Investing in green property not only has social added-value, but also reduces the financial risk in the property portfolio. Experts warn that outdated, non-sustainable buildings are in danger of becoming unlettable.
Sustainable investment is popular among investors. Pension funds are focusing on lowering the CO2 emissions of investments and reducing physical climate risks. The aim is to contribute to the fulfilment of the Paris climate objectives: a maximum 2° Celsius temperature increase. Although the allocation to real estate is usually limited, there is a lot of climate benefit to be gained here. “Buildings are responsible for almost a third of global CO2 emissions and use about 40% of the world’s energy”, said Rene Reyna, head of thematic investing at Invesco.
In April, Invesco launched the MSCI Green Building ETF, the first tracker to closely track the MSCI Global Green Building Index. “This ETF not only offers investors access to sustainable real estate, but also invests in companies that are active in or advise on making existing buildings more sustainable”, said Reyna.
According to him, green buildings can play a crucial role in limiting global warming. “They are more environmentally friendly, have lower energy consumption and a healthier indoor climate than older buildings. In short, they permit ETF investors to contribute to a more sustainable society. Moreover, the Covid pandemic has increased the importance of a healthy building.”
Stranded assets
To qualify for inclusion in the index, a company must derive at least half of its turnover from green buildings. Certificates from consultancies such as BREEAM and LEED determine the sustainability of a building. Reyna explains: “Ultimately, all companies in the index will move towards the Paris Climate Accord target of zero emissions by 2050, although this is not a selection criterion. Index builder MSCI and we too monitor the progress companies make in this area.”
This makes it important that most companies have concrete climate targets. “For example, property developer Sun Hung Kai Properties, the largest holding in the ETF, is aiming for a CO2 reduction for its buildings of 25 per cent by 2030. This can be done through new construction, but also by making existing buildings more sustainable. For most companies, we consider the Paris target feasible,” said Reyna.
According to him, real estate investors must make their portfolios more sustainable because both users and investors increasingly demand that their properties are sustainable. “As a result, outdated, unmarketable buildings are at risk of becoming stranded assets, with the risk of a sharp drop in value. New or sustainably renovated buildings will perform much better in the long term because tenants and investors are prepared to pay higher prices for them. On top of that, energy costs for older buildings will increase considerably in the future.”
Although real estate investment trusts (REITs) account for an index weight of 93 percent, the portfolio is not comparable to traditional global real estate indices. For example, the weight of Japan is remarkably high and that of the US relatively low. In addition, the ETF is mainly invested in offices and retail property, while residential property is under-represented. Homebuilders are also part of the portfolio and the exposure to mid caps is above average.
Still, Reyna does not think the ETF is more sensitive to the business cycle than a traditional real estate ETF. “Potentially, volatility is lower, precisely because of the large exposure to office REITs, which will invest heavily in improving the sustainability of the portfolio and therefore benefit from relatively strong rental growth and positive revaluations.“
Stimulating innovation
Asset manager DWS has been formally integrating ESG factors into its property investment strategy since 2011. With new acquisitions and the annual portfolio review, the main climate risks are identified, explains Jessica Hardman (photo), head of portfolio management European real estate at DWS. “These are the transition risks associated with measures to combat global warming, such as new legislation and regulations. But also physical climate risks and the risk of exceeding social standards.”
Hardman points out that transition risk in particular poses a huge challenge for the real estate sector. “Of all the buildings in the world, only roughly 20 per cent are still sustainable, and for the remaining 80 per cent, lower energy consumption is only feasible after renovation. Think of insulation and the installation of solar panels and heat pumps.”
In order to map the transition risk of its real estate portfolio, DWS uses the Carbon Risk Real Estate Monitor (CRREM), which is supported financially in part by PGGM and APG. “The monitor calculates the period within which buildings must undergo renovation due to future stricter government guidelines. This helps us to identify in advance individual properties that do not meet these new energy standards. This is important, because these properties will become unletttable. In the future, tenants will increasingly focus on energy-efficient properties. There is also the risk that some governments will ban the use of non-sustainable offices in the long term”, warned Hardman.
DWS is not only working to make existing buildings more sustainable, but also to stimulate innovation in the sector. “By investing in new buildings with the latest climate technology, we can use the knowledge and experience we have gained to reduce the greenhouse gas emissions of our older buildings. We believe this can make a significant contribution to solving the C02 problem in the property sector,” said Hardman.
Polarisation in the property market
In recent years there has been a polarisation in the property market, with rents and property prices in the secondary market falling further and further behind first-class property. “We are now also seeing the first signs of divergence between energy-efficient properties and non-sustainable properties. There is a strong user demand for new buildings with a healthy indoor climate. Especially in the European office market, demand is currently focused on flexible office space in good locations in central business districts of large cities that meet the ESG standards of the end user,” said Hardman.
She sees this reflected in rents and valuations. “This polarisation is still in its early stages and will only continue. It reinforces the need to make existing buildings more sustainable, which is also much more environmentally friendly than demolishing older buildings to make room for new ones. Moreover, investments in sustainability are usually profitable, as tenants and investors are willing to pay a premium for sustainable buildings. Modernised buildings in good locations can certainly compete with new buildings.”
Due to the tight supply, DWS does not yet see any divergence in the logistics and residential markets. Hardman elaborates: “For the time being, users in the logistics property sector mainly look at the location, followed at a great distance by the ESG characteristics of the building. So when it comes to sustainability, there is still a lot of room for improvement in this sector.”