By Eric Rothman & Scott Crowe
An appropriate consideration of Environmental, Social and Governance (ESG) issues is important to making the right real estate investments. Real estate assets are one of the primary locations of energy usage (environmental), the cornerstones of our societal infrastructure (social), and capital intensive, with financial outcomes heavily influenced by transparency and alignment (governance). CenterSquare has been incorporating ESG considerations into its listed real estate investment process for decades. However, as its clients’ focus on these issues has increased, so too has the formalization of the firm’s approach. One concern that arises in ESG discussions is the utility of ESG to drive better investments; however, CenterSquare’s analysis finds that factoring ESG elements into the investment process correlates with better returns for investors.
Put simply, ESG principals make good business sense. It stands to reason that better-managed firms with sustainable business practices should be rewarded by the market over time. As it pertains directly to REITs, more efficient buildings are more profitable buildings. More sustainable buildings are more valuable buildings. In that sense, we believe that ESG considerations have an important role in the evaluation of a REIT investment strategy.
Real estate’s capacity to mitigate environmental risks is evidenced in its energy usage. In 2016, real estate consumed more energy than both the transportation and industrial sectors, accounting for almost 40 percent of total energy usage in the United States, according to the U.S. Energy Administration. Energy-efficient policies directly impact the bottom line, making efficient assets more profitable and sustainable. Additionally, tenants and consumers are increasingly demanding sustainability and are willing to pay premium rents for such assets.
When assessing the environmental factors of a REIT, we seek to capture the robustness of the company’s environmental sustainability policies addressing energy efficiency, conservation and carbon footprint reduction, as well as the execution and disclosure of those policies. As the company develops additional assets, brown-field development and mass transit-oriented development is considered environmentally friendly. So too is the company’s existing real estate portfolio. Heightened sustainability standards, such as attaining LEED and GRESB certification, improve the score. Companies also receive superior scores for being leaders and advocates within the environmental sustainability space.
Real estate is the cornerstone of society; it is where people gather, live and work. As such, real estate’s impact on its community directly impacts the asset’s long-term sustainability and value.
A social assessment of a REIT seeks to capture the company’s quality of employee engagement and extent of community involvement. This category also considers policies regarding ethics, conduct, anti-corruption and anti-bribery for employees and contractors as well as the company’s commitment to community involvement, civic service and philanthropic efforts.
As a capital-intensive industry, appropriate governance of real estate assets and proper alignment of interests are key drivers of risk management and value creation when assessing a company’s potential for long-term outperformance.
Shareholder alignment and board independence measure the shareholders’ influence over the company and the board’s ability to carry out its fiduciary responsibility as the stewards of shareholder capital. Governance factors also measure the extent to which strategic efforts have been clearly identified and implemented to enhance governance of shareholder capital and the quality of governance disclosures.
As investor focus on ESG has continued to grow, CenterSquare has formalized its process for incorporating ESG considerations into its bottom-up analysis of each stock in the REIT universe. The results of the firm’s analysis are summarized at the sector level below:
- Apartment: The sector’s emphasis on environmental sustainability (through electricity and water conservation), board alignment and independence, disclosure clarity, and strong community and employee involvement award it a high ESG score.
- Industrial: These REITs score well for their leadership in transforming and developing assets with a strong focus on energy efficiency and emission reduction, which has helped the industry receive recognition from GRESB. The sector also focuses on social efforts within the community and demonstrates strong governance standards.
- Office: Infill office owners include quality developers whose new buildings often target high LEED certifications. They have clear policies on community involvement and charity along with strong governance structures. For suburban office owners with less new product and smaller assets, the investment in green buildings simply has not been made to the same extent. Nevertheless, these companies are involved in their communities and have governance disclosures largely on par with the infill office names.
- Retail: Mall owners demonstrate clear policies and leadership in the ESG space as many companies report to GRESB and develop sustainable assets. Most companies are actively involved in their communities by sponsoring events and making charitable contributions. The shopping center owners have fewer disclosures but generally follow the trends seen for mall owners to a lesser degree.
- Hotel: These companies, aside from the largest companies, are typically less focused on ESG efforts with varied disclosures, resulting in relatively low ESG scores.
- Health care: This industry has varied levels of disclosures, resulting in lower scores on their social and environmental efforts, although there is a recent push for developing and transforming buildings to be more energy efficient. However, their governance is relatively strong, especially for the larger companies.
- Alt Housing: These REITs have clear ESG policies and focus on environmental sustainability and community involvement. The ESG focus for single-family REITs is slightly unproven given the sector’s infancy.
- Self Storage: This sector scores poorly as most companies have little to no disclosures regarding their ESG efforts. Only one company reports to GRESB on its environmental efforts, while only one other scores well on its social efforts.
- Specialty: Data center companies score well, given their strong focus on renewable energy and social efforts regarding employee and community engagement. However, they do rank lower on their governance scores as they have poor disclosures and less independent boards.
- Triple Net: These REITs have poor to no disclosures, as the nature of the sector allows the asset owners to worry less about efficiency of their assets. Their employee engagement, however, is comparable to REITs overall.
CenterSquare believes managing ESG risks is not only important to real estate investing, but also generates long-term value. CenterSquare’s ESG analysis, while long-standing, has evolved as the demand and focus on ESG products has continued to grow in the last decade. While the concept of ESG might have been considered in the past as a deterrent to superior returns, CenterSquare’s data show portfolios of companies with the top CenterSquare ESG scores have significant alpha-generating potential.
The statements and conclusions made in this article are not guarantees and are merely the opinion of CenterSquare and its employees. Any statements and opinions expressed are as of the date of publication, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of CenterSquare.