In recent years, one of the most transformative shifts in commercial real estate (CRE) has stemmed from ESG, or Environmental, Social and Governance issues.
Once considered a specialized niche, ESG has expanded far beyond its former status in the investment realm. It’s become an integral part of private equity real estate transactions, as investors seek detailed views of how portfolios impact the environment. Tenants also have a heightened awareness of ESG — they prioritize sustainable spaces, which shape their choices about where to work and live.
The rise of ESG’s role in CRE can be traced to climate change. Specifically, as weather patterns become more extreme, energy consumption typically increase to maintain comfortable temperatures. When a property’s energy use rises significantly, that affects its environmental impact as well as operating costs. These factors do not escape the attention of potential investors or occupants.
With that in mind, let’s examine why committing time and resources to ESG initiatives can lead to reduced risks and increased value for CRE investment portfolios.
If you ask someone to name the biggest source of carbon emissions, they might mention cars or planes, or even farming. Many would be surprised to learn the real answer: Buildings. They produce 39% of global energy-related carbon emissions, according to the World Green Building Council. Materials and construction account for 11%, while most of the total —28%— comes from operational emissions like heating and cooling.
Although It’s a long road to net-zero emissions, there are meaningful steps real estate investment firms can take along the way to benefit the environment while reducing costs. To limit energy use, make ENERGY STAR certification a priority. According to the EPA, ENERGY STAR certified buildings use 35% less energy and generate 35% fewer greenhouse gas emissions compared to buildings without the certification.
By investing in smart commercial technology, firms can significantly lower energy costs. That includes smart buildings with sensors that automatically adjust lighting based on occupancy or the amount of daylight filling a space. HVAC systems represent another opportunity: When they have occupancy sensors, energy use becomes selective and targeted, supplying heating or cooling to the places that need it most.
Energy use matters even more than it did decades ago because severe weather events are increasingly prevalent. Extended heat waves and frigid temperatures can wreak havoc in communities—and in real-estate portfolios as well. We believe climate change issues represent the largest risk faced by CRE today. Companies can take steps to mitigate that risk and prepare for increasing weather extremes. To avoid soaring energy costs for heating or cooling, the proper sealing of buildings is essential. Carefully evaluate how climate change affects properties’ location: What is the long-term risk of wildfires, flooding, or mudslides?
Building materials represent another important consideration. For example, timber has become popular as a climate-friendly option for commercial construction. It performs well in earthquakes, and some studies suggest it could help cut carbon emissions (approximately 8% of global GHG emissions come from cement production). Norway currently has the world’s tallest mass timber structure—at 18 stories, it contains apartments, office space and a hotel.
As you think about ESG’s role in how buildings operate, consider that green leases—which factor in renewable energy, carbon emission reduction, and decreased water use— have grown in popularity for both tenants and investors. That’s reflected in a 2021 report by JLL (Decarbonizing the Built Environment) which showed that about 34% of occupiers already have green lease clauses, and an additional 40% plan to sign them by 2025. Meanwhile, 42% of investors now have green lease clauses in place, according to JLL, with an additional 37% looking to adopt them by 2025.
Some firms may think climate change and energy-efficiency issues aren’t compelling enough to shift strategy. For those skeptics, here’s yet another reason to develop ESG initiatives: Companies who don’t, may find themselves able to compete. That’s because an industry shift is underway for green benchmarks. Instead of just “nice to have,” these benchmarks are becoming a requirement to attract tenants and investors. Keep in mind that ESG benchmarks are already being used to evaluate properties, and we expect that trend to accelerate.
Government efforts continue to bolster this dynamic. In April 2021, President Biden announced a new U.S. climate goal: Cut greenhouse gas emissions in half by 2030. A few months later in September, SEC Chair Gary Gensler told the Senate Committee on Banking, Housing, and Urban Affairs that investors want “consistent, comparable, and decision-useful disclosures around climate risk.” Gensler went on to say that his staff is developing proposals for the SEC to consider regarding these potential disclosures. “Companies and investors alike would benefit from clear rules of the road,” the SEC chair said in his testimony. “I believe the SEC should step in when there’s this level of demand for information relevant to investors’ investment decisions.”
Because it’s easy to get caught up in thinking about ESG as a climate or emissions issue, one component that’s often overlooked is wellness. Remember the JLL report we mentioned earlier about green leases? It also reflects a growing emphasis on how buildings promote wellness. In an article about the report, JLL’s EMEA corporate research and strategy director underscored the role of wellness for CRE with this observation: “Five to 10 years ago, green leases were more around energy efficiency and waste reduction, which today are standard practice, while other dimensions such as health and wellbeing and biodiversity are now leading practice.” Improvements in health and wellbeing can take many forms in ESG-focused building design— including upgrading ventilation systems for improved air quality and increasing occupants’ access to natural light.
As CRE continues to adopt ESG strategies, it also faces heightened scrutiny. Critics are quick to spot initiatives that position properties as environmentally conscious but don’t represent meaningful action. With that in mind, how can the industry avoid accusations of greenwashing? CRE can start by moving away from subjective rating systems, because they undermine credibility. Instead, objective standards will help build trust, whether it’s additional green building certifications or better measurements for environmental impacts in ESG.
These efforts point to a common goal for investors and property owners. They both benefit from integrating ESG strategies, whether it’s improved financial results from carbon-reduction initiatives or improved worker productivity (thanks to a healthier environment). As CRE increasingly uses ESG to shape portfolio decisions, that investment in time and resources will strengthen today’s portfolio and create a more resilient, adaptable strategy. Although we can’t predict the weather, here’s one forecast you can count on: Firms that plan for climate-related changes will enjoy favorable winds
As a PRI Signatory, Sanne is committed to integrating ESG considerations into real asset investment practices. We are a leading fund administrator offering ESG advisory and reporting services and our expert Real Assets, Private Equity, Private Debt and Corporate Services teams have a proven record in administering infrastructure and renewable energy funds and asset holding vehicles. Sanne offers a full range of fund and corporate services across our global network of offices, with leading alternative assets expertise.