If it seems like you are seeing or hearing the term “ESG” a lot lately, you aren’t mistaken. This is a new, hot, buzzword in corporate circles and it signals a major shift in future real estate operating practices. For this reason, it is important that everyone understands what it means.
In this article, we are going to describe what ESG stands for, why it is important, and what it means for the future of commercial real estate investing. By the end, readers will be able to use this information as part of their own capital allocation decisions.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored commercial properties. As we continue to grow and expand our property portfolio, ESG concerns play a growing part in our investment decisions. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is ESG?
ESG is an acronym that stands for “Environmental, Social and Governance” and it is increasingly being used in corporate circles as a way of saying that these concerns should be incorporated into all business decisions. As it relates specifically to commercial real estate investing, they touch nearly every part of the investment. Details are below.
Environmental
Of the three concerns, this one may be the most relevant to commercial real estate investment because commercial properties have a major environmental impact. So, an increasing focus on ESG concerns means that property owners/investors must make a concentrated effort to reduce a property’s carbon emissions and increase the sustainability of the properties in their portfolio.
For developers of new properties, this means using sustainable building materials and practices. For owners of existing properties, this means doing things like updating lighting to energy efficient LED bulbs, replacing sinks and toilets with options that decrease the amount of water consumption, adding renewable energy sources and updating landscaping with less grass and more native plants that don’t need to be watered all the time. Many of these practices are codified in the LEED (Leadership in Environment and Energy Design) rating system, which is one of the most widely used in the world. They provide guidance on how to create a “green building” and offer ratings and certifications so that investors know what level of energy efficiency a property has.
A focus on sustainability is good for business in two ways. First, it is good for the bottom line of a property because less energy consumption means less utility expense, which can lead to more profitable operations. Second, it is good for investors, capital markets, and stakeholders because they are increasingly demanding that their operators give consideration to a property’s environmental impact. Those who are at the forefront of this trend stand to benefit.
Most importantly, it is also good for the environment. By doing everything possible to reduce a property’s carbon footprint, real estate operators can do their part to reduce the impacts of climate change and contribute to the long term health of the environment.
Social
Real estate assets are not monoliths. In many cases, they are vital parts of the communities in which they are located and the “S” in ESG demands that property owners and investors give more consideration to the social impact of their properties on their local communities. Specifically, there are two things to think about.
First, social considerations mean that property owners and institutional investors need to pay more attention to the welfare of vendors, employees, suppliers, and production sites. For example, suppose that a developer is trying to build community support for a new shopping center they want to construct. They are much more likely to accomplish this if they promise to use local suppliers and local vendors like architects and contractors who pay a fair wage and offer a healthy work environment. Further, if they make a concerted effort to give small or overlooked firms a chance to bid on their work, they may gain a lot of goodwill. Doing this means that the entire community will benefit from the effort.
Second, Social consideration means paying close attention to the labor practices of all involved in a project or investment. This goes far beyond just paying a fair wage. Socially conscious companies want to work with companies that pay a fair wage and offer manageable working hours, provide skills and technology training, and have a focus on helping their employees build successful careers. These types of initiatives mean that employees are more motivated, more loyal, and more likely to feel ownership in the results of the company. This is a net win for everyone involved in a deal.
Governance
The idea of governance doesn’t necessarily have anything to do with a single property or a portfolio of properties. Instead it has everything to do with how the company that owns the real estate is structured. So the “G” in governance seeks to align corporate structure to make it easier to accomplish environmental and social initiatives. In commercial real estate investment, there are two ways to encourage responsible investment.
First, in a corporate structure, executive compensation structures can go beyond traditional investment return metrics to include ESG benchmarks. For example, compensation could be tied to an asset meeting an IRR benchmark and carbon reduction, or net zero emission targets.
Second, it can be helpful to create an ESG focus at high levels within the corporate structure. For example, there could be an ESG committee within the board of directors whose job it is to incorporate ESG considerations into all levels of their risk management program and decision making processes.
Why ESG Matters
Broadly, the goal of a commercial real estate (CRE) ESG program is to create an investment framework that allows capital allocation and asset management decisions to include considerations for the environmental and social impact of planned and existing properties. While this may seem like a lofty goal, there are several tangible reasons why it can make sense to pursue it.
Lower Maintenance Costs
Building or updating a property to address ESG issues may require more capital on the front end, but it can make for a far more sustainable – and profitable – asset in the long run. For example, suppose that a multifamily investor decided to replace the appliances in all 100 units with new, energy star rated, appliances that will reduce the overall energy consumption of the property. This will require some upfront investment, but lower maintenance and utility costs over time can more than make up for it.
Regulatory Environment
As governments worldwide continue to take steps to address climate risk, it is likely that one of their primary policy tools will be to increase regulation of corporate activities. So, companies that proactively implement an ESG strategy are likely to be ahead of the curve as regulations tighten.
Opportunity to Build For The Future
The entire idea behind an ESG program is to minimize a property’s negative impact on the environment and to maximize their positive impact on their surrounding communities. The savings achieved and goodwill earned will allow investors to build sustainable properties and communities for the future. Again, those that are ahead of this trend stand to benefit financially.
How ESG Works in Commercial Real Estate Investing
There are two perspectives from which to view ESG issues, investors and operators.
Individual investors looking to allocate capital to commercial real estate investments have an opportunity to vote with their dollars. For those especially concerned with ESG initiatives, it is suggested that they allocate capital to firms who have established and mature ESG programs. According to CBRE’s ESG report, 60% of survey respondents stated that they have already adopted ESG criteria into their investment strategies. So, it shouldn’t be too hard to find one.
From an operator perspective, it is important to recognize that ESG concerns are rising in prominence and real estate investors are going to prioritize those firms that have strong ESG/sustainable investing programs. So, private equity firms, REITs, individual deal syndicators, asset managers, property managers, and any other firm in the real estate industry should take heed of this trend and understand that their future success and financial performance may depend on leveraging it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
