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Future-Proofing listed Real Estate : Sustainable Real Estate Securities

10 January 2018

It is widely acknowledged that “sustainable investment” is one of the fastest-growing investment approaches in the world. (Sustainable investment is defined here as an investment discipline where environmental, social, and governance (ESG) factors are considered alongside more traditional financial metrics in selecting securities and building portfolios.

The objective is to combine strong financial returns with positive environmental and social impacts). One proxy for this rapid growth is the remarkable expansion of the Principles for Responsible Investment (PRI), a coalition of asset owners who have committed publicly to implement sustainable investment practices in their portfolios. In the space of only 10 years, the volume of managed assets committed to the PRI has mushroomed more than tenfold from $6 trillion to over $70 trillion.

Initially, sustainability considerations were largely confined to equity portfolios. More recently, however, some of the largest and most sophisticated asset owners in the world (Japan’s GPIF, the U.S. funds CalPERS and CALSTRS, Sweden’s AP4 and APG, and PGGM in the Netherlands, to name just six) are intensifying their efforts to spread the integration of ESG analysis beyond equities to their other asset classes. In no asset class is sustainability a more compelling factor driving competitiveness and profitability than in the listed real estate sector. We would argue that the best way to “future-proof” a real estate portfolio is to make ESG an integral part of the analysis of every company being considered for inclusion.

A New Competitive Environment: Global Megatrends
One reason for this is the profound impact, which a number of secular, global megatrends are beginning to have on the real estate sector. Among the megatrends with particular relevance and importance for the sector are the following:

  • Urbanization: fuelled by both overall population growth and internal migration. The UN projects a global urban population of 5 billion by 2030, with 90% of the growth coming from Asia and Africa;1
  • A shift in the economic centre of gravity and dynamism: from the developed markets of the OECD countries to the exploding economies of China, India, and the rest of Asia; by 2050, six of the largest seven economies in the world will be found in emerging markets;2
  • Ageing societies: with particular needs for housing, health care, transportation, recreation, and social services;3
  • Technological innovation: in construction methods and materials, smart cities, smart buildings, distributed energy production and use, and so on;
  • Closer collaboration with governments: whether in their capacity as regulators and policy-makers, or as key financial players in public/private partnerships;
  • The globalization and intensification of real estate competition: The larger real estate companies are both expanding their property portfolios and extending their activities to entirely new countries and regions;
  • Growing concerns about sustainability: concerns about issues such as climate change and eco-efficiency, have now expanded beyond government and civil society, and have now become a central preoccupation for institutional investors. The Institutional Investors Group on Climate Change, for example, brings together asset owners and managers with $20 trillion under management.

Taken together, these structural changes are literally reshaping the global competitive environment within which real estate developers and managers must operate. Collectively, they place a new premium on a number of skill sets and operating approaches which real estate companies may or may not possess: adaptability, responsiveness, horizon-scanning, and innovation. Without those attributes, their ability to thrive and even survive amidst 21st century hyper-competition will remain very much in doubt. For that reason, those qualities feature prominently in Inflection Point Capital Management’s (IPCM’s) proprietary 5-Factor model, along with the more traditional E,S, and G elements. We believe that a sophisticated analysis of companies’ performance and strategic positioning on sustainability issues provides an excellent prism through which to assess those capabilities.

The Investment Thesis
The investment thesis underpinning the introduction of ESG factors into the analysis of listed real estate companies is actually quite straightforward: the challenges posed in the sector by the imperatives of sustainability are sufficiently complex, difficult, and rapidly changing that they provide a robust test of and leading indicator for the overall strategic management quality of the leadership of both real estate investment trusts (REITs) and real estate operating companies (REOCs). The companies’ performance (or non-performance) on ESG issues can reveal important insights about that management quality, at both strategic and operational/implementation levels. Real estate companies demonstrating sustainability leadership tend to be more forward-looking, agile, adaptable, innovative, and sensitive to changes in the marketplace than their peers.
Since it is widely accepted in investment circles that superior management quality will generally translate into superior competitiveness and profitability, any insights into those capabilities must, almost by definition, be of value. And this is particularly true in the case of listed real estate companies; from an ESG perspective they are badly under-researched by financial (and even ESG) analysts, so high quality, proprietary research on companies’ performance and strategic positioning can provide a powerful information advantage for investors.

“Greener” or more sustainable real estate can offer a number of tangible commercial and competitive benefits to its corporate owners4, including:

  • Operating costs which may be 20% lower, partly due to superior energy efficiency
  • Rents which provide a 20% premium on average
  • Occupancy rates which are 10% higher
  • Greater tenant satisfaction and productivity, by an average of 16%
  • Lower tenant turnover and attendant costs
  • Higher resale values

It follows logically, therefore, that if proprietary, in-depth research on a given investment universe can identify REITs and REOCs that are superior to their peers on ESG issues, those companies have a high probability of out-performing their peers, on both accounting measures and share price performance...

1 UN Department of Economics and Social Affairs.
2 PWC (2017) Shift of Global Economic Power;
3 United Nations (2017) World Population Prospects: the 2017 Revisions;
4Sources: World Green Building Council, U.S. Green Building Council, Building Research Establishment, and “ The Financial Rewards of Sustainability: a Global Performance Study of Real Estate Investment Trusts “. Franz Fuerst, University of Cambridge, June 2015)

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