Why is everybody talking about ESG?

ESG is an acronym for three of the central factors that are considered when measuring the sustainability and social impact of an investment – Environmental (E), Social (S), and Governance (G). While the term ESG can be used in various contexts, it is often used as a framework for assessing the varying impacts of different investments on each of the three factors.

The concept of sustainable investing is not new. Over the last few decades, there are numerous cases of investors and capital allocators giving consideration to ESG factors, but largely under different names and acronyms: socially responsible investing (“SRI”), morality-based investing (e.g., religious investing), social-focused investment (e.g., microfinance and community-based investment), environmentally conscientious investing, etc. However, the adoption of these criteria was not widespread, making these considerations largely a niche type of investment management.

Unlike past efforts, the market’s current focus on adopting and implementing ESG considerations and standards is broad-based and momentous. The current push towards ESG is unlike anything seen before. Rather than a minority of the investors and capital sources calling for it, the market participants are coming to a consensus that points to ESG having a material and lasting impact on capital markets and nearly all asset classes going forward.

What is the current state of ESG within CRE?

Market participants and regulators are accepting ESG as a next stage in the capital market’s evolution and are beginning to move towards implementation. However, before implementation, the scope has to be discussed, frameworks clarified, and measurable attributes identified so that impact can be tracked and managed.

The wide scope of ESG will affect all asset classes, but the speed of ESG-related changes will vary by asset class and factor – and this is especially true for commercial property. Before any tangible changes come about within the commercial real estate industry, there needs to be an understanding of how the ESG factors are defined, measured, and managed for commercial property.

For commercial real estate, the Environmental factor is arguably the most straightforward to consider. Many of the physical aspects of commercial property can be considered from an Environmental perspective – from site selection / location to construction (e.g., materials, process) to land use to building energy efficiency. In many ways, environmental consideration has already been implemented into industry practice (i.e, GRESB), but the current ESG momentum may help to transform many of these optional practices into mandatory practices through regulation.

While there are some existing examples of the Social factor being considered in the commercial real estate industry (e.g., workforce or affordable housing, tax-incentive programs, public-private partnerships), this factor still needs further definition. Commercial property plays a major role in communities big and small, and as such this community impact will likely be what needs to be measured and understood by this factor. At present, this community impact is largely still in the scoping stage; a commercial real estate specific framework, measurable metrics, clear definitions, and implementation plan are still needed.

The Governance factor, while no less important, is likely more narrowly focused than the Environmental or Social factors. The Governance factor is predominantly focused on the commercial real estate corporate culture and composition – focusing on the roles, responsibilities, and oversight within companies. The real estate industry will most likely not differ too much from other industries with how this factor is considered and changes implemented. Consideration of this factor is likely a more significant issue for larger organizations – as greater size tends to draw greater scrutiny.

The degree of influence that the commercial real estate industry will have on any of the emerging ESG metrics (e.g., key performance indicators) will likely vary by factor. The Environmental and Governance metrics that will emerge in the coming years will most likely be directly managed within the commercial real estate industry – by the property owners, developers, property managers, and CRE service provider companies. The Social metrics, however, will most likely be indirectly managed outside of the industry – by the city planners, government, and lenders.

What will be impacted?

The potential impact of the broad markets’ adoption and implementation of ESG principles is huge. Many of the changes will be physical, while others will not be so visible from the outside and will flow through from capital providers and show up in the cost of capital.

At the property level, energy efficiency changes will be a key driver of ESG-related change, especially in the areas of heating, ventilation, and air conditioning (HVAC), lighting, solar, and insulation. According to the International Energy Agency, US buildings account for approximately 31% of US total final energy consumption, only behind the transportation sector (40%). Despite the significant carbon footprint and availability of energy efficiency solutions, there have been few powerful incentives to materially change the industry’s level of building energy efficiency. Since 1990, the buildings’ share of US total final energy consumption has risen by 2 percentage points (200 bps).

Retrofitting outdated and inefficient buildings in the US cannot be done overnight. It will require significant policy action to incentivize the building owners (and disincentivize non-compliance) and will likely create thousands of new jobs – likely a positive for the Social factor metrics. Smart developers will take this into account when they are planning their new projects, so as to not fall behind the building energy efficiency curve before or shortly after project completion.

At the operating level, one can expect to see some moderate variances among the operating line items, but many of these may have countervailing impacts that result in a reduced net impact. For example, building efficiency gains (reduced on-going expenses, after retrofit investment) may be offset by increased insurance, administration, and contracted service expenses related to ESG adherence.

Finally, at the financing level, the market momentum in adopting and applying ESG principles and frameworks will likely result in a minor increase in the cost of capital, due to the increased regulatory and compliance burden that capital sources (i.e., banks, insurers) will take on. Depending on the ESG-related reporting requirements, both monetary and time costs may increase. For example, lenders may require additional ESG-related reports prior to closing a mortgage or making a loan.

However, on the bright side and likely more than offsetting the aggregate increased costs associated with the added regulatory burden, new or expanded capital sources stemming from government programs would likely emerge. These programs would likely build off of existing financing programs that are already addressing the different ESG factors (i.e, CPACE, LIHTC, increased SEC disclosures). While the applicability and availability of the financing made possible by these future programs will vary from one property situation to the next, the overall CRE market impact will likely be that there’s no material increase in the cost of capital for CRE and may serve to decrease the cost of capital for many projects and properties.

What’s next for ESG in CRE?

CRE is still in the early innings of ESG adoption and implementation. The industry participants, regulators, and stakeholders are largely still figuring out how to best incorporate ESG principles into industry practices. While the direction appears clear in terms of moving towards baking ESG considerations into all stages of CRE business and the potential impact is big, the speed of adoption and change remains uncertain. That said, the CRE industry is well-prepared to accommodate the change ahead.