The business case for sustainability in commercial real estate
In commercial real estate space, both debt and equity market players are focusing more and more on the importance of environmental attributes of their assets. However, what are the next steps as finance, operational performance, and sustainability come together?
Article by Sofya Shuster, originally published on NREI.
Earlier this year ING issued a survey which found that in the Americas, sustainability strategies have shifted from being a cost cutting or brand reputation strategy to being a true revenue driver. This holds true for commercial real estate (CRE) as well. The importance of sustainability in CRE as a growth engine is now recognized by market participants both on the equity and on the debt side. No longer secluded to simply “doing the right thing,” market participants’ decisions to go green are based upon positive impact on revenues, reduction of operating costs and the reduction of capitalization rates, all leading to higher property values.
Asset Owners Lead the Way
Brookfield Properties, a leading owner, operator and developer of office and multifamily assets, reports that their tenant survey results repeatedly indicate a strong interest of tenants in reducing the amount of energy used and waste generated at their buildings. As of 2016, at least 80% of their tenant survey respondents indicated sustainable building practices were important to them [i]. Not surprisingly, Brookfield Properties have put sustainability at the core of their business strategy. 90% of their eligible global office area has achieved a sustainability designation.
USAA Real Estate Company is another leading market player who has integrated sustainable growth and financial performance. Their approach is to improve efficiency and reduce environmental impact by keeping a sharp focus on tenants comfort and satisfaction while improving financial performance. In 2016, the company reported overall annual operating cost savings from sustainable improvements of $1.5MM, including $0.6MM of energy cost savings. Their aggregate energy cost savings since 2000 have reached $24.5MM. Their analysis of the results on performance shows that the LEED-related audits and implementation of recommendations show a 59% ROI and less than 2 years simple payback [ii].
Debt Providers Recognize Importance of Sustainability of Assets
Recent studies find evidence of lower default risk on commercial mortgages for buildings with sustainable labels, as well as better loan terms (lower interest rate and significantly longer interest-only periods), compared to those for non-green buildings. For instance one study shows that office CMBS loans can have more than 30 percent reduction in default risk after the collateral property becomes Energy Star labelled or LEED certified (after controlling for other factors that affect default risk, such as mark-to-market loan-to-value ratio, debt-service-coverage ratio, etc.) [iii].
Another study focuses specifically on the effects of building-level energy consumption and the energy pricing on the default risk of securitized commercial mortgages (including office, retail and mixed use properties). The research finds that building asset characteristics and operational practices that affect energy use intensity of the property have very important effects on the likelihood of default, suggesting that accounting for energy efficiency and price risk shall be an important part of the loan risk assessment process in new mortgage originations [iv].
While the body of research on performance of sustainable assets is growing, the market still lacks transparency and solid evidence base which would help market players to improve capital allocation strategies. Regulators are also increasingly looking for reliable data which would justify providing capital relief for energy efficient lending (e.g. European Commission in exploring the feasibility of recalibrating capital requirements for banks in relation to their sustainable investments, a so-called green supporting factor) [v].
In response to the increased policy and market momentum, European banks are exploring a concept of “green tagging”, a systematic process where banks identify the environmental attributes of their loans and underlying asset collateral. The Green Tagging of bank assets is expected to help scaling up sustainable finance and contribute to the development of new energy efficient business models by providing better tracking of green loan performance and allowing for easier access to green bond markets. The UN Environment Inquiry into the Design of a Sustainable Financial System and Climate Strategy & Partners has recently published an interesting joint study into the practices of 10 leading European banks  in tagging energy efficiency finance in real estate [vi].
The momentum behind sustainable investments is undoubtedly growing. In commercial real estate space, both debt and equity market players are focusing more and more on the importance of environmental attributes of their assets. Systematic approach to identifying and tracking financial and operational performance of sustainable investments will help to increase market transparency and improve efficiency of capital allocation.
 ABN AMRO, BBVA, Berlin Hyp, HSBC, ING, Lloyds, SEB, Suedtiroler Volksbank, Triodos and UniCredit
[i] Source: Brookfield Properties, Corporate Social Responsibility Report, 2017.
[ii] Source: USAA Real Estate, “High Performance Sustainable Real Estate: Our Business Case Approach”, 2016 Performance Report, published June 2017.
[iii] Source: X. An, G. Pivo, “Sustainable Development and Commercial Real Estate Financing: Evidence from CMBS Loans”, July 2016.
[iv] Source: N. Wallace, P. Issler, P. Mathew, K. Sun, “Impact of Energy Factors on Default Risk in Commercial Mortgages”, May 2017
[v] Source: European Commission - Press release “Sustainable finance: Commission's Action Plan for a greener and cleaner economy”, 8 March 2018
[vi] The study “Green Tagging: Mobilising Bank Finance for Energy Efficiency in Real Estate” can be accessed here: http://unepinquiry.org/publication/green-tagging-mobilising-bank-finance-for-energy-efficiency-in-real-estate/