Real Estate Impact Investment: From Niche to New Normal?
Real estate sits at the intersection of some of the most significant global challenges. It contributes, positively and negatively, to issues including transportation, land use, climate change, resource use, health, and social mobility.
Real estate, somewhat similarly to gold, has long been considered an attractive alternative investment. Owning property, particularly of the residential type, can offer security in the long-term by hedging against inflation whilst also acting as a profitable, tangible store of value1, even in turbulent times. Indirect ownership of real estate through, for example, stocks in a listed property company or a Real Estate Investment Trust (REIT), are also generally viewed as stable investment options. Furthermore, indirect investors into real estate need not worry about the barriers to entry that come with purchasing physical property, where a (large) up-front capital investment is needed.
Nevertheless, investing in real estate (whether directly or indirectly) comes with risks, many of which relate to Environmental, Social and Governance (ESG) issues2. A changing geo-political landscape characterised by populism, nationalism, conflict and migration, as well as rising inequality fuelled by a focus on short-term profits, has fostered higher awareness of how removed investing has become from its original goal of serving the real economy and the needs of society. The world has simultaneously seen several consecutive years of record-high temperatures and economic losses caused by extreme weather events3. Scientists are now able to demonstrate a correlation4 between these events and a changing climate caused by unsafe concentrations of greenhouse gases in the atmosphere, the vast majority as a result of human activity5.
The rise of sustainable and responsible investment
These drivers have helped to bring about the relatively new set of strategies that can be grouped together under the term sustainable (or responsible) investment. There is a lack of consensus among the investment community on the precise terminology, but all sustainable investment aims, at the very least, to mitigate the risks arising from ESG issues. Depending on the motivations of the investor, some strategies are even geared towards making a positive impact on a given ESG issue. The current understanding of the taxonomy of sustainable investing can be broadly summarised as follows6, 7 & 8:
Integrating ESG issues into investment analysis and asset management in the real estate space has become mainstream in the last few years. Few investors today would fail to take into account at a minimum the ‘E’ in ESG by considering, at a minimum, energy and water use and waste disposal in potential and existing investments. The growth in participation in the Global Real Estate Sustainability Benchmark (GRESB) from a handful of large pension funds in 2009 to 850 property companies and funds with a combined USD 3.7 trillion in assets under management (AUM) in 2017 supports this notion.
It is no wonder that GRESB has seen such significant growth in the space of just eight years: at the same time, a relatively robust body of research demonstrating the benefits of ESG integration into real estate has emerged. Assessments9 on the so-called ‘green premia’, meaning higher rent and sales prices earned by buildings classified as green, have shown to be up to 17% for residential sales, and up to 26% and 12% for the sale and rental of office buildings, respectively. The benefits generated do not end with the investor, though: measured productivity increases10 under green building conditions range from 8 – 11 % (good indoor air quality) to 1 – 9% (thermal comfort), and even a 61% increase in cognitive function. Others have been able to quantify11 the benefits of increased sporting provision through improvements in wellbeing.
The need to scale up impact
Although convincing data on the benefits of ESG is beginning to emerge, there is still a long way to go for the built environment sector to avoid the expected doubling or even tripling of its global greenhouse gas (GHG) emissions contribution12 under a business-as-usual scenario. The share is currently at approximately 30%, which highlights the vast potential for mitigation that the sector and its investors hold. To put the challenge into perspective: a report13 by the World Green Building Council from May 2017 found that the entire global building stock – forecasted14 to grow from 223 billion m2to 415 billion m2 – must achieve net zero carbon status by 2050 in order to avoid global warming of two degrees or more.
In light of this, it seems that more radical means are needed to advance the decarbonisation of the real estate sector. It is worth, then, to investigate the more ambitious of the sustainable investment strategies outlined above, namely impact investing: a “turbo-charged” version of ESG. The prevalent notion among the investment community has long been that impact investments generate lower returns than conventional investments. This has, until recently, been difficult to contest due to a lack of data. However, in 2017, the Global Impact Investing Network (GIIN) and Cambridge Associates (CA) released a report15 launching benchmarks for impact investments in the real assets universe, specifically for timber, real estate and infrastructure. The report collated data on the performance of 55 funds raised between 1997 and 2014 (2004 to 2014 for real estate funds). The impact types for real estate were grouped into green buildings, affordable housing, and community services, or a mixture of these.
The report found that for all three asset types, it is possible for impact funds to achieve risk-adjusted market rates of return. However, as with conventional investing, the key is to select the right fund to meet each investor’s goals, as outcomes vary significantly. The mean pooled net internal rate of return (IRR) of real estate impact investing funds was 0.8% compared to the 4.9% of conventional funds. The number is dragged down by a few larger funds performing relatively poorly. Over half of the impact funds studied were also raised after 2011, compared to 31% of the conventional funds, which may skew the results. Smaller impact funds (AUM less than USD 50 million) generated on average a 10.2% net IRR versus the conventional universe’s 6.3%, highlighting again the fact that fund selection (with size as one factor) is key to securing competitive returns on investment.
When employing an equal-weighted calculation methodology for net IRR, the impact funds’ mean return was 3.8% compared with 4.9% for conventional funds – a much smaller difference than with pooled IRR. Overall, the real estate impact funds studied also proved to be less volatile than their conventional counterpart, speaking to their potential in offering stability as a long-term investment. Out of all the real estate impact investing funds, the best-performing funds were concentrated on residential multi-family assets. This sub-sector returned an average equal-weighted net IRR of 17.2% compared to the 10.4% return of their conventional counterparts.
New opportunities and reasons to invest for impact
Similarly, the returns of infrastructure impact investment funds offer encouraging data with the top fund producing a net IRR of over 29%. Close to 25% of the funds also generated a net IRR of 10% or more. As urbanisation is set to intensify, the quality and access to housing, transportation and utility infrastructure becomes more important. Jonathan Williams of the IPE sees potential connections here, arguing that in future we may be investing not only in buildings within emerging market cities, but also for example light railways that serve those cities16. The potential is already there: according to the GIIN/CA report, real assets offer the third largest opportunity for impact investing (after private equity/venture capital and private debt), with almost 25% of impact funds focusing on real assets.
It is clear that impact investing in real estate and the wider real assets universe can be lucrative purely based on the financial incentives offered. However the moral imperative of mitigating climate change and improving the quality of life of whole communities represents another clear driver. Furthermore, a PwC survey17 finds that one of the most important trends driving changes in the property sector globally is the increasing interconnection between work and life. This raises the possibility that in future, there will be less place-dependent ‘9 to 5’ types of employment, and consequently more spaces that people can simultaneously use for working, living, socialising and accessing services. Addressing these lifestyle factors and emphasising human wellbeing can help to avoid the risk of ‘stranded assets’.18
Assets may become stranded also due to physical climate change risks, whether chronic or acute.19 A 2014 paper20 from the Urban Land Institute argues that:
“…to a large degree, a major consequence of climate change – extreme weather events – has yet to be seriously addressed by the [real estate] industry. Many real estate investors and associated players are simply not aware that these events -- pose a rising, compelling and more immediate threat to property value, and are therefore overlooking the related risks within their investment decision-making.”
Investing for impact from a climate change mitigation and adaptation perspective can help. The potential benefits are myriad: early movers in the market can avoid costly insurance claims or other economic damages resulting from storms, floods, droughts, or indirect effects, such as utility infrastructure disruption, civil unrest or unfavourable fiscal policy responses. Impact investors can also avoid the potentially high costs of reactively conforming to upcoming policies that are expected to morph into legislation in the not-too-distant future. Examples include the increase in disclosure requirements on how companies and investors address sustainability and climate change in their strategies, recommended by the Task Force on Climate-related Financial Disclosures (TCFD)21 and the European Union’s High-Level Expert Group on Sustainable Finance (HLEG)22, as well as a potential price on carbon – emitted or embodied.
Finally, the moral imperative is clear. To quote Marilou van Golstein Brouwers from Triodos Investment Management22: “How we invest determines what the world will look like in the future and as such we are all responsible for shaping our future.”
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