Investment in ESG: a real estate view – part 2

Developing and implementing your ESG investment strategy

In part one of this article, we explored what Environmental, Social and Governance (ESG) means and the drivers behind why it is has become more important, and more relevant, to real estate investors than ever before.

Having established why, the next question is how can an investor develop and implement an investment strategy with the aim of accumulating a portfolio of commercial properties with strong ESG credentials?

We considered this question recently during a panel event the firm held as part of Entrepreneurs Week, a firmwide initiative showcasing the influence entrepreneurs have on society and the economy.

The panel, which was hosted by Mark Gauguier, was comprised of: Harry de Ferry Foster, head of UK for Savills Investment Management; Dr Eime Tobari, founder and director of COCREATIF; Paul Sutcliffe, founder and director of EVORA Global; and Jay Sattin. We set out below some of the key thoughts and takeaways from our panel.

Creating a framework

When considering the jump to “how”, Paul Sutcliffe advises clients to apply a “forward-looking lens” and to develop a framework that clearly addresses the material legal, physical and transition risks and opportunities that exist and lie ahead. Mr Sutcliffe explains that one way that he has helped clients do this is by advising them to align their frameworks (covering acquisition, management and operation) with external guides and standards. The UN Sustainable Development Goals, a set of broad objectives which are underpinned by various social, economic and environmental issues, may form a good starting point. The “UN Principles of Responsible Investment (PRI): An introduction to responsible investment: real estate” [1] also provides some initial guidance for investors who wish to align their strategies with the UN PRI (investors can also choose to join the PRI scheme and rate their performance annually), as does the Property Industry Alliance’s “best practice framework for a responsible real estate industry” [2], published in February 2020.

Building on that theme, Dr Eime Tobari observes that “once identified, these risks and opportunities can (and should) then form part of your investment strategy”. Dr Tobari advises that, when putting together a framework, investors need to evaluate:

• what their values are and what they are trying to achieve; and
• if, and how, those goals are relevant to local and societal needs.

Of course, the overlap between these two areas will differ, and therefore should be considered on a project by project basis. We have seen this approach work for a number of our clients. Most notably, this has long since been a fundamental principle of the legacy development projects undertaken by the Duchy of Cornwall, at Poundbury and elsewhere, where the specific needs of the local community are central to the development strategy. For further information on a “place-making” approach to development, please click here.

Mr Sutcliffe goes on to explain that there is no one size fits all answer to ESG; risks and opportunities will differ, so understanding this from the outset is important. Embedding ESG into governance, strategy, management and measurement processes, will then help ensure risks are managed and, perhaps most importantly, opportunities realised.

Finding the right property and gathering the ESG information

Once a framework and a set of goals have been outlined, the next step is to implement the strategy – this can be for new funds and assets, through acquisition, or for existing portfolios. Harry de Ferry Foster, fund manager for the Charities Property Fund (Fund) for more than a decade, explains that one approach is to adopt “‘negative tenant screening’, in other words, exclude tenants that don’t take have ‘an ethical stance'”. A method that has been used by the Fund since inception, Mr de Ferry Foster suggests that investors can go one step further by looking to positively screen in organisations that have a social purpose and achieve their objectives in a sustainable way. A good example of this is vertical farming, which experts have noted brings certain key benefits – such as elimination of the use of pesticides and fertilisers, reduced food miles, on-shoring and the de-risking of supply chains.

Tenants with strong ESG credentials may also be identified using sustainability rating agencies, however these are not perfect [3]. Investors therefore still need to carry out further investigations to make sure tenants comply with their ESG requirements. A blend of legal and technical expertise will be needed for such due diligence. Compliance is, of course, important and will be investigated as part of the usual fact-finding machinery, such as inspections, enquiries of a vendor and searches. However, ESG goes beyond compliance – and focusses on actual performance.

Another useful metric is to address the energy performance requirements of a building, especially given that minimum energy efficiency standards are expected to rise (given UK and European government commitments to establishment of net zero carbon strategies) and some, if not many, existing properties therefore risk becoming “stranded” in the near future – where energy and carbon performance breach minimum standards. Local authorities are starting to demand more than just strong energy ratings and, increasingly, require a very good or outstanding Building Research Establishment’s Environmental Assessment Method (BREEAM) rating. To that end, we are seeing an increasing number of planning permissions with prescribed environmental standards.

This may persuade real estate advisers to focus on newer buildings, which also have to achieve a good energy performance rating as part of building regulation requirements – and therefore present a safer option. As a result, investors may seek greater involvement in the early stages of a development’s design and request components that yield better ESG performance. Saying that, older buildings should not be discounted if they have been refurbished to a high specification or have the potential to be without excessive cost.

Data often presents a challenge. EPCs, for example, are based on modelled rather than actual performance (an issue that is under review) and, while information on performance may be readily available for properties that participate in benchmarking schemes, tenants can provide invaluable information, either through mandatory or voluntary reporting [4]. Social performance can also be difficult to measure and Dr Tobari believes this leaves space for judgment: much will depend on how investors define social performance in the context of their business.

Understanding the complete picture and how issues can affect value may require more time than is available in a “normal” transaction [5], particularly when it comes to gathering and reviewing detailed resource consumption data. Setting a wider “scope”, for example assessing the materials sourced for the building or identifying a tenant’s governance policies, can extend this timeline further or mean that certain data cannot be gathered. It is important, therefore, that, when designing an investment strategy, an investor avoids setting objectives which are unrealistic and, by becoming too time and cost intensive, prevent the investor from satisfying objectives which otherwise might be achievable.

Engaging with tenants – the “ESG lease”

While tenants can play a significant role in helping investors achieve their ESG goals, investors should be prepared for tenants to insist on some sort of quid pro quo. Mr de Ferry Foster explains that the Fund has found that tenants are more willing to engage because of the benefits they have enjoyed as a result of the Fund improving the environmental performance in about 50 per cent of its buildings over the past 10 years (eg by installing electric charging points, solar panels and improved building management systems) and the positive knock-on effect that this has had on the tenants’ service charge expenditure. As already stated, access to building level data is integral, particularly for those investors who have to disclose their ESG risks, either as part of their annual report or through global benchmarking schemes, such as Global Real Estate Sustainability Benchmark (GRESB) [6]. However, this can prove challenging if tenants are reluctant or unwilling to engage.

A good place for an investor to start is to make sure that it has the right kind of lease [7] which enables it, so far as possible, to achieve its ESG aims. That is great in theory, of course, but what might an ESG lease look like? ESG standards, for example in relation to the performance and use of the building or the type of business carried out by the tenant, could be prescribed with any changes (including via assignment) being subject to the landlord’s consent (which could be refused if such changes would lead to a deterioration in those standards). Flexibility in the lease could allow for the landlord to change those standards over the lifetime of the lease.

So far so good, but this is not as easy as it sounds. While there may be opportunities to introduce these requirements on new lettings, self-evidently it will be more difficult to do so where landlords are faced with existing leases, tenants with strong bargaining power or security of tenure rights under the Landlord and Tenant Act 1954. Much will also depend on the location, age and nature of the building, whether it is single or multi-let and its intended use. In addition, the market and the prevailing economic conditions will play a key role.

Even where there is push-back, however, for example where the tenant has operational control and is responsible for insurance, repair, maintenance and other variable costs, an investor could still offer to share knowledge and provide finance for projects in return for the tenant taking steps to comply with the investor’s ESG requirements. This could be included in a tenant handbook or a memorandum of understanding which sets out an ongoing process (eg meetings and data sharing).

It is also worth remembering that many tenants have their own ESG strategies and many more will do so in the future. With that in mind, landlords should strive to obtain as much information as they can about prospective occupiers, so as to determine whether certain potential tenants might be more willing to engage and cooperate with their ESG-based requirements than others.

Conclusion

In our panel discussion, our diverse and experienced speakers covered a lot of ground and raised a number of interesting and relevant points. Our panel spoke with one voice, however, when they stressed the importance of a tailored ESG investment strategy. In all cases, this will be an iterative and intuitive exercise and lessons learned will continually need to be fed back into improving the underlying framework. As we write, there is a plethora of available information and guidance, which investors can and will tailor towards their own structures and values in order to focus on the risks and opportunities that are most material to them.

Another key message is that well-advised investors need to ensure that, from day one, those involved in the process – from agents to their professional advisers and their tenants – are fully aware of the investor’s ESG requirements, including any red lines in their criteria. These requirements may add a layer of complication to transactions, and have the effect of slightly prolonging the due diligence process, but a well-organised investor can factor this into the transactional process and take pro-active steps to negate the adverse consequences of any possible delay.

In our next article we will discuss in more detail the challenges around measuring the success of ESG in real estate investments, such as following GRESB. We will also consider further some of the ways in which ESG can be implemented in practice in both commercial real estate investment and development.

Footnotes

[1] https://www.unpri.org/an-introduction-to-responsible-investment/an-introduction-to-responsible-investment-real-estate/5628.article

[2] https://propertyindustryalliance.files.wordpress.com/2020/02/a-best-practice-framework-for-a-responsible-real-estate-industry.pdf

[3] For example see Attracta Mooney’s article for the Financial Times dated 26 July 2020: “Frédéric Janbon: ‘Sustainable investing will be a major force” which highlights this issue, view here (subscription required)

[4] For example mandatory energy and carbon reporting being extended to unquoted companies and large LLPs for financial years starting on or after 1 April 2019, view our article on this here

[5] The January 2014 RICS Red Book edition now specifically lists sustainability as a factor that valuers need to take into account when performing valuations and risk assessments for their clients as these sustainability factors can in investment decision-making

[6] www.gresb.com/

[7] Read, for example, the thoughts of Kiran Patel, Global CIO and Deputy Global CEO, Savills Investment Management commented in an article for Propertyfundsworld: Propertyfundsworld.com March 25, 2020 “Green” leases to be universal by 2026, Savills IM research, view here

If you require further information about anything covered in this briefing, please contact Mark Gauguier, Jay Sattin, 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.