ESG (Environmental, Social, Governance) in CRE
If you're in the commercial real estate space, you've likely seen at least five headlines around ESG (Environmental, Social, and Governance) and heard about it in at least two webinars. Green is the new black! These strategies have increasingly become more popular in the CRE industry, but what does ESG mean and why is it so popular?
Sustainability has become a concern in every aspect of life, from eating cleaner to shopping cleaner, and it's even started creeping into the commercial real estate industry with ESG. While the two are very similar, and are often used interchangeably, ESG and sustainability are different. Think of ESG and sustainability like squares and rectangles. ESG is a form of sustainability, but sustainability isn't just ESG; it's a specific concern of sustainability, addressing three dimensions that rely on data and results.
In the commercial real estate world, ESG initiatives have been found at every stage, from investing and construction to acquisitions, asset management, and leasing. They're even written into your loan docs! *Learn more about Sustainability Within Loan Docs.
Sustainability used to be the icing on top, an afterthought that was nice to have, but increased climate change awareness and concerns have led to a steady rise in ESG investing, especially on the environmental side.
What exactly does ESG entail?
Environmental: This one is pretty straightforward, it’s the environmental impact a firm has — think carbon emissions, energy and water efficiency, etc. The environmental impact of a building is largely embedded in its construction and ongoing operation. The environmental dimension currently leads ESG initiatives in CRE because there are several ways to address it. From plans to build carbon neutral buildings and smart buildings to solar panels and energy-efficient lightbulbs, investors have ambitious goals for the near future.
Climate risk is investment risk.
— Larry Fink, chairman and CEO of BlackRock
Social: The social aspect is the impact a firm has on its employees, customers, and community. This includes workplace diversity, customer satisfaction, etc. In CRE, the social focus is on the underserved population, overlooked and vulnerable communities, addressing this issue with assets such as affordable housing. The social dimension is slowly gaining traction in the industry but still lags behind Environmental.
Governance: Governance focuses on the structure and leadership of an organization, their management philosophies, practices, policies, etc. These directly affect the firm’s ability to build trust and strong relationships with investors, tenants, and the community. This dimension has been slower to be addressed but there has been an increased pressure for executives to focus on sustainability goals.
So we know what ESG is, but why is it so popular?
Firms that adopt and embrace ESG tend to have a better reputation with the public (it’s good PR!) and with potential investors. Some long-term benefits include a positive impact on organizational structure, client relations, budget, the environment, and more. Expectations have changed since the “woke era” and being socially aware has become a necessity. It’s crucial to align internal values with the values of potential tenants, investors, etc.
Investors also seek green assets because they carry less risk, they’re cheaper to operate, and are usually more attractive to tenants. All of these increasing its value. Many big names have even announced that they will use ESG (especially environmental impact) as a key factor in future investments.
According to CBRE, these are the top 10 things investors are considering:
- Energy-efficiency with a net-zero carbon emissions goal (Here's how you can Decarbonize Your CRE Portfolio)
- Premium between green vs brown rentals
- Availability of green construction materials
- Regulation and requirements
- Risk and cost management
- Affordable housing opportunities
- Health and wellness concerns
- Corporate responsibility and accountability
- Performance benchmarking and reporting
- Technology investments
But of course, it’s easier said than done.
The age-old challenge with sustainability is the higher upfront cost. Can you be in the red while being green? Are these sustainability practices sustainable on your wallet?
From methodology to materials, investors are always concerned about cost — but the perception is often higher than the reality. The advancement of sustainability technology has increased availability and decreased price, typically to a point where it’s not as expensive as you’d think.
There are also programs to help!
CPACE (Commercial Property-Assessed Clean Energy) is a financing program meant to provide costs for either new construction or retrofit projects that reduce energy/water consumption or generate renewable energy. Funded by private capital providers (they're not federally provided but do require authorization through state and local legislature), these are non-recourse and provide 100% of financing for eligible improvements and offer a 20-30 year amort with a low cost of capital and a fixed interest rate.
CPACE is supplemental to senior financing but offers a significantly lower interest rate than conventional mezzanine debt with the ability to cover up to 100% of a project’s hard and soft costs. The sum of senior and CPACE financing provides for unusually high loan to value ratios up to 90%.
- Matt Swerdlow, Director of Capital Services at Ariel Property Advisors
As a property assessment, this type of financing is repaid through assessments on the building owner's tax bill. They can be prepayed, but prepayment penalties may incur.
Another major challenge with sustainability initiatives is data attainment and enforcement. How wide is the gap in desire to go green between investors and tenants? Do the property managers know what is necessary for the transition? These all play a role in how easy it is to transition toward sustainability.
It’s difficult to enforce disclosure from investors and/or tenants — and for some asset classes, it’s harder than others. In an attempt to get investors to disclose information, conditions are sometimes being written into loan docs. In order to incentivize disclosure (or allowing usage tracking) from tenants, borrowers have had to get more creative.
For the Assemble Chicago project (a proposed $102 million, 20-story mixed-use building intended to be the city of Chicago’s first net-zero, all-affordable high rise) one potential solution was giving tenants an energy budget that could translate into discounts on rent if they were to stay under budget.
The long-term benefits of ESG are attractive — we can’t blame investors for wanting a piece of the pie. ESG has been a major player in recent CRE trends and doesn’t seem to be slowing down anytime soon.
Let us know what you think!
Email us at theboss@loanboss.com
Stay in the loop on more CRE trends with our industry insights.