Can (Jon) Tavsanoglu, Founder & Chief Investment Officer at Caldera Real Estate Ventures, an external CIO & Asset Management Platform.
With the built environment currently accounting for 40% of global greenhouse gas emissions, the real estate sector stands at a pivotal crossroads—where proactive ESG adoption could define the trajectory of its growth, resilience and contribution to a more sustainable world.
Let’s start by breaking down the definition of ESG:
• Environmental: This element reflects owners’ efforts to improve property resilience, sustainability and recovery through efficiency, waste reduction, retrofits and decarbonization.
• Social: This refers to properties’ impact on communities and well-being of their occupants—emphasizing health, safety, engagement, diversity and quality of life.
• Governance: This is key to sustaining stakeholder relationships through policies, practices and structures that ensure accountability, transparency and ethical behavior.
Current Trends
There is currently an ESG emphasis in CRE capital markets. Capital for impact funds surged from $2.6 billion in 2019 to nearly $34 billion in 2022, with North America representing 53% of fundraising, while ESG-mandated assets are expected to make up half of all professionally managed assets globally by 2024.
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Regarding investment returns, sustainable funds’ 2023 median returns of 12.6% are nearly 50% higher than traditional funds.
And regarding the CRE industry, 70 of the 100 largest REITs by equity market cap have set environmental sustainability goals, and over 80% reported owning certified green buildings.
Additionally, tenant requirements and legislation are promoting positive trends. Tenant demand to meet net-zero commitments is expected to require 310 million square feet of net-zero carbon (NZC) space, yet only 23 million square feet is currently available. Meanwhile, the Inflation Reduction Act (IRA) directs around $400 billion to sustainable practices.
ESG As A Profitable Value-Add Strategy
Implementing ESG strategies in real estate can lead to numerous financial benefits, such as:
1. Cheaper Financing
Fannie Mae Green Financing plays a vital role in reducing the financial burden of building sustainability strategies. The IRA’s Section 60101 further boosts capital for such practices, allocating $20 billion to the newly established green bank. In the private sector, the Net-Zero Banking Alliance has mobilized leading institutions to target net-zero emissions by 2030.
2. Incentives And Incentive Monetization
The passage of the IRA also promoted sustainable practices through tax credits like ITC (Investment Tax Credit), now capped at 70% of costs (up from 26%), PTC (Production Tax Credit), offering up to $30 per MWh of clean energy generated, while 179D ceiling (Commercial Building Energy-Efficiency Deduction) has increased from $1.88 per square foot to $5 per square foot.
3. Operating Expense Reduction
Deep retrofits for existing buildings can reduce energy use by up to 79%, improving financials through direct cost savings in utilities. Another important opex category is insurance, which surged 32% in 2023 alone, due in part to an increase in $1-billion-plus natural disasters.
To support property risk-mitigation practices, public and private incentives currently offer discounts on insurance premiums. Coupled with other financial incentives for building upgrades and disaster liability savings, each dollar invested in such practices yields an average of $4 in savings.
4. Green Premium
A Laselle survey suggests that a 5%-15% green rental premium is commonly accepted by various financial institutions, while in some cases, it can be as high as 45%. From an asset value perspective, New York and London witness the most substantial green premiums, 28% and 19% per square foot respectively, largely due to compressed exit cap rates.
Opportunities
1. Funding Through Green Financing
In some states C-PACE can potentially finance 100% of eligible sustainable improvement costs, over 20-30 years with competitive fixed rates of 7.5%-8%, compared to conventional construction financing rates of 10%-15% in today’s tight lending market. Additionally, C-PACE payments are streamlined and less frequent, added to the property tax bill and transferable upon ownership change.
However, some mortgage lenders may require borrowers to escrow additional C-PACE reserves, as it is treated like real estate tax and technically holds priority over the senior mortgage, although C-PACE cannot be accelerated like a traditional loan.
2. Green Retrofit
Finding a suitable strategy customized to the asset is important. When the same retrofit package is applied, building improvements can account for 74%-79% of energy savings in colder regions, compared to 58%-64% in warmer areas where equipment replacement is more effective.
Technology is also crucial in green retrofitting: For instance, coated glass can save up to 12% of energy usage, while heat recovery systems reduce consumption by approximately 5%.
3. Building Certification
A study concluded that employee satisfaction with their employing organization was higher in WELL-certified offices.
Additionally, certified buildings benefit from increased legislative recognition, as states and cities base their incentive qualification criteria on third-party certifications. For example, Energy Star or Zero Energy Ready Home (ZERH) certified multifamily projects can earn up to a $5,000 per unit tax credit.
Final Thoughts For Investors
In conclusion, I believe that there is a strong demand from real estate investors to actively engage in sustainable practices and adhere to ESG initiatives, which could aid as an additional profitable value add investment strategy.
These recommended actions could add value to the deal through expense savings, return enhancement and legislative risk mitigation. However, the future success of real estate ESG practices truly depends on several factors:
• Profound understanding of the underlying asset and investment horizon.
• Thorough due diligence/financial analysis for ultimate risk assessment.
• Knowledge and access of available financing vehicles, incentives and other supportive measures.
• Creation of asset/portfolio specific business strategies.
Family offices and investors, especially the ones who do not have the right in-house team to diligently assess risks, may want to consider working with external advisors that have a direct, asset level real estate investment track record, as well as ESG specific knowledge.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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