Despite the crisis, sustainability remains on the agenda for institutional investors wanting to understand the link with investment performance, says Pirkko Juntunen

Institutional investors across Europe are working on several initiatives to improve sustainability in real estate. Legislation is a powerful incentive, as is the increasing attention tenants give to costs relating to energy use and other sustainability issues. And then there are investors’ own sustainable investment principles.

In the past, real estate investors looked at sustainability from an individual asset perspective, but they are now moving towards green strategies for their entire portfolios and at a company level, finds a recent survey by Union Investment, the German asset management company. The survey of 172 property investors in Germany, France and the UK shows that the search for improved environmental performance will require greater involvement of building users and service providers.

Some 34% of investors have incorporated sustainability into their corporate social responsibility (CSR) strategies. A total of 31% base their sustainability activities on a sustainable product strategy for the overall portfolio. A specific product or individual ‘green building’ was at the heart of the sustainability strategy for just 29%.

In the Nordic region, the majority of the large real estate investors have incorporated sustainability into their CSR strategy, and sustainability in real estate is a real selling point. Unn Hofstad, head of real estate sustainability at Storebrand, the Norwegian financial services provider, says the company, as a long-term investor, believes that sustainability does add value and returns more than it costs.

According to the Union Investment survey, investors are increasingly focused on aspects such as maintenance and service providers taking sustainability into account.

Hofstad says Storebrand follows its investments from each stage in the developments and makes sure that each step takes sustainability into account, including such factors as materials used. “Sustainability is not one isolated issue but involves all aspect of investments. This has become a standard way of operating for us and for many other Nordic investors,” she says.

Some 65% of the property professionals surveyed believe that user behaviour has a significant impact on a building’s environmental performance. However, the figure is significantly lower in Germany, at 52% compared with 72% in France and 77% in the UK.

Jenny Pidgeon, head of responsible property investment at Henderson Global Investors, says occupier preferences and behaviour are an increasingly important factor in pushing sustainability to the fore, particularly energy efficiency issues, which translate directly to savings for the occupiers.

The desire to be able to assess and compare green portfolios continues to rise among real estate investors, with 62% of the investors surveyed stressing that transparency was impossible without benchmarking.

Simon Ringer, head of property funds at Bridges Ventures, a firm that focuses on sustainable growth investments, says institutional investors are working on taking sustainability issues further, proving that sustainability is not more expensive.

Legislation is one of the most important factors behind improving sustainability in the UK.
The Energy Performance of Buildings Directive was updated in April 2012 to stipulate that all buildings being sold or rented must include a copy of the Energy Performance Certificate (EPC) of the building within the property particulars. As of 1 July 2012, an EPC is required within seven days of the commencement of the marketing of the building. In addition, there is provision within The Energy Act 2011 to prevent the letting of commercial properties that fall below a prescribed level of energy efficiency, unless specified improvements are made.

“Properties with an F or G rating could be unlettable after 2018. This is not far away in property terms,” says Chris Strathon, director in the sustainable valuation advisory team at Jones Lang LaSalle.

Christina Cudworth, head of sustainability at Investment Property Databank (IPD), says there are some 930 EPCs in total, of which 13% are F and G, with a total value of £1.9bn.

Cudworth says that although there are a lot of questions surrounding the proposed legislation, it has focused the collective mind of the industry. “It is all down to money, after all. There may only be one opportunity between now and April 2018, when minimum energy efficiency standards are alleged to be set at EPC rating ‘E’, to make these buildings more energy efficient, but the questions are when to retrofit and how much it will cost.”

Hofstad says tighter regulation in Norway is also forcing the issue, particularly with the target of nearly zero-energy buildings by 2020. “Of course, this is a risk as we have to consider systematic energy and environmental improvements as part of the retrofitting and renovation of buildings is crucial,” she says.

Norway is in a fortunate position as most of its office buildings have been built in the last 50 years, which make them relatively easier to refurbish to future standards, compared with, for example, UK’s listed buildings. But future-proofing will still be challenging.

Tim Mockett, joint managing director of Climate Change Capital’s Property Fund (CCPF), says not being up to required standards will pose significant risks for lenders, insurers, fund managers and investors. “We have been working on these issues for five years and future proofing is key in real estate,” he says.

Nina Reid, head of sustainability at PRUPIM, says the most pertinent questions are around risk and how to improve the structure of funds and implementation of them, noting that it is not unrelated to discussions on the value side. “Increasingly, sustainability risks are impacting on long-term performance,” she says. “The ‘green alpha’ is more difficult to strip out, whereas risk is much more quantifiable.”

The UK is also leading the way in terms of getting property valuers on board and aware of sustainability issues. The Royal Institute of Chartered Surveyors is working to incorporate sustainability issues into valuation of property.

As institutional investors try to make sustainability issues more central to their real estate investment process, several ratings systems are used, which is also one of the challenges. BREEAM is one of the earliest global ones, launched in 1990. It is an environmental assessment method and rating system for buildings, with 200,000 buildings with certified BREEAM assessment ratings and over a million registered for assessment since it was first launched. Across the globe there are further local rating systems.

Hofstad said Storebrand is using the BREEAM criteria in order to measure and clarify the ‘greenness’ of its refurbishment projects and assets. At the same time Storebrand is working on joining the Global Real Estate Sustainability Benchmark (GRESB).

Mervyn Howard, managing director of Grosvenor Fund Management’s UK operations, is responsible for sustainability issues internationally. He says the challenge for the industry is to find a more unified rating standard. “It is all well and good to have rankings and ratings but in the end it is about performance.”
Going green, going GRESB

GRESB, backed by 35 global institutional investors, tracks the sustainable performance of around 450 real estate funds and property companies, managing some 36,000 properties worth approximately $1.3bn (€1bn). The organisation works with institutional investors and their portfolio managers to identify and implement sustainability best practice to enhance and protect shareholder value.

Sander Paul van Tongeren, senior sustainability specialist at APG Asset Management, says GRESB has been developing and improving since it was established by APG, PGGM, USS and Maastricht University in 2009. “GRESB enables investors to see how to track sustainability in the entire portfolio rather than individual assets. Recent research shows that there is a 2% outperformance from sustainability,” he says.

The GRESB survey uses over 50 metrics to reflect the sustainability performance of an institutional investor’s real estate portfolio (see table opposite). These metrics are divided between seven sub-categories within the environmental and social dimensions, with an additional category for members with property development activities which is not included in the total GRESB score. The weight of each dimension depends on how it might affect the risk-return profile of the investment portfolio and the individual metrics are scored to represent the relative impact to investors.

GRESB has grown substantially since 2009, and its membership includes more than 35 institutional investors, major industry associations such as EPRA and INREV, and a variety of sustainability solution providers. The GRESB members are mainly European, Canadian and Australian but the team is working hard to get institutions from all over the world to join.

Van Tongeren said the end goal with GRESB is for sustainability issues to become an integral part of the real estate investment process. “Sustainability should be an integrated part of reporting and ESG factors, and be the focus of the executive board and part of the mission and vision of property companies and fund managers,” he adds.
Howard applauds the efforts of GRESB, but questions what the end goal will be. He urges the industry to move from a value-at-risk thinking towards value creation. “That is the prize,” he says.

Mathieu Elshout, senior investment manager at PGGM, says transparency is the key issue and believes once GRESB is the global standard, transparency will improve further and will lead to better performance. “Performance transparency gives clarity about our strategy. For us capturing value while focusing on and mitigating risk is vital,” he says.

Case study: 77 Gracechurch Street, London

Recent research from Climate Change Capital and Jones Lang LaSalle (JLL) shows that sustainable, or ‘green’, real estate generates excess returns compared with less sustainable property. According to their analysis, some 15-20% of the total performance came from ‘green alpha’.

The existence of this so-called green alpha is not the easiest to prove, but this is what Chris Strathon and Lionel Newcombe, directors at JLL’s Sustainable Valuation Advisory team aimed to do by attempting to quantify any added outperformance. They undertook extensive analysis of 77 Gracechurch Street in the City of London, a property owned by the Climate Change Property Fund (CCPF) for the 15 months up to July 2011. They also compared it with two similar but less- sustainable properties in the City.

The JLL sustainable valuation model was developed to analyse the impact on value of sustainability. The model exam- ines the effect of green value drivers on investment risk and return. They analysed the energy performance and investment performance, while looking into the discounted cash flow assumptions of 77 Gracechurch Street.

The Gracechurch Street building was bought by CCPF in March 2010 for £35.9m (€44.1m) with an initial net yield of 6.5% and an expected internal rate of return (IRR) of 15%. In the first half of 2011, an independent valuation put the price at £38.5m with net initial yield of 6% and expected IRR of 11.5%. The fund sold the property in July 2011 for £43.5m with a net initial yield of 5.37% and actual IRR of 21.2%, or 6% above IPD’s capital growth index (City offices), ungeared total return.

During the 15-month holding period the capital expenditure was £70,000 or £1.40/sq.ft. It produced a saving in energy cost of 14% or nearly £1/sq.ft./per year. The cost saving to net present value (the difference between the present value of cash inflows and the present value of cash outflows) over a 10-year hold period would have been £610,000, assuming service charge savings translate into benefits to rental value.

The impact of the active energy management on outperformance represents around 10% of the total hold period performance – that is, 10% of the 21.2% total return.

“Additional facts, such as tenant goodwill, lower letting risk, lower exposure to carbon tax, stronger defensive position at rent review,could impact total outperformance by another 5-10%,” Strathon says. In total, the green alpha represents between 15-20% of total performance, adding an additional £1m to £1.5m to the value of the property.

JLL used a Monte Carlo simulation to identify market risk, including rental growth and exit yield volatility. Future volatility was forecast from 20-year historic times series data with worst-case and best-case assumptions.

It also used market forecasts from March 2010 and July 2011 to demonstrate changes in market conditions and sentiment. In March 2010 it was deemed ‘very unlikely’ (11% probability) that the building would achieve a sale price of £43.5m, given the conditions at the time. The same sale price was deemed ‘reasonably unlikely’ (43% probability) in July 2011. It was ‘more likely’ (78% probability) that the sale price of the independent valuation of £38.5m would have been achieved. As a result, although the London City property market improved during the holding period as a whole, outperformance was achieved.

The Gracechurch Street property was refurbished in 2007-08 to a good quality grade-A specification, with an energy perfor- mance certificate (EPC) of B – the average ECB for a refurbished building is D.

Once acquired, CCPF worked to install measurable ‘green’ equipment, such as full sub-metering and a live energy/carbon screen giving half-hourly data floor by floor. “This way it is possible to track spikes and anomalies and work towards improving over- all energy consumption,” says Tim Mockett, joint managing director at CCPF.

Electricity and water automated meter readings (AMRs) were installed, again pro- viding half-hourly data. In addition, enhance- ments to the heating and air conditioning were also made. The occupiers and landlord co-operated in the active sustainability management and had quarterly sustainability meetings, something that is crucial for a successful project, says Mockett.

“We reduced carbon use by 15% per year during our ownership of the property, which is a good effort considering that the government is finding it hard to stick to its pledge of 10% annual carbon emissions,” he says.

Mockett and Strathon are convinced that the investment performance of CCPF is replicable elsewhere. “The fundamentals have to be solid with a sustainable overlay,” Mockett says. “We believe we can achieve an additional 5-10% of the performance from green alpha. It is not a matter of paying more for green property. But once the economy recovers, downside risk protection, compared to less sustainable real estate, will again be key.”

The UK property industry is now trying to monitor property performance through the IPD Sustainable Property Indicator (ISPI). The indicator is being re-invigorated after a mass collation of relevant sustainability data compiled by valuers through the IPD RICS EcoPass. The index aims to monitor the relationship between environmental performance and financial returns as the market develops.

The CCPF is ranked joint third among European property funds and is given the top ‘green star’, alongside industry giants such as Lend Lease, Hermes and Prupim. It was also ranked second out of a global ranking of 451 real estate managers by the Global Real Estate Sustainability Benchmark Foundation.