The real deal

The battle against climate change in real estate construction is an economic opportunity as well as a necessity, writes Jakes Ferguson. Investment opportunities in the sector will bear fruit for shrewd investors

The real estate sector offers the biggest potential for reducing energy consumption and preventing greenhouse gas emissions, and therefore the sector can play a key role in combating climate change.

Combine this with the remarkable performance from real estate since the market lows in March last year (from March 9-24, November 2009 global listed real estate, as measured by the Standard & Poor’s BMI Property Index, is up 70 per cent in sterling terms, about 35 per cent ahead of the S&P Top 500 US stock Index). Many investors are questioning whether they should now be looking at the sector once again, but this time they will introduce an overlay that seeks out a new sustainable dimension to the underlying assets.

Some investors may have been hurt by exposure to real estate over the past two years, but the sell-off was as much related to the distress in financial markets and then the knock-on effects on the broader economy, than any underlying problems in the real estate sector, where occupancy levels have remained high and defaults relatively low.

Winning ways
Over the long-term, real estate has been a winning asset class (over ten years to end-September 2009, listed global real estate is 147 per cent ahead of the S&P, and over 20 years, it is 102 per cent ahead of the MSCI World index).

So, given that the real estate sector is producing a healthy yield spread to other asset classes, and that capital values have been written down 30-40 per cent, is the real estate crisis now over?

Investors’ growing risk appetite and the cyclical recovery are the main reasons favouring another advance in real estate equities. Furthermore, there are clear signs that real estate prices are stabilising, while falling credit spreads are improving real estate companies’ access to finance for transactions.

Cycle ways
Aside from cyclical factors, modern portfolio theory supports investment in real estate, indirect real estate funds and real estate investment trusts (REITs) as an ideal way for the smaller institutional investor to gain efficient diversification within a portfolio. This is supported by the relatively low correlations between real estate and broader equities. By including real estate in a portfolio, risk can be reduced by virtue of the portfolio being spread more evenly across several asset classes, optimising a portfolio’s risk/return profile. Listed real estate funds and REITs bring liquidity and transparency, and it is hard to imagine an optimal portfolio without real estate assets being included, bearing in mind their correlation properties.

Accepting the fact that real estate is chosen by many charities, life assurance companies and pension funds as an ideal vehicle for long-term investing, what is the rationale for charitable foundations to be investing in sustainable real estate and how might they obtain the best exposure?

For more
Addressing sustainability is one of the most pressing challenges worldwide today. Humanity’s footprint outgrew global biocapacity in the 1980s, and at the current rate it takes at least fifteen months for the Earth to produce the resources used in a single calendar year.

Based on a 2006 survey of fund management, a EuroSIF report revealed that European socially responsible investment funds were estimated to be worth up to €1 trillion: as much as 10-15 per cent of total European funds under management, having increased by more than a third since the end of 2002.

The energy required to build, heat and cool our workplaces, schools and homes is by far the biggest single contributor to greenhouse gases. Buildings currently represent 24 per cent of global carbon dioxide emissions (American Institute of Architects, 2008), with an estimated 280 per cent increase in carbon emitted from buildings since the 1950s. According to the OECD’s 2008 International Transport Forum, domestic and international aircraft travel only accounts for 11 per cent of total carbon emissions.

Buildings are not only the largest single source of carbon emissions; they are also the biggest energy users, representing 40 per cent of global energy consumption: 33 per cent is attributable to commercial properties and 67 per cent to residential (World Business Council for Sustainable Development, 2007). Thus real estate is a significant culprit, and doing nothing is not an option.

The rewards for constructing sustainable buildings are many: 86 per cent of respondents in a 2008 survey by architects Woods Bagot believe that green buildings improve corporate reputation, reduce operational costs and risk, and improve staff productivity. There is also an increase in awareness of indoor environmental quality in the light of growing research linking the indoor environment with the productivity of staff (Clements-Croome, 2003). The survey also highlights energy generation and efficiency, and focuses on reduction in water usage and carbon footprint to be important.

Complex matters
The business case for sustainability has often been argued purely in financial terms: that in an environment of high energy costs or energy taxes, the long-term operational cost savings from green buildings outweighs the cost of their construction. However, research shows that there is a much more complex matrix of drivers. Financial drivers, such as reduced operating costs, make up only a small percentage of the key reasons to go green. Companies are equally focused on the need to promote ecological and corporate social responsibility, and so 73 per cent of respondents believe that green buildings are useful tools for attracting and retaining key talent.

All these factors have a positive impact on the value of sustainable properties more than conventional buildings. A further issue for investors in the recent downturn has been liquidity as some investors have been trapped in investment vehicles that did not offer the ability to redeem that they expected.

The issue of how to wrap these three perhaps mutually exclusive aims of liquidity of investment into a physical asset like real estate in a sustainable manner is being tackled by a small but growing number of investment managers. In Germany, HypoVereinsbank’s subsidiary III-Investments has launched a real estate “spezialfond” to invest exclusively in green real estate assets. The Green Building Fund aims to invest €400 million over the next two to three years in sustainable and energy-efficient real estate developments. Credit Suisse has also launched a Swiss green real estate fund. In the UK, there have also been market-leading initiatives. Sarasin has launched the first fund investing in the market leaders among the world’s top real estate companies and REITs screened for sustainability; and Climate Change Capital has launched a fund to invest in sustainable property.

Two ways
A two-tier market will emerge with energy efficient sustainable buildings likely to outperform, with the risk of non-compliant buildings being downgraded in value. Investors are becoming increasingly interested in the potential economic benefits of investing in sustainable buildings. Low energy costs also mean that green buildings are preferred by tenants and achieve above-average rental rates.

All of this is underpinned by growing political pressure to promote a stronger focus on sustainability in construction and building design, and an increasing number of global initiatives introducing minimum standards of certification for the energy efficiency of buildings: a clear indication that real estate developers and owners are expected to make an active contribution to reducing greenhouse gases.

Investors have an important role to play in combining sound real estate investment rationale alongside the undeniable benefits that responsible real estate investment will bring to the planet.

References:
American Institute of Architects (2008). Architects and climate change:
www.aia.org/searchresults/index.htm?Ntt=climate+change&Nty=1&Ntx=modepercent2Bmatchallpartial&Ntk=Main_Search

Clements-Croome, D. (2003). Environmental quality and the productive workplace:
www.extra.rdg.ac.uk/ib

OECD: Transport and energy: The challenges of climate change: www.internationaltransportforum.org.Topics/pdf/ResearchFindings2008.pdf

World Business Council for Sustainable Development. (2007). Energy efficiency in buildings: Summary report: www.wbcsd.org/DocRoot/kPUZwapTJKNBF9UJaG7DEEB

Jakes Ferguson is a partner at Sarasin & Partners and is fund manager of Sarasin Sustainable Equity Real Estate Global Fund.

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