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Earlier this year we published two Environmental Social and Governance (ESG) focused articles, which respectively looked at what "ESG" means and why it is important and relevant to the real estate industry (read here), and an overview of a panel discussion we hosted on how property investors can implement investment strategies with the aim of increasing ESG credentials across property portfolios (read here). In this part 3, we look in more detail at some of the practical ways in which ESG criteria can be implemented in practice in commercial real estate investment and development, as well as the challenges around quantifying the success of ESG in real estate investments.

Working on the basis that ESG is undoubtedly going to become more of a consideration for investors going forward, how can investment managers make their portfolios ESG positive? We will now turn to some of the practical ways in which this might be achieved.

Old or new?

One of the most appealing options is to purchase a new building which, through its design, construction and/or operation, emits minimal or zero carbon. A good example of such an asset would be "Halo", the landmark green office development in Bristol (forward funded to Tesco Pension Investment for c.£70 million) which has been designed to satisfy as many ESG criteria as possible. The developers are targeting a BREEAM "Outstanding" accreditation, and it will have a focus on employee wellbeing, with key features including outdoor space and a glazed façade to maximise views and daylight.

However, while some investment managers may be in a fortunate position in that they can start from scratch and acquire properties that are environmentally-friendly from the outset, many others will not be so lucky. There is also likely to be a limited supply of such buildings available for immediate purchase, at least in the short term (with 80 per cent of the buildings required in 30 years’ time already built [1]). Furthermore, "new" does not necessarily mean "better", and some investment managers might prefer to purchase older, historic buildings for their character and heritage.

Given this, investment managers will need to work harder and adopt a more creative approach to their investment strategies in order to diversify and incorporate ESG-positive assets into their portfolios, especially since 35 per cent of the buildings in Europe are over 50 years old and almost 75 per cent of existing building stock is energy inefficient [2]. The obvious answer is to retro-fit – in other words, modify existing buildings in order to improve their energy credentials. For example, at the more obvious end, this can be achieved by upgrading insulation, moving away from fossil-fuel heating systems and towards low-carbon alternatives, such as solar or heat pumps, and installing more economical electrical appliances. This can also save costs (both financial, and in terms of the impact of building materials and construction processes on the environment) associated with tearing down existing buildings and replacing them with greener ones [3].  

However, while in theory retrofitting is a good place to start, doing this to a portfolio of tenanted buildings will not necessarily be a cheap or quick option (and it is likely that many existing leases will not permit landlords to enter demised spaces to carry out such works). We considered some of the difficulties with this approach in our 2017 article "How green is your lease?". The wider difficulties of retro-fitting are borne out by the fact that less than one per cent of building stock in Europe is actually renovated each year [4].

Management and occupation

The next place to target improvements is through greater focus on ESG issues in management and occupation. In this way, owners can have an impact on all three limbs of ESG. Whilst the "E" has to date received greater attention than its counterparts (particularly in the real estate sector), there is a growing sense that the importance of "S" is now starting to catch up and has gained even more importance throughout the COVID-19 pandemic, whilst in respect of "G" it is now almost a given that there will be good governance.

One way of addressing all three limbs is through securing the right mix of occupiers (in other words, letting to more socially conscious tenants) and then ensuring that those tenants adhere to ESG principles throughout their occupation. We discuss the relationship with tenants and existing leases in more detail in the "Engaging with tenants- the ESG Lease" section of our part 2 article.

Where the landlord is in the fortunate position of being able to negotiate terms with an occupier, they should ensure that their agents make it clear at the outset of such negotiations that "green lease" wording will be a requirement in any new lease or renewal (outside of a statutory renewal under the Landlord and Tenant Act 1954 where the options are more limited). This will make it harder for tenants to push back when these clauses are introduced into their leases. Green lease wording can take many forms and cover all three components of ESG. Green clauses in leases are still not standard in the market and care should be taken when incorporating such provisions to avoid, for example, inadvertently impacting the value of the asset. However, reports indicate that many institutional investors expect green leases to become the norm over the next decade [5] and so investment managers need to be prepared, especially since the requirements to share and disclose ESG-based data are only set to tighten in the future. Banks are already encouraging borrowers to operate more sustainably by offering incentives such as lower margins to those who comply with ESG criteria. It may be the case that in order to encourage tenants to agree to green clauses, landlords will also need to start offering similar incentives.

Addressing the "S" is undoubtedly more difficult, particularly in a property context. Occupiers, as well as their employees, are becoming increasingly discerning and not only questioning how their buildings impact the physical environment but also how buildings affect their health and wellbeing as well as the local communities in which they operate. Looking again at the Halo building, the developers are deliberately incorporating various features with the intention of prioritising the wellbeing of occupiers, such as cutting-edge digital connectivity, outdoor space on the rooftop and a bike park. With the availability of such highly thought through space on the market, investment managers will need to be alive and ready to respond to such competition. They should also be alert to the fact that their own investors and occupiers are likely to hold them to greater account over their ESG credentials in the months and years to come.

Measuring the success of ESG

While ESG-based real estate investing only looks set to grow in the years ahead, the benchmarking of ESG investments and the metrics used to measure ESG performance has not yet fully matured. The quality and consistency of ESG-based disclosures is poor across sectors as the Alliance for Corporate Transparency found earlier this year [6]. However, there are concerns that ESG metrics within the real estate community in particular are not yet fit for purpose.

One of the most popular benchmarks amongst real estate investors is GRESB which posits itself as providing a framework by which participants can analyse and compare ESG performance data. Yet some commentators have called into question the quality of the benchmark on the basis that members are scored on the strength of their reporting rather that the concrete data which underpins these reports. Others comment on the fact that GRESB assessments seem to take a homogenous approach and give preferential treatment to certain factors over others [7].

The general consensus consequently seems to be that in order to reduce the risk of "greenwashing", more attention needs to be given to quantitative evidence and specific metrics rather than sweeping qualitative-type statements. However, the sector itself is not entirely to blame. To date, the legislation put in place is vague and open to wide interpretation, as has been recently acknowledged by the European Securities and Markets Authority [8]. The "S" and "G" elements are also harder to quantify and arguably demand a more conceptual approach than the "E" which can be more easily measured against hard data [9].

As the market for ESG-focused real estate investment grows, so will the need for companies to share consistent, meaningful and decision-useful information. This will not only be necessary in order to meet regulatory requirements, but also to enable investors to make informed decisions and, in turn, future-proof their investments.

Rules that are due to come into force next year for certain financial services firms will, amongst other things, require financial services firms to make specific ESG disclosures and ask for their clients’ ESG preferences. It is only a matter of time before these measures trickle down to the real estate industry as financial services firms request further information from the managers about their assets and investee companies. It is not yet clear what approach the UK will take in relation to these disclosure requirements, but it might seek to align these with the recommendations of the FSB’s Task Force on Climate-Related Disclosures (TCFD). Indeed, the FCA has recently said that it expects to do further work to adopt TCFD’s recommendations more widely within their rules and will be consulting on implementing client-focused TCFD disclosures for asset managers and contract-based pension schemes in the first half of 2021 [10].

Therefore, one solution for the real estate industry would be following recommendations of the TCFD. Beginning in 2018, the UN Environment Programme Finance Initiative (UNEP FI) convened a pilot group of twenty institutional investors to apply the TCFD recommendations, including in relation to direct real estate investments. 12 institutions in this pilot scheme worked with Carbon Delta, a specialist external provider of climate risk data and analytics, on the development of methodologies for forward-looking, scenario-based assessments of climate-related risks and opportunities. A report was subsequently published (read here) by the UNEP FI which provides an overview of the Carbon Delta methodology, illustrates results from the climate risk analysis, and details the experiences of investors working with the tools of scenario analysis through a series of case studies. The report also includes a discussion of the benefits that scenario analysis brings to real estate investment decision-making and where it should be developed further.

The future of ESG

It is an inescapable truth that the environmental and social pressures that already face us will only increase. Yet, whilst potential costs lie ahead for the real estate investment market, so too do significant opportunities. ESG investment is no longer just about mitigating against risk but also about uncovering and adding value in an ethical, resilient and responsible way. Investors who embrace ESG concepts look set to gain a competitive advantage over those that fail to do so. This is an exciting time to be investing in real estate and making choices which have the potential to have a positive social, environmental and economic impact, as well as protect portfolios, for years to come.

If you require further information about anything covered in this briefing, please contact Helen Auden, Kya Fear or Meghan Hatfield, or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, November 2020

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