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Why REITs And Their Investors Are Betting Big On ESG

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REITs are embracing ESG — environmental, social and governance policies — as a set of best practices that can reshape the way they do business in the 2020s. Sometimes REIT management is hot for ESG, especially new environmental policies, but the pressure is on from investors as well to adopt ESG policies.

The adoption of ESG best practices by REITs can have a profound impact. According to NAREIT, the U.S. REIT industry, with its collective portfolio of more than 500,000 properties accounting for $3 trillion in gross real estate assets, accounts for a significant environmental and social footprint.

Jeannie Renne-Malone
Prologis Vice President–ESG Jeannie Renne-Malone

"ESG performance and disclosure, particularly around climate change, has reached an unprecedented level of importance within the real estate sector," Prologis Vice President–ESG Jeannie Renne-Malone said.

ESG means a company is a responsible steward of the environment and a good actor in the communities it operates, and governs itself in a responsible way. Those goals sound lofty, but as ESG has evolved in the larger business community, the goals have become more specific, with frameworks created to measure progress.

There is a large global movement to invest in assets that are evaluated by ESG performance, and a growing portfolio of these assets. There were $12 trillion in ESG-evaluated U.S. assets under management at the end of 2018, and $30.7 trillion worldwide, a 34% increase from 2016, according to the US SIF-Forum for Sustainable and Responsible Investing.

Why should commercial real estate companies and their investors keep closer track of environmental, social and governance performance than previously?

For one thing, monitoring ESG data can mean improved risk-adjusted returns, said Anna West, Callan senior vice president and ESG practice leader. Callan is an investment consulting firm based in San Francisco.

"As ESG data is becoming more widely available and useful to investors, we’re seeing clearer ties between ESG performance and overall performance," West said.

The implications in the environmental category are particularly relevant, she said — real estate is among the most demanding asset classes on the environment, given the materials, energy and resources required to build and operate investment properties. 

Incorporating sustainable practices can directly benefit asset-level performance through cost savings, and many investment managers believe that properties focused on ESG appeal to a broader and more attractive tenant and buyer pool.

"Companies that proactively track and report ESG measurements in a transparent manner can benefit from attracting a more diverse set of investors, attracting and retaining good talent, and demonstrating their long-term commitment to giving back to communities," Renne-Malone said. "We see these trends as both a responsibility and an opportunity, given the connection between good ESG practices and good business that point the way forward to a more resilient future."

Why REITs And Their Investors Are Betting Big On ESG
Salesforce Tower under construction

Investor-Driven ESG

"Public companies, including REITs, are experiencing growing demand from stakeholders to disclose and manage ESG performance," NAREIT Vice President of ESG Issues Fulya Kocak said.

That means increasing focus on quantifying ESG initiatives and impact.

"The integration of ESG factors plays a more significant role in investment decision-making worldwide," said Hendrik Garz, head of Sustainalytics’ ESG Rating Products. Sustainalytics is a provider of ESG and corporate governance research and analysis. "ESG data points can be integrated into valuation models and portfolio construction in meaningful ways."

For example, CenterSquare — which has about $10B in assets under management — has incorporated ESG considerations into its REIT investments since the 1990s, but more recently has formalized the process. It ranks a company using 10 factors for each component of ESG when assessing an investment.

According to Chief Investment Strategist Scott Crowe and Portfolio Manager Eric Rothman, environmental factors account for 40% of an ESG score — the company’s sustainability policies regarding energy efficiency, conservation and carbon footprint reduction, along with the execution and disclosure of those policies.

Social factors account for 20% of the score, reflecting a company's quality of employment engagement and community involvement. Governance factors — like the board of directors' independence and its ability to carry out its fiduciary responsibility — account for the remaining 40%.

"A common concern that arises in ESG discussions is the extent to which it drives better investments," Crowe and Rothman wrote. "In fact, our analysis suggests that incorporating ESG factors may enhance financial performance in REIT investment strategies."

Using CenterSquare's proprietary ESG scoring system, the company posited a hypothetical Pure ESG Portfolio composed of U.S. real estate securities that fall within the top quartile of ESG scores. For the period from 2005 to 2017, this Pure ESG Portfolio outperformed the FTSE NAREIT Equity REITs Index by 402 basis points on an annualized basis. 

Goldman Sachs co-Head of Private Real Estate Joseph Sumberg said in a Goldman Sachs vlog that his firm has seen ESG investments impact return on investment by 10% to 40%.

"For example, in our multifamily portfolio, to the extent that we're able to add a farmers market, or lease an apartment unit to a teacher at half cost, [having] that teacher provide services to our tenants in the clubhouse — maybe a tutoring program — these are things we've found that people pay for, which drives the revenues of the asset."

Sumberg added that the environmental part of the equation typically represents investments in properties that drive down expenses, a dynamic that is now well-known in the real estate industry.

"These investments in our properties are akin to any real estate investment, like a lobby renovation or any sort of tenant improvement dollar," he said.

Environment

REITs Are Gearing Up Their ESG Efforts

NAREIT's Kocak said REITs are responding to investor demand by actively managing their ESG reporting, with ESG criteria being incorporated into their operations.

The transition, while complex, doesn't necessarily represent an alien way of thinking for REITs. In many important ways, REITs have long informally practiced environmental stewardship, value creation at the community level and good governance, thus laying the foundation for more formal ESG policies, Kocak said.

Prologis, for example, has consistently expanded its ESG policies in recent years. The company issued green bonds in Europe in March and November 2018, and in Japan in August, the first logistics real estate specialist to do so, according to Renne-Malone.

"We see environmental stewardship as staying ahead of customer needs while doing our part to benefit our surrounding communities and the environment."

She said the company is developing a road map to meet an approved science-based target, which is a greenhouse gas reduction goal approved by SBTi, an internationally recognized assessor of such goals.

Last year, the company also achieved WELL Certification, which is administered by the International Well Building Institute and focuses on building performance as it relates to occupant health and well-being. 

In the social aspect of ESG, Prologis has partnered with local workforce training programs to put community members in touch with career-building job opportunities in logistics in Miami, Chicago and Southern California.

"Strong governance ensures that customers and investors can place their trust in a company's oversight and the resilience of its operations," Renne-Malone said. "Operational resilience to us means dedicating local teams on the ground to get ahead of the evolution of logistics."

Boston Properties is another example of a REIT diving into ESG. It was an early adopter of green buildings frameworks like LEED and began benchmarking key performance indicators like energy, emissions, water and waste as long ago as 2008.

Last year, among a large variety of sustainable initiatives it undertook, Boston Properties issued $1B of green bonds in an inaugural green bond offering that was two and a half times oversubscribed, with the proceeds used to fund eligible green projects.

This year, the company is focusing on the development of its pipeline of green buildings, implementing efficiency measures at existing buildings and engaging stakeholders about sustainability, according to Boston Properties Director of Sustainability Ben Myers.

“Environmental, social and governance performance indicators are increasingly important to our customers, employees, shareholders and [the] communities we serve," Myers said, citing the company's Salesforce Tower in San Francisco, newly awarded LEED Platinum, as a prime example on the environmental side of the equation.

“Salesforce Tower establishes new benchmarks for energy, water and indoor environmental quality performance, and is an addition to our actively managed operating portfolio of 23M SF of green buildings certified at the highest LEED Gold and Platinum levels,” Myers said.

"ESG best practices are good business," Kocak said. "Lowering resource use, investing in one’s workforce, and strengthening internal governance mechanisms are just a few of the many ways REITs’ ESG efforts contribute to bottom-line performance. 

"And more often than not, these kinds of practices support further investment, brand loyalty, and talent and tenant attraction and retention."

Social

ESG Reporting, Disclosure And Ranking Frameworks

Formulating and keeping track of new ESG policies is complex. Currently there are more than a dozen ESG reporting, disclosure and ranking frameworks used by investors, according to NAREIT, so understanding the universe of ESG frameworks is critical to effectively meeting stakeholder expectations for REITs. 

Not every framework for measuring ESGs among REITs uses the same benchmarks, but there is a lot in common among them.

NAREIT and AccountAbility recently reviewed 10 ESG reporting frameworks, which were then evaluated to determine their common elements in the three broad categories, environmental, social and governance.

All of the frameworks surveyed included a company's strategy and policies for climate-related risks — the tools companies use to identify, assess and address climate change.

For the environmental aspect of ESG, most of the frameworks include metrics and policies related to greenhouse-gas emissions, including emissions from company operations and mitigation strategies. The completeness of a company's environmental management policies is also part of most frameworks. 

The social aspects of ESG tend to include management and performance of social aspects of a company’s supply chain, such as workforce and labor standards, codes of conduct, transparency, health and safety. 

Also under the social rubric are policies and practices related to occupational health of employees, and policies regarding outreach efforts with a company’s internal and external stakeholders.

Governance

One major ESG framework, with a stress on environment, is the Global Real Estate Sustainability Benchmark, which relies on company disclosure of data, which is then made public. In 2018 GRESB assessed 903 real estate funds and property companies, 75 infrastructure funds, 280 infrastructure assets and 25 debt portfolios.

Real estate carries a particularly heavy — and measurable — environmental footprint compared to most other investment asset classes. 

According to the Environmental Protection Agency, buildings contribute around 12% of U.S. greenhouse-gas emissions. As governments and communities worldwide look to transition to a low-carbon economy, environmentally sustainable buildings will be better positioned to adhere to emerging regulations related to energy usage and efficiency.

"Companies like GRESB are helping to create a universe of consistent, material data that enables investors focused on value — maximizing risk-adjusted returns — to make informed decision about real estate investments," West said.

Another kind of ESG framework is a third-party aggregator, which takes data from public filings, such as annual reports of Securities and Exchange Commission filings. Bloomberg Terminal ESG Analysis is an example of this kind of framework, with the company making ESG data available to investors to incorporate into their financial analysis.

The Global Reporting Initiative, for instance, uses specific disclosure guidelines for reporting on economic, environmental and social performance areas. The standards can be used to meet the desired compliance level and disclosure needs of the reporting organization.

Sustainalytics, another third-party aggregator, recently launched its ESG Risk Ratings, which are designed to help investors identify financially material ESG-related risks within their portfolios.

As important as environmental policies are, organizations like GRI and GRESB have been increasingly stressing social and governance issues more in recent years, according to NAREIT. GRI’s standards include such social categories as employment, labor/management relations, training and education, diversity and equal opportunity, and local communities. 

GRESB includes a stakeholder engagement section, and a separate module for reporting on health and well-being for employees.

As for governance, most frameworks include a company’s strategy and practices for compensation across the company, including line workers but also C-suite and board members. The level of board oversight of a company is also in most frameworks, including the roles and responsibilities of the company’s board of directors.