strategies for All Investors. BlackRock Investment Institute, Global Insights

4 Investing in a Time of Climate Change. Mercer

5 Returns on Resilience – The Business Case. Urban Land Institute

6 The Global Risks Report 2016, 11th Edition. World Economic Forum

7 L’Accord de Paris: A Potential Game Changer for the Global Real Estate Industry. Urban Land Institute Center for Sustainability

8 The Impact of Green Buildings on Cognitive Function. Harvard T.H. Chan School of Public Health, Center for Health and the Global Environment