Paul McNamara is a leading authority in the sustainable real estate debate: he chairs the Institutional Investors Group on Climate Change (property workstream), and is co-chair of the UNEP FI Property Working Group. Until recently, he chaired the IPF Special Interest Group on Sustainability. He believes strongly in the impact of sustainability on value and that it must play a central role in everyday investment decisions. He talks to Martin Hurst
Where does the sustainability debate stand at present?
Usually, when I speak on this topic I identify two paradoxes at the heart of the sustainability debate in property. One is that ‘98% of the debate is about 2% of the problem' by which I mean the focus is overwhelmingly on development but only 2% of the stock is being added to, each year. The industry needs to concern itself with existing stock; new development is the slow lane for property to make an impact.
The second paradox is that ‘those with the power don't have the knowledge and those with the knowledge don't have the power'. Until now, the investment community has sub-contracted this issue to the technicians in their organisations. Typically, these individuals don't make the major decisions on assets. Therefore, my sights are firmly trained on helping investment fund managers see that it is in their interest and, indeed, understand it as their fiduciary duty, to understand this issue and what its likely impacts on value might be.
I am pleased to report that this issue has risen rapidly up both the research and business agenda. In 2003 we began researching the issue of how much sustainability is affecting current value. Around that time we also sponsored a session on ‘sustainability' at the European Real Estate Society conference where we told academics that the industry needed them to focus more actively on this area. Sadly, for a variety of reasons, the wider property research community has only recently really started to show significant interest in this area.
Why should sustainability affect value?
Firstly, if tenants, perhaps through their CSR policies, increasingly decide that they want to be seen occupying green buildings, then a differentiation in rental levels will likely develop between green and non-green buildings. Such differences amount to a form of accelerated depreciation for non-green buildings as they gradually become relatively less attractive. Of course, the owners of non-green buildings might inject capital to get them up to the new standard - but that's just depreciation by another name. Either way, from an investment perspective, the owner of the non-green building has seen relatively lower performance.
Furthermore, non-green buildings are, by definition, likely to be less efficient and a euro spent on electricity is a euro less the occupier can pay in rent. Energy inefficiency will restrict rental growth in non-green buildings and, thereby, impact value.
Similarly, if tenants prefer green over non-green, it may take owners a little longer to re-lease non-green stock and all property investors know that interruptions to cash flow will increase the risk premium on an asset and depress its capital value and, ultimately, its performance.
Finally, if investors prefer green buildings over non-green, then the latter will become even more illiquid and demand a higher risk premium than green buildings. As these tenant and investor preferences grow, the more they affect price in the future. Discounted cash flow theory tells you that anything affecting future values should be reflected in current values, albeit at a discounted rate. As such, it is the fiduciary duty of investment managers to understand the implications of sustainability issues.
A study by Kingston University is still probably the leading attempt to try to quantify these effects. The research, led by the head of Kingston University's School of Surveying, professor Sarah Sayce, estimated that given the changing circumstances for property investments going forward, a non-green building could currently be worth 1-2% per year less than that of an equivalent green building (one case study suggested 7% less). If this was the case then, as the market moved to some new form of ‘sustainability-informed equilibrium', this difference in present worth will manifest itself as a difference in performance, as the non-green asset's value falls and the green asset value holds steady. If this took 10 years and, for argument's sake, we said the current difference was 5%, this would generate 0.5% annually underperformance for the non-green asset in each of the next 10 years.
In terms of cost-benefit the sustainable real estate argument still seems rather nebulous. How do you see this?
With so much going on in the UK market, it is hard to discern any specific impacts of sustainability on value currently. However, I have heard at least one senior valuer opine publicly that it is there, underneath current market movements. In Australia, where these issues are probably taken more seriously than anywhere else, the evidence is mounting that it is impacting values.
But the valuation issue is an interesting one because, in essence, valuers are ‘second phase' players in this game. I spoke at the recent Vancouver Valuation Accord conference which looked at how best valuers could respond to the sustainability issue and said that, in essence, it needs investors to incorporate this issue into their estimates of ‘worth', which will then affect what they are willing to accept or pay for assets in the marketplace, and it is these offers and bids which will ultimately affect valuations and asset performance. So, for now, prospective impacts on valuation remain an article of faith but, I have no doubt it will impact values in the future and everything you read suggests sustainability is going to matter a lot.
The interesting thing about real estate in the sustainability debate is that, not only is it a major conduit through which real estate emissions are made but it is also fixed in situ. This means that it is an obvious target for regulation.
SRI has been around for many years in equities. Why has it been slow to take off in property?
Some of the SRI and ethical investment push that we have seen in the equity markets has not translated into the property markets easily because, until recently, property has been seen as a distinct asset class. This is changing partly due to the work some groups like the Institutional Investors Group on Climate Change (IIGCC) are doing to raise consciousness in this area - SRI equity analysts are increasingly asking questions about how companies occupy their properties. They are also increasingly interested in knowing more about institutionally held investment property portfolios from a sustainability point of view. So, the pressure is coming from all sides.
Furthermore, the recent success of property as an investment class has raised its profile and reminded people of its importance. In Europe, the European Social Investment Forum (EuroSiF) has done a report on real estate. In the US, the Boston College has done a review of sustainability and its implications for all the major asset classes.
So we have the coincidence of two trends - an upwelling of desire to understand sustainability within the property industry and the movement of property to centre stage in the investment world over the last few years. Consequently, many more are now thinking about sustainability issues and how they will impact property investment.
At the EPRA conference there seemed to be little interest in sustainability. Why do you think this is?
My general impression is that the property investment community is in a quandary over sustainability; it wants to help but doesn't know how. Over a 10-year period we have moved from a position where sustainability in property wasn't thought about at all or not believed, through a transition period where people acknowledged the issue of climate change but saw it as a long way off in the future and couldn't see how they could influence it; now people are starting to realise that the issue and the policy responses to it are going to impact value in the long and short term respectively.
For example, the Investment Property Forum (IPF) sustainability group were holding workshops on this issue in 2004. They were typically attended by up to 40 people who were already persuaded by the issues. By contrast, IPF with IIGCC held two similar sessions in 2007 - both were attended by over 100 senior investment professionals. There is a real sea-change happening around this issue.
The most recent IPF workshop looked at how sustainability links to fiduciary duty - the usual first barrier put up by investment professionals to doing something in this area. We have to find ways in which social and fiduciary responsibilities can both be honoured together. For example, if we can show that managing property portfolios responsibly enhances performance then it is the fiduciary responsibility of every fund manager to do so - because it enhances returns. However, even if one can only demonstrate that there are forms of responsible investment that don't harm performance then, arguably, it becomes the fund manager's moral duty to implement them. The same IPF workshop also looked at how this issue is seeping into the property manager selection process. This will be another major influence and pressure on fund management houses to develop their skills in this area.
What is the level of involvement and understanding of pension funds of sustainable investment?
I would hope that most of the major insurance companies would now be thinking about these matters seriously. In the pension fund industry, USS and Hermes in the UK are notable powerhouses in this area. The local authority pension funds are also very conscious of these issues and thinking hard about what they can do; fund managers, which are well positioned in this area, should be a natural ally. Property companies like Land Securities, British Land, Quintain and Hammerson are all very active in this area.
How might there be broader co-operation between industry associations on these issues?
In truth, I think there is a real issue surrounding the proliferation of organisations and consultancies in the sustainability arena - it is daunting and offputting for any stranger to sustainability to look at the ‘alphabet soup' of forums, groups and associations out there.
The Green Property Alliance - the green dimension of the UK Property Industry Alliance (PIA) is chaired by Prupim managing director Martin Moore - is a key means by which to bring the industry together on this issue. Four of the big UK trade organisations - IPF, BPF, RICS and British Council of Offices (BCO) - are all active on sustainability issues. They all have their own particular focus and can articulate different aspects of the green agenda through that. The IPF is interested in how sustainability will impact worth and the value and efficiency of the marketplace; BPF has an interest in ensuring that related regulation comes forward in a way that is implementable. The BPF has done some terrific work on landlord energy statements and tenant energy records (LES-TER). The RICS is interested in how this fits into valuation, professional conduct and all manner of other areas, and the BCO naturally has a focus on how this affects the occupation and operation of office buildings. Outside the PIA, the British Council of Shopping Centres is also doing major work in this area now.
I am also pleased that the academic research community is starting to get more actively involved. The IPF has commissioned Oxford Brookes University to do some work on tenant attitudes to occupying green buildings, specifically whether it's just about corporate image and CSR brochures, or whether it truly influences their decisions on what buildings to occupy.
Kingston University has been similarly commissioned by IPF to look at how sustainability influences landlord-tenant relationships, in particular whether the lease contract could play a role here. The issue of ‘green leases' is now coming to the fore and it will be interesting to see if the Green Property Alliance can build links to tenant organisations in this regard.
How far are Europeans involved outside the UK?
If the UNEP FI (United Nations Environment Programme Finance Initiative) Property Working Group is anything to go by, there is a very strong interest in this issue in mainland Europe. My co-chair is Blaise Desbordes, of Caisse des Dépôts in France. AXA REIM is also represented on the board, as well as a German property investor. We are still trying to grow membership. We would expect Nordic investors to be very advanced in this area and from southern Europe Sonae are known activists in this area. The Dutch are interesting in that they now manage much of their property through indirect investment. As such, they are probably locking into the debate through their property securities portfolios. PGGM and BNP Paribas are both very active on IIGCC, which is increasingly developing its European profile.
What is your opinion of the commonly held view of the US as a sustainability pariah?
It would be wrong to characterise the US in this way. At corporate, state and metropolitan level the US is doing a great deal in the sustainability field. For example, both Scott Muldavin of the Green Building Consortium and Gary Pivo from University of Arizona are global figures in this field. Fund wise, CalPERS is very committed in this area (viz. the Green fund it has set up with Hines). This said, we hosted our recent UNEPFI meeting in New York because we were keen to promote the issue further in the US.
What is the key contribution of UNEPFI to the sustainability debate?
Its main contribution is to maximise the arena to exchange ideas and best practice literally from around the world. The other great benefit is that when UN headed notepaper lands on the desk of a policy-maker or a CEO, it gets noticed. In late 2007, the UNEP FI PWG published a set of examples, or ‘briefs', to show the various ways property investors can ‘do well by doing good'. These covered everything from environmental to more social issues and illustrated social responsibility in its broadest sense.
Is there agreement as to what a green building is?
In truth, you could fill a library with the various attempts to define what a green building is. The one likely characteristic you would find in most definitions would be energy usage, which seems uppermost in most peoples' minds today. However, even here, one has a problem of definition, namely, that you have not only the built structure but also the activity within it. Do you rate a building on its structure or on the activity within it or on both? This is a key issue that has dogged the debate about Energy Performance Certificates in the UK.
We need to think hard about what we can do with existing buildings. If tenants are too ‘absolutist' in their occupation demands, it could leave some poorer properties un-lettable. The worst thing one could do from an environmental perspective is knock such buildings down. More attention needs to be given to recognising the improvements made to an asset by owners. You could consider creating a green fund with green buildings and green tenants, and such a fund might do very well - but such an investor will have contributed only minimally to addressing the sustainability issue.
Within current cost constraints, one can only take sustainable improvements so far in existing buildings. My hope would be that one could implement a first tranche of improvements then, as the technology gets cheaper and energy, water and waste costs rise, we might be able to implement a further tranche of improvements which might not have been economic initially.
Is the social aspect the poor relation in the sustainability family?
That may be so generally but it has never been that way here at Prupim. The interesting thing about property, and particularly shopping centres, is the presence they give an investor in a community. We manage the property portfolio of the Prudential Life Fund which is a major owner of shopping centres. These assets have proved a significant route through which to express our overall corporate responsibility effort. For example, in a number of shopping centres we have set aside a retail unit for training long-term unemployed people for work in the retail trade. Tenants love it because they are provided with a ready source of trained staff. So, it is ‘win-win' for tenants and investors.
Similar initiatives have included working with local young people on reducing vandalism or mobile phone theft in centres, the logic being that if you make the centre safer more people will visit, stay longer, spend more, and that rents will rise.
What is your long-term goal?
I think we would have a real sign of success if we reach a situation where the culture of awareness of sustainability is embedded in the myriad of day-to-day choices that property investment managers take. This includes the relatively minor alterations such as materials to repair a floor, replacing windows or fixing a roof. We need to see all of those working in property considering sustainable options in everything they do. We are still a long way off that. People often look for a radical ‘silver bullet' solution to the issue but it could actually lie in the myriad of small decisions we make every day.
Paul McNamara is also head of property research at Prupim. He has published widely and is visiting professor with the department of real estate management at Oxford Brookes University. He was awarded the OBE for services to the property industry in the Queen's Birthday Honours list in 2003