Investing with Values – ESG Real Estate: What Investors Need to Know
Incorporating our values into investment criteria alongside balancing risk and return via Environmental, Social, and Governance (ESG) is not a new concept. Investors have used this criteria for years to evaluate publicly traded securities, and decide whether they want to invest in companies that align with their values. ESG real estate, however, is just entering the spotlight. For any investors who may be skeptical, note that ESG does not mean accepting lower returns. It has been regarded as a powerful investing strategy for public securities with real correlation to returns at and above market, and this philosophy can apply to CRE investments, as well.
In this article, we’ll explore what ESG real estate means for us at EquityMultiple, and how self-directed real estate investors can add sustainable projects to their own portfolios.
ESG Real Estate: How Investors Can “Do Well by Doing Good”
The three pillars of ESG real estate are environmental impact, social impact, and quality of corporate governance. See below for a brief description of each, along with key questions that can guide sound investment decisions:
Self-directed investors operating in today’s alternative asset ecosystem may want to consider environmental factors, such as a property’s energy management, water management, tenant sustainability impacts, and climate change adaptation.
- Energy management: What is the total energy consumption? Does the property use electricity, or renewable energy sources? Is the building LEED-certified?
- Water management: What is the total water withdrawn? Is the property located in a drought-prone area? If so, what steps has the operator taken to reduce their impact on the watershed?
- Tenant sustainability impacts: How do operators incentivize tenants to improve energy efficiency? Are tenants separately metered for electricity consumption and water withdrawals?
- Climate change adaptation: What is the building’s total carbon footprint? Is the property located in a potential flood, fire, or earthquake zone? If so, does the operator have plans to mitigate these risks?
As an added bonus, this level of environmental awareness can effectuate stronger returns and mitigate risks. When sponsors make ESG part of their business plan, the property will likely be more resilient in the long-term, and more competitive in a market where tenants value sustainability.
Conscious investors should consider the social impact of the property itself. Is the building designed to support tenants’ health and well-being? How does it contribute to the surrounding community?
At EquityMultiple, we believe social impact means creating housing stock that is inclusive. We often work with sponsors who provide quality, affordable dwellings that are accessible to transit, as well as other amenities and resources. By doing so, we aim to increase the housing stock in areas that are supply-constrained without displacing residents.
As a business strategy, ESG can mean taking advantage of tax incentives (local or federal) to create compelling bottom-line returns. Alternatively, sponsors may opt for adaptive reuse of obsolete or under-water assets. Example projects include converting a mall that would otherwise have been abandoned; and upgrading aging Class B or Class C apartments to be safer and higher quality for working families.
The governance aspect of ESG real estate is often overlooked. However, it is just as crucial as its “E” and “S” counterparts. Investors might care about the company’s plans to address broadspread diversity and inclusion issues. Or, they might point to how well the company treats its employees in general:
- Do employees receive reasonable compensation?
- Do employees receive competitive benefits, including opportunities for personal and professional development?
If available, you may want to review the sponsor’s leadership principles, and any disclosures they provide to key stakeholders. Investors should feel confident that the leadership team will make decisions that are in line with investors’ best interests. For example, investors might opt to work with companies that demonstrate a commitment to diversity in their board of directors, and provide oversight into top executives’ compensation.
When we consider potential sponsor partners, we typically look for steady leadership, happy employees, a good reputation in the market, and decent reviews from tenants. These things all portend a good working relationship and give us confidence the sponsor will work collaboratively to deliver strong returns for our investors.
ESG Does Not Mean Low Return
Some sponsors might think it is too expensive to make older buildings more energy efficient. However, these updates often decrease operating costs, and increase their property’s marketability, as well as its overall value.
- Rental Revenue & Tenant Satisfaction: According to the U.S. Green Building Council, many buildings that employ LEED have higher occupancy rates, lower tenant turnover, and can lease for more dollars per square foot than non LEED-certified buildings.
- Operating Costs: Green buildings often cost less to operate than traditional properties. In fact, recent survey respondents estimated that green building retrofits would decrease operation costs by 9% in just one year, and 13% in five years. This is largely due to savings from lower energy and water bills.
- Asset Valuation: Reducing the property’s operating costs increases its net operating income (NOI), which creates additional value. As a result, green properties may sell at a premium compared to “brown” properties.
Of course, social and governance can also be part of a strong risk-adjusted returns strategy. The shortfall of quality middle-income housing in many markets, and the relative under-development of non-luxury residential in recent years, means that there are many “S” opportunities across a variety of creative strategies. In addition, quality corporate governance can mitigate risk by enhancing employee productivity, and reducing the chance of unforeseen legal liability.
ESG Real Estate In Action
At EquityMultiple, we believe that ESG real estate can be a winning investment strategy, not an acceptance of lower returns. We are proud to offer select investments that provide attractive returns, while also contributing positive social impact. In particular, a number of offerings on our platform check the “S” box by helping to generate quality, amenity-rich housing that is affordable for middle-class communities.
For example, EquityMultiple investors recently participated in the conversion of an underperforming hotel to an apartment complex in Phoenix, Arizona. Given the project’s low cost basis, many of the units will be affordable upon completion. This makes a difference in a market like Phoenix, where as of 2018, 46.9% of renters qualified as “cost-burdened”—when housing costs eat up more than 30% of household income.
Note that Phoenix is actually on the low-end of the spectrum when you consider median rent as a percentage of median renter income. In Miami, for instance, a middle-class renter would need to spend 39.3% of their income to afford the area’s median rent. After Miami, the median renter is most burdened in Southern California, Boston, and New York (see below).
This goes to show there are plenty of opportunities in various markets to execute on ESG strategies that may offer attractive risk-adjusted returns.
The Bottom Line
As a passive real estate investor, it may be difficult to identify potential ESG real estate opportunities. Investments on EquityMultiple’s platform will not always qualify based on the above criteria. That said, we are looking to add more ESG real estate offerings in the future.
We recognize that many of EquityMultiple’s offerings are located in supply-constrained markets, with a high percentage of cost-burdened households. As such, building new units and upgrading existing inventory can help counteract the affordable housing crisis—particularly for middle-class renters. We believe it’s possible to do so, without forgoing investor returns. Our team works with sponsors throughout the lifecycle of an investment, ensuring timely reporting and the best outcomes for all parties involved.
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