While the real estate industry has become much better at integrating sustainability into new development projects, owners and developers have been less successful at driving sustainability in existing buildings. The market is not collectively taking advantage of the period when a building changes hands as an opportunity to address the financing of energy efficiency and sustainability features.
As buyers and sellers look to close a real estate transaction, one of two problems typically arises: often there is not enough time to identify sustainability opportunities in the property being sold, or the individuals dealing with the transaction do not have the capacity or knowledge to evaluate the long-term return on investment (ROI) of deep building retrofits as part of a larger repositioning.
Findings from ULI’s research suggest that real estate companies that successfully integrate sustainability into their transactions use a comprehensive due diligence process and leverage both underwriting and their capital plan to finance longer-term sustainability investments. Though no industry standard exists for how best to assess and incorporate sustainability early in an asset’s hold cycle, best practices are beginning to emerge from the market.
Leveraging Due Diligence
As a key part of deal assessments, the due diligence process should identify potential risks and opportunities for value-add in an acquisition. Ed Walter, ULI global chief executive officer, says that when he was an executive at Host Hotels, he used the underwriting phase to embed sustainability opportunities found during due diligence.
“Identifying sustainable upgrades to prospective hotel acquisitions was a consistent element in our underwriting process,” he says. “We knew the upgrades could drive improvements in cash flow, and it was valuable to include the benefits of those investments in our return projections. By capturing both the costs and benefits in our underwriting process, we enhanced the probability the investments would be made early in our holding period, thereby maximizing the benefits we received.”
Like any sound due diligence process, sustainability due diligence should include awareness of key risks for major mechanical system maintenance and replacement, increases in utility and other expenses during the hold cycle, and even future obsolescence of building systems (and even the building itself).
One way to ensure that sustainability is considered early in the process is to integrate an environmental, social, and governance (ESG) analysis into the standard due diligence process. LaSalle Investment Management systematically seeks ways to better integrate upgrades with environmental and economic benefits.
“An ESG checklist has become a core component of LaSalle’s comprehensive due diligence process,” says Eric Duchon, the firm’s global head of sustainability. “Sustainability is an important consideration to ensure we’re sufficiently analyzing and accounting for all areas of value and risk for every acquisition in order to achieve the best investment performance for our clients.”
Instead of simply making environmental standards and sustainability single line items in a traditional building assessment, companies that successfully account for and quantify ESG in transactions tend to have a robust process or checklist that details specific sustainability nuances, opportunities, and risks.
Capturing the Value of Certification
Evidence increasingly suggests that sustainability is becoming a key consideration for real estate companies. When the Leadership in Energy and Environmental Design (LEED) rating system, devised by the U.S. Green Building Council (USGBC), was new to the market, roughly 60 projects were registered per month between 2000 and 2006. By 2008 that number ballooned to over 2,000 registrations per quarter. Today, more than 32,000 commercial buildings have been LEED certified, USGBC reports.
In addition, the Institute for Market Transformation (IMT), in a 2015 survey of multiple studies (David Leipziger, “Rental Premiums of Green Commercial Buildings in the U.S.”), reported that buildings certified under LEED and the U.S. Department of Energy’s Energy Star program earn higher rents and have lower vacancy rates than those lacking certification. As a result, they also tend to command a higher asset value than conventional buildings, IMT notes.
On the portfolio side, the number of real estate companies using the GRESB Real Estate Assessment—which evaluates the sustainability performance of real estate and infrastructure portfolios and assets—also continues to grow. In 2017, more than 900 real estate funds and property companies representing over $18 trillion in institutional capital participated, GRESB reports.
Though these numbers demonstrate an encouraging increased focus on sustainability across the built environment, they represent only two pieces of the complex puzzle of a building’s life cycle. Upgrades—such as those required for certifications under such programs as LEED, Energy Star, the International WELL Building Institute’s WELL Building Standard, or Fitwel, operated by the Center for Active Design—require capital and a sound financial strategy.
Though numerous utility, government, and third-party programs and incentives exist to finance or offset the cost of energy efficiency and sustainability upgrades, a cohesive cross-functional approach addressing these opportunities early, such as at the point of building underwriting, has yet to be widely adopted. This missed opportunity will be a key focus for ULI in upcoming research. Through interviews with key stakeholders and an examination of transactions, ULI connected the market momentum toward sustainable buildings with information on how to finance sustainability in commercial real estate transactions.
Incorporating sustainability into due diligence is an integral first step toward understanding the sustainable components of an entire building, but the information garnered from those assessments is only as valuable as the company’s financing strategy allows. Increasingly, investor pressure is driving companies to analyze not just typical financial risks, but also how sustainability plays into the equation and positively affects a deal.
“We are finding that investors are asking more questions and doing more diligence on how managers adopt sustainability into their platforms,” says Dara Friedman, senior vice president at Bentall Kennedy. “We have been able to see the evidence of leading sustainability practices resulting in stronger and more sustainable investment returns. Our strategy is focused on investment performance and investment resiliency. As such, we incorporate a sustainability lens over each portion of the investment process, including investment strategy, due diligence, and business plan execution.”
In theory, the process of integrating sustainability into transactions would be smooth and the business case would be apparent. In reality, multiple questions arise during this process:
- At what point is the buyer and/or seller’s sustainability department brought to the table?
- How is the hurdle rate of a proposed sustainability upgrade going to affect the project and company in the long term?
- Are the acquisition/disposition teams armed with a checklist or data to better analyze the possible sustainability leverage points in a property?
- Does the due diligence done on a property include a comprehensive analysis of the energy and sustainability features?
- Is legal counsel prepared and up to speed on green terminology that may surface in contracts or negotiations?
- Have the building’s sustainability features been appraised?
Each of these potential pinch points introduces another layer to the equation and brings another stakeholder to the table. ULI’s research seeks to answer and analyze these questions and bring critical analysis and tools to the real estate sector to help make embedding sustainability into transactions standard practice.
Source – Urban Land