A more pragmatic approach is required if the industry is to make serious progress on sustainability issues, as Shayla Walmsley reports

Building standards aren't, well, standard. LEED (Leadership in Energy and Environmental Design) and the Building Research Establishment Environmental Assessment Method (BREEAM), which measures new buildings, have different environmental ‘grades', but do tenants care which level the building is at - and should investors?

Super-sustainable buildings won't necessarily attract super-prime rents. In fact, there is some debate about whether they will attract any premium at all. Piet Eichholtz, professor of real estate finance at Maastricht University, points to research showing that sustainable buildings can command higher rents than non-sustainable buildings. One study of US office, for example, found rental cashflows for energy-efficient assets were 6% higher.

But for many investors it isn't the premium on sustainable buildings that's the issue but the penalty for non-sustainable buildings."The choice is between green and brown buildings," says Paul McNamara, director and head of research at PRUPIM. "The price might not be higher for green, but it will be lower for brown."

For McNamara, the prospect is of a two-tier market between future-proofed and non-future-proofed assets. But the idea that there should be a penalty for non-sustainable buildings assumes that tenants particularly care whether they are occupying an energy-efficient building. Some, undoubtedly, do. Just as big investors don't want to be seen holding poorly performing buildings, FTSE 100 companies can't be seen to be taking environmental issues lightly. "They want sustainability throughout the portfolio, including secondary buildings," says Michael Pillow, director of the building consultancy at Savills, which offers sustainable refurbishment at four levels.

But that is not necessarily true for all tenants. Tatiana Bosteels, head of responsible property investment at Hermes Real Estate, acknowledges that downstream demand is still muted. "It might be that you don't have occupiers asking for green buildings but they want performance," she says. "What we might end up doing is not stressing the green element but stressing how well designed and efficient the building is."

According to Jean-Francois Le Teno, global head of operational architecture and sustainable development at AXA REIM, investors and landlords need to convince tenants by engaging in dialogue with them about how to reduce their charges. "If you build up that relationship, they'll stay and pay. From an investor perspective, it's about securing cashflow. It combines benefits to landlord and tenant, and it will lead to improvements in vacancy rates," he says.

In short, there need to be better incentives for tenants than ‘do-gooding'. Bill Hughes, managing director of property at Legal & General and chair of the Green Building Alliance, gives the example of offering occupiers in multi-tenanted shopping centres the cost-saving opportunity to share waste disposal.

It's not sexy, it's not earth-saving, but it will save money. Eichholtz points out that the popular image of sustainability is based on past narratives - of the Earth's core cooling and solar energy. "To some extent, you can make money with it [solar]," he says. "Putting windmills on the roof is bad business. Putting more efficient energy systems in buildings, with better light and energy-saving technology, is good business. Investors should be looking at the less sexy stuff - improving energy performance and saving money in the making of energy are where the values are currently positive."

For Eichholtz, there has been too much how and when, and not enough of what. Doing business, he says, quoting Warren Buffett, is all about picking the low-hanging fruit. "Companies are in business to make money for their shareholders and there's a lot of money to be made," he says. "Investors don't need subsidies. They don't need regulations. They just need to go for it."

The point is, after all, to turn a profit. Hughes says he is looking at existing assets, focusing on assets with improvement potential. "It's a natural expansion into increasing value. It will pay off over time," he says. "It's the direction the technology is moving in, and the direction of the incentive regime - you have to pay more attention." Energy savings of between 20-40% are not uncommon within L&G's portfolio.

He adds: "Given the capital expenditure with or without a penalty, it makes sense or it doesn't. If we can turn it around, it makes sense. If it doesn't provide a sensible payback, we won't buy it. And some assets are borderline obsolescent in any case - for example, where the flood risk is unmanageable."

Aled Jones, ESG investment manager at the £3.84bn (€4.34bn) London Pension Funds Authority (LPFA), likewise describes retrofitting as "the most cost-effective thing to do" - and he reckons it is a trend on the increase. "After that, you have to reach for the higher stuff but it's a good place to start," he says.

The LPFA's board's commitment comes from the belief that, over the long term, an environmental focus within the investment strategy would reduce risks and better enable it to pay pensions - effectively, out of fiduciary duty.

LPFA has 6% allocated to pure environmental assets and social investments. "We're not doing it because it's a good thing to do. We're doing it because we believe long-term returns are to be had from it. We're not sentimental about investment. We need an assessment of both risk and return. It's all about meeting liabilities in the long term," says Jones.

Two trends are converging that will make the payback issue critical. The first is the mainstreaming of sustainability, as evidenced by the focus away from new buildings towards retrofitting existing ones. "Everyone - and that includes occupiers - is concerned about energy. Companies want to be seen to be responsible occupiers. The driver is a corporate effort to lower emissions," says Pillow.

The second is the proliferation of standards. There are simply too many benchmarks. As a result, there is a trend for companies to bypass them all and set their own. Barclays did so, for example, when it set a target of 6% reduction in emissions by the end of 2011.
As the industry matures, it will become high time for some attrition. Just as investors can ignore the all singing, all dancing, rooftop windmill-style retrofitting to focus on the kind that will pay pensions, they can just as well ignore earth-saving initiatives to focus on energy saving - at least in the short term.

"There is a thick alphabet soup of initiatives - but you don't have to drink it," says Le Teno. "Some are not appropriate and could become obsolete. You could have a certificate one year that will be obsolete five years later. What counts is if the energy performance can be measured at the end of any scheme. Commonsense is the international currency. Directives with a focus on energy measurement and reduction drive most regulations in most European countries. That will be reflected in any certification scheme you have on top."

The confusion comes from what people think standards mean compared with what they actually mean, he says. Certification is simply the first line of control in obsolescence-risk mitigation. "HQE, LEED, BREAM - you can name it what you want, as long as the measurement, engagement and actions are in place."

Another problem is that the benchmarks are underpinned with relatively meagre data. The paucity of data is a problem - and a big one, according to McNamara (see Keep switched on by switching off, IPRE March/April 2011). He is not alone in having been critical of IPD for its "shallow interpretation" of data gathered from 1,200 properties from 100 portfolios worth just over £23bn (€26bn).

"Performance can be driven by a number of things - lease lengths, differences between prime and secondary... You couldn't hang a dog for chasing chickens on these data," he says. "The data are beginning to come through but they're taking their time. You need a lot of data to nail this down."

What makes the job of compiling the data more difficult is the fact that few metrics providers are applying the same criteria. "The question is how you create an environmental performance benchmark. The investment community is baffled but they're also asking for a colossal amount of data on properties. It's hard to compare Prupim or Aviva or Land Securities because you have partial data on all," says McNamara.

Hughes likewise has an issue with IPD data because the index has been compiled from the small sample size, although a review is underway of what the industry needs to do to create whole-portfolio strategies. Is the index important? If investors believe sustainability has an impact on investment performance, yes. Without it, there is no strong evidence that might encourage those who are not convinced to reconsider.

In the meantime, the data issue hasn't gone unnoticed in the rest of the industry - although the solution seems to have been to increase, rather than consolidate, the benchmarks. The SIRE platform developed by Juerg Bernet, managing director of the EURO Institute of Real Estate Management in Switzerland, is designed to aggregate reliable data on financial performance of sustainable office and retail properties in Europe. It already has 40 European investors contributing data.

Bernet describes his mission as to advance "credible knowledge" on sustainable investment, creating a reporting framework with 30 indicators based on the Global Reporting Initiative (GRI) and the Construction and Real Estate Sector Supplement (CRESS). Among the pension fund and pension fund management participants are Hermes Real Estate and the €12bn SPF Beheer, which manages the Dutch railway scheme. Bauke Robijn, senior asset manager for real estate at the Dutch scheme, said at the launch last November that it was a move towards the recognition that "substantial sustainability investments in real estate can only be achieved when risk-adjusted returns of sustainable real estate are superior to those of standard real estate".

In the meantime, according to McNamara, the problem is that metrics providers want to "ask 50 questions on 150 properties" - a task so cumbersome and time-consuming that it will not gain traction. "We're having early conversations in an attempt to look at the investment community moving forward with a relative set of data. It is a tactical approach to get more traction. There is a hiatus now with overly demanding data providers when what we need is reasonable coverage," he says.

On the other hand, you have providers with fewer questions but without the front-door access to organisations that IPD has.

The alternative is for powerful capital owners, such as the large Dutch pension fund managers - APG, PGGM - to use their muscle to extract data collectively. Such a move is not that far away. Back in March, 11 pension scheme managers launched a global real estate sustainability benchmark (GRESB) designed to benchmark fund managers with $1.4trn (€1trn) in assets under management. It comes on the back of a project launched in 2009 by APG, PGGM, the £32bn (€36.6bn) Universities Superannuation Scheme (USS) and ATP Real Estate to create more transparency by measuring the energy efficiency of its real estate holdings. It also has the backing of Hermes Real Estate, the CA$96.4bn (€73bn) Ontario Teachers' Pension Plan, and the Australian local government superannuation fund.

"Within the community, there is support for an index but they don't know what to do for the best. You have to ask yourself how much of the data collected is relevant to the investment community," says McNamara.

"Sustainability used to be seen as something worthy done by campaigners. When the issue started to burgeon, it was something architects did with new buildings. But now the issues are catching up with them. If you could bring six parties together to hammer out a set of questions, you'll get the nub of an environmental benchmarking service - maybe. Then you can go to find organisations in the industry with the data."

McNamara believes that as sustainability becomes mainstream, the most appropriate benchmarks will out in a standardisation process common to all maturing industries. "It has parallels with the early days of benchmarking performance. At that time IPD had a rival, but it was like a battle between VHS and Betamax," he says.