ESG Basics in Commercial Real Estate

It’s hard to read about the real estate industry today without encountering the acronym ESG. While many real estate practitioners know it relates to environmental sustainability, not all understand that social justice and corporate governance are also key components.

For decades real estate professionals have been focused on mitigating the negative effects of building construction and operations on the natural environment. And today, not just landlords but occupiers – especially those from public companies – are also focused on reducing environmental impacts and creating more diverse employee pools and corporate boards.

As landlords and tenants align around these issues, unpacking the concepts behind ESG can help bring these parties together as they negotiate leases.

ESG stands for environmental, social and corporate governance, three concepts that originated in 2004 when Kofi Annan, then Secretary General of the United Nations, invited more than 50 CEOs from major financial institutions to create and integrate ESG policies and disclosures into corporations.

The concepts were meant to be built into the day-to-day operations of major global companies to help strengthen the capital markets, especially in small or underdeveloped countries where transparency was sorely lacking.

Additionally, focusing on these three areas was meant to help mitigate behaviours that resulted in environmental degradation, exploitation of employees and stale corporate boards dominated by a select few individuals.

By requiring public disclosures verified by third parties such as the sustainability benchmarking group GRESB, a company’s compliance – or lack thereof – with ESG practices can become part of the public record. This transparent disclosure can make it clear to stakeholders – such as municipalities, investors, lenders, clients and employees – which companies are good stewards of these practices.

Since its introduction almost two decades ago, the commercial real estate industry has focused largely on environmental elements – the E of ESG. They have been primarily implemented in the real estate industry in an effort to reduce the impact of building construction and operations on the environment with companies seeking to reduce energy usage and carbon emissions, among other things.

• Environment. Generally, environmental policies focus on reducing or eliminating negative environmental and/or climate impacts. They centre around priorities such as reducing the use of natural resources, reusing and recycling materials and generating energy from renewable sources. In the UK and Europe, guidance around these issues is set by organisations like the Building Research Establishment Environmental Assessment Methodology (BREEAM) and Green Globes. They provide methodologies by which professionals related to construction and property management can assess and minimise the negative environmental impacts of constructing and operating buildings. Areas of focus include energy and water conservation, waste mitigation, reuse of existing materials and use of regional and sustainable resources.
  
• Social. Social issues require evaluation of a company’s diversity and inclusion efforts from the boardroom to entry-level employees and across the supply chain. Work environment policies and programmes must ensure that employees are treated fairly and work in safe and harassment-free environments. Companies are also called on to engage with their local communities and aspire to have a positive effect on them.
  
• Corporate Governance. Governance focuses on a company’s leadership and how it upholds legal and ethical obligations and navigates critical risks over time. This includes ensuring that the board, company executives and managers represent diverse points of view – that can be communicated without reprisal – especially as it relates to issues with long-term impacts.

While the commercial real estate industry is often associated with flashy building transactions in the millions and billions of pounds, real estate, at its core is about constructing, operating and maintaining physical assets. As such, the CRE industry has played a greater role than many other industries in creating and implementing policies and practices that mitigate the effects of building operations and construction on the natural environment and the climate.

Numerous building owners have addressed environmental concerns and decreased their operating expenses by upgrading building systems to conserve water and energy. Other real estate companies have focused on social equity issues by hiring diverse individuals and strengthening ties to their local communities.

Additionally, some have modified their corporate governance structures by appointing individuals with unique experiences and innovative ideas to corporate boards, challenging them to focus on long-term planning and investing, as opposed to short-term profits.

Adopting ESG practices, however, is not without controversy. For example, building owners invest capital to upgrade buildings so they are more environmentally friendly, yet environmentalists say they are not doing enough.

Additionally, standardising disclosures – about a multitude of items as varied as greenhouse gas emissions and employee diversity – and making them fair for companies of various industries, sizes and complexities, poses real challenges.

Despite these complexities, understanding the basics of ESG is critical for both landlords and occupiers, who are now working together more closely to bring ESG initiatives to fruition.

LoopNet spoke with Julie Townsend, vice-president and ESG lead for Europe and Asia-Pacific at PGIM Real Estate, who said that ESG in real estate is starting to come full circle, “in terms of all the key stakeholders now being at the table”. For the past decade, ESG-related building improvements have in essence “been set by the investor and the landlord, and now it's fair to say that the occupier – especially the corporate occupier – has similar commitments in this space”.

Corporate occupiers have become more engaged because as part of their ESG disclosures, they must provide metrics related to their carbon footprint, for example. Therefore, they are motivated to occupy buildings that are highly energy efficient and constructed with low carbon-emitting materials.

With higher-performing buildings required for occupiers to meet ESG benchmarks, this has resulted in occupiers actively seeking out energy-efficient and sustainably-built spaces. This has generated more demand for these types of spaces, “and this helps the business case”, for investment in ESG practices, Townsend said.

“The business case must always show that capital expenditures generate a return on investment,” she added. This expectation means that upgrades to buildings, for example, and the corresponding expenses incurred, must illustrate that the capital investment will yield additional revenue typically in the form of higher rents.

“And I would say that sustainability is now a very key priority within that decision-making process for those corporate occupiers in their next space,” Townsend said.

With occupiers seeking high-performance or resource-efficient buildings, Townsend said landlords will be able to charge and receive a “green” premium or increased rents above comparable buildings lacking energy and sustainability upgrades. These higher rents enable owners to cover the costs of the improvements they made.

Interestingly, she added that the green premium seems to be related to “energy performance, as opposed to other factors of ESG”.