Sustainability: Quantifying ‘green alpha’

It is now possible for investors to quantify ‘green’ alpha, which is created predominantly through active energy management, write Tim Mockett and Chris Strathon

Green alpha is a relatively new concept but is quickly becoming a critical metric for investors in sustainable property. Green alpha quantifies what proportion of total ungeared differential returns from an individual asset investment can be attributed to sustainability and energy efficiency initiatives.

While sustainability specialists have been talking about this concept for some time, to date attempts to quantify it have been limited to anecdotes and estimates. A robust, quantitative, replicable methodology has proved elusive. Investors want to know what percentage of a total return has been derived from enhanced sustainability, and how to estimate it in future returns in a predictive modelling tool.  

Our experience with core-plus assets we have assessed has shown that about 10-15% of the total ungeared differential return is attributable to green alpha. This percentage is likely to be greater for value-add strategies where there is a greater level of capital expenditure involved in retrofitting older buildings to meet exacting sustainability standards.

It is hard to identify when the idea of sustainable property started to take hold in the European property market. The publication of the Stern Review of the Economics of Climate Change in October 2006 was certainly an important trigger in raising investor awareness of the possible impacts of climate change on property portfolios. Since then, the growing scientific evidence of man-made climate change has further highlighted the investment risks across many asset classes, while investors have also come to realise that there are compelling opportunities to invest in solutions such as greener buildings. 

Property has traditionally been considered a high-carbon asset class. It is therefore inevitable that the ever tightening ratchet of global environmental policy and the subsequent implementation of stricter policies will impact the sector increasingly in the future. The UK government is leading the way with some of the strictest property environmental regulations in the world. Energy performance certificates (EPCs) were introduced in the EU in 2007 and are now mandatory for all new commercial buildings. In 2008, the UK went a step further with the requirement for all public sector buildings to display energy certificates (DECs) to demonstrate real operational data.

Additional proof of the UK government’s commitment was the adoption of the Energy Efficiency Regulations 2015, which will require all non-domestic rental properties to have a minimum EPC of ‘E’ by April 2018. It is estimated that a fifth of all EPC-rated buildings in the UK might not meet the standard and risk becoming unlettable in 2018. This legislation poses a considerable threat to the value of many commercial property portfolios. 

Most new buildings are now constructed to high sustainability specifications. However, there is considerable scope to create value for investors through adapting existing buildings from ‘brown’ to ‘green’. Reducing carbon and energy costs through comprehensive retrofits and engaging in environmental improvement discussions with tenants is clearly of value but can be costly and time-consuming.  

Investment theory suggests that sustainable buildings should command a rental premium from high-quality tenants, experience shorter vacant periods, slower depreciation and reduced obsolescence, and ultimately secure higher capital values. 

“There is considerable scope to create value for investors through adapting existing buildings from ‘brown’ to ‘green’”

Since 2007, a number of academic studies¹ have been published seeking to investigate the economic value of sustainability. These have typically been conducted at the multiple-property level, using eco labels such as BREEAM (Building Research Establishment Environmental Assessment Methodology), LEED (Leadership in Energy and Environmental Design), Energy Star and EPC as a proxy for sustainability – and as a predictor of improved environmental and energy performance. This research can only be as good as the methodology employed by these eco-rating labels. To date, comprehensively benchmarked data of institutional quality has been in short supply in the UK commercial property market.

In 2015, Cambridge University² published an empirical study seeking to prove the link between sustainability improvements and the financial performance of global REITs. This considered both the operational performance, including return on assets (ROA) and return on equity (ROE), together with stock market performance represented by the annualised stock market return. This research attempted to link the financial performance of REITs against their GRESB (Global Real Estate Sustainability Benchmark) ratings (which provides a measurement of the environmental policies and carbon emissions of a portfolio). This work was a useful development in measuring sustainability returns. However, again, these results were only applicable at portfolio level using a generalised sustainability benchmark that does not link environmental performance with value.

A new and more detailed approach and methodology is required to generate a robust quantification of green alpha at individual asset level using actual benchmarked financial data. To achieve this, two principal data sets are needed:

• The detailed measurement and data for energy and resource use of a building;
• The property investment market returns from the asset over the hold period.

Step 1: Energy performance analysis 

Advances in technology and software can now facilitate detailed environmental performance measurement. Investors today can have immediate online access to a full suite of verifiable energy and property market data. Data collection can begin when an asset is acquired and continue until exit, offering the opportunity to identify and isolate where capital expenditure on sustainability re-fits has led to tangible operational savings.

Active energy management means that buildings are equipped or retrofitted with sub-metering and half-hourly data loggers. The property is subject to continuous monitoring and subsequent EPC and DEC and relevant benchmarking and re-rating, corroborating any energy efficiency improvements and associated carbon reductions.

Cost savings and sustainability key performance indicators (KPIs) over the holding period of the investment can then be benchmarked against the market. Furthermore, Department of Energy and Climate Change (DECC) energy-pricing forecasts can then be used to estimate potential future savings for the building for five years after its sale, to reflect the short-term future benefit to landlord and tenant.

Input data:

• Capex in energy efficiency measures;
• Calculation of energy savings;
• Benchmarking sustainability KPIs over hold period;
• Property performance analysis against comparable transactions;
• IPD benchmarking and JLL forecast comparison.

Step 2: Investment performance analysis 

To isolate the impact of the sustainability-led capital expenditure on income, capital or total returns it is necessary to account for the impact of macro and micro-economic cycles. With respect to the achievable price on any given asset, there is also the need to check for special purchasers (who may be inclined to pay a premium for a specific reason), competitive bidding and other market factors. 

Using databases of local rental and capital growth and yield movements over a 20 to 30-year period, as used here by JLL, it is possible to account for the impacts of potential variability within the market up until the asset disposal. Using a discounted cash flow (DCF) valuation model, together with rent and yield forecasts at the date of acquisition for the local market, it is possible to use Monte Carlo simulation to identify the most likely or median exit value for the asset at any given date.

This analysis can then be adjusted for the many other possible factors that could impact returns; the greatest of which is usually inflation. To address this, both the nominal delivered returns from the asset are adjusted for consumer price inflation (CPI) as are the results of the IPD index over the hold period. This isolates the ‘real’ performance differential of the asset against the market otherwise known as ‘alpha’.

There are, of course, many factors that contribute to the total overall observable alpha of any given asset. These include the perceived impacts from reduced letting risk, tenant goodwill, lower exposure to carbon tax and enhanced yields from a stronger defensive position at rent review and all need to be accounted for. 

DCF model involves:

• Statistical analysis of 30 years of yield and rental growth data;
• Comparing probability distribution curves against JLL forecasts;
• Controlling for inflation and IPD market movement using real value;
• Isolation of outperformance over and above the market that highlight alpha.

Step 3: Attributing green alpha

Green alpha can finally be estimated using future tangible cost savings accruing from the point of exit for a five-year period, using a net present value (NPV) calculation. This NPV figure is then expressed as a proportion of the total alpha described above. 

Green alpha total return attribution:

• NPV of energy savings as % of total alpha;
• Isolation of outperformance from Monte Carlo analysis;
• External valuation opinion regarding overall green alpha.

Putting it into practice

The following case history demonstrates current best practice in how to future proof a building in order to maximise sustainability performance and returns, and optimise green alpha generation.

An extensive sustainability audit of the building at 5 St Philip’s Place, Birmingham was carried out when it was acquired in 2009. The new landlord and tenant collaborated under a ‘green lease’ arrangement to share data and manage the building to top quartile as measured by DEC environmental standards. 

At acquisition, the building had a DEC of G, but within three years was re-rated to a C following an extensive retrofit of the building out of hours with the tenant remaining in full occupation. The retrofit included full re-metering of the building with the installation of half-hourly data loggers and an upgrade of all the heating, lighting and cooling controls. The number of boilers was reduced with more efficient models and the building was entirely re-lit using LED lighting. A total of £700,000 was invested in the property by landlord and tenant. The carbon emissions (and energy costs) were reduced by 63% over the investment hold period. Full payback on the investment, through reduced energy bills, was achieved in less than five years.  

The application of this ground-breaking methodology leads to the quantification of green alpha at individual asset level. The hypothesis that sustainable buildings are better investments than buildings with poor energy efficiency can now be quantified and proven. Investors now have their Holy Grail.

This work highlights how green alpha is created predominantly through active energy management. The remainder of the excess returns are generated by other positive externalities which are more likely to occur with more sustainable properties. These attributes may, for example, mean that greener buildings are more attractive from a corporate and social responsibility (CSR) perspective. In theory, these buildings will attract and retain stronger covenants and ultimately stave off rental depreciation and rental obsolescence. 

Proving to what extent these additional factors have contributed to the excess or overall alpha remains a work in progress as the data set of greener buildings increases. However, for now, energy cost reductions are real and quantifiable and can be expressed as a percentage of the ungeared net differential total return.  

Investors can apply this method of isolating green alpha from market beta performance to any assets and use it as a predictive tool to assess the probable monetary value of investment returns before commencing a retrofit or investing in a sustainable property.

Tim Mockett is managing director, property at Impax Asset Management, and Chris Strathonπ is a partner, valuation advisory at JLL

References:

^{1 Eichholtz, Kok, Quigley (2010) Doing Well by Doing Good? Green Office Buildings.}

^{Eicholtz, Chegut, Kok (2012) Supply, Demand, and the Value of Green Buildings}

^{2 Fuerst.F. (2015) The Financial rewards of Sustainability. A global performance study of real estate investment trusts.}