As the world struggles to contain the spread of the devastating coronavirus pandemic, a commitment to sustainability has never been more important. At this point, there are both opportunities and challenges in navigating the ESG landscape within real estate, especially with sustainable development. For details on the matter, we turned to Bradford Stoesser, senior managing director & global industry analyst at Wellington Management. The private, independent investment management firm has under management client assets in excess of $1 trillion and the firm serves as investment advisor to more than 2,200 institutions in more than 60 countries.
You’ve been with Wellington Management for more than 15 years. Walk us through the changes you’ve witnessed during this period pertaining to the increasing attention paid by investors to sustainability and ESG practices.
Stoesser: Wellington has a 40-year history of researching challenges and investment solutions for a sustainable future. Since I joined 15 years ago, those efforts have grown, mirroring the increasing interest from clients and investors. Wellington has developed thought partnerships with academia, industry leaders like the UN PRI and, more recently, the Woodwell Climate Research Center. We formalized our ESG Research team in 2011, and their research and engagements are a key component to our conversations with portfolio companies.
The ESG team’s focus is on building an alpha-additive process through ESG integration that can be used by any investor at the firm, across asset classes and investment styles. The firm’s mission is to be fiduciaries for our clients and deliver excellent investment results. We believe ESG and sustainability issues are strategic business issues that can affect financial performance, and that understanding them can help us mitigate risk and unlock value.
What ESG behaviors does the real estate team analyze when choosing the companies in which you invest? How do you assess the risks of climate change to your portfolio companies?
Stoesser: Over the past few years, we have developed a quantitative process of incorporating environmental, social and governance in scoring stocks. By actively incorporating ESG issues into our investment process, we believe that we can potentially realize lower downsize capture while participating in most of the upward swings in the market.
One area of particular focus we have is on the potential impact of climate risk on the portfolio. In partnership with the Woodwell Climate Research Center, we are now able to analyze over 500,000 REIT-owned properties globally for risks of heat, drought, wildfire, hurricanes, flooding, water scarcity and air quality. In collaboration with Wellington’s Fixed Income municipal bond and insurance teams, we have analyzed local city fiscal health and demographic trends to better understand cities’ ability to react and protect against climate change. Our proprietary climate change analysis combines the physical risk to assets with local city risks to understand the potential impact of climate change on property terminal values.
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As an example, we have an unfavorable view of a particular U.S. shopping center REIT. The REIT has a high percentage of non-essential retailers—restaurants, apparel, fitness, etc.—and fundamentals worsened due to COVID-19. In addition, the company has a high percentage of its properties in areas of Florida that are highly vulnerable to hurricanes according to climate science inputs from Woodwell. These climate risks could impact the trajectory of local taxes and insurance in the future and, ultimately, the terminal values of the REIT’s properties.
Two years ago, Wellington Management, in partnership with Woodwell Climate Research Center and the California Public Employees’ Retirement System, launched an initiative to study the effects of climate change on capital markets. Tell us how the learnings from this partnership have impacted your investment approach.
Stoesser: On the real estate team, we leverage research and data from Wellington’s climate research team and the Woodwell Climate Research Center throughout our investment process, and these data ultimately feed into our ESG scoring for companies in which we invest. For us, by far the most useful output of the collaboration has been Wellington’s climate model mapping tool called the Climate Exposure Risk Analysis, or CERA.
Our CERA tool facilitates overlays of climate variables that are the focus of the climate research partnership onto geospatial maps that pinpoint capital assets and project their exposure to those risks. The tool’s geospatial mapping precision allows us to see specific building locations and enables us to analyze the climate risk of all the properties owned by the companies in which we invest. The aim of the mapping tool is to help Wellington investors better understand potential risks of climate change on assets they invest in and whether those risks are appropriately priced.
Another way we leverage our climate research team’s work is into the real estate team’s Environmental, Social, Governance and Climate (ESGC) model, which produces a warranted premium/discount assessment that is then applied to our valuation models to arrive at target prices for stocks. Just because a company has significant climate risk does not mean we will not invest in that company. Ultimately, we are seeking to understand if the market is appropriately discounting the risk of climate change a company faces in the future.
Some research has found that overall commercial property values in areas affected by costly, recurring natural disasters have decreased. What opportunities do you see for maintaining/improving the value of existing properties located in such areas?
Stoesser: We see the risks of climate change to real estate values as multi-dimensional. At the asset level, landlords can take numerous measures to adapt their properties to physical risks. These include increasing vegetation and green spaces around properties to absorb rainfall and runoffs, rooftop gardens to cool buildings, relocating generators to higher elevation and purchasing flood-protection systems. Wellington, in partnership with Woodwell, developed a framework that companies can use to better understand how physical climate risk will impact their own operations, as well as those of their customers and suppliers. We frequently send this framework, called the Physical Risks of Climate Change or P-ROCC, as a follow-up to our engagements with companies.
But landlords can only do so much. Most real estate tail risk comes from a property’s physical location. We find that municipalities in the U.S. with significant exposure to climate-related risks have very different policies and resources to combat the effects of climate change. Cities that are in stronger fiscal positions and with growing demographics can more readily invest in infrastructure to mitigate the effects of climate change, whereas locales in weaker economic positions tend to struggle to implement these preparations.
We are already seeing a divergence in the efforts of at-risk municipalities to protect against climate change. For example, New York City and Boston, large cities in relatively strong fiscal positions, are evaluating measures to protect property and infrastructure against hurricane storm surge, while Houston, a city in a weaker fiscal situation, is doing very little to adapt.
All three of these coastal cities could benefit from barrier walls or harbor islands, increased green space, particularly along the waterfront, and improved drainage routes. Of course, just having the resources is not enough; ultimately political leaders need to be willing to advocate for and invest in climate-risk-mitigating infrastructure. These efforts can be at odds with certain stakeholders, including property owners, who may resist efforts to designate high-climate-risk areas for fear of a decline in real estate values.
Looking at the global marketplace, Europe seems to be leading in terms of green investing and sustainability issues. Where does the U.S. stand and how do you see it progress in the foreseeable future?
Stoesser: From a real estate perspective, the U.S. is generally behind Europe but ahead of Asia in focusing on sustainability. The reason for this is twofold. First, governments in Europe have been more progressive in setting requirements for building emissions, energy consumption and water usage. Second, asset owners in Europe have been more vocal and proactive in requiring that their investments meet green building and sustainability standards.
In recent years, the U.S. has started to see a greater focus on sustainability, in part driven by investor sentiment and political will. Some state and municipal governments are enacting stringent carbon-footprint-reduction requirements for commercial buildings. New York City, for example, has targeted reducing carbon emissions by at least 40 percent by 2030 and 80 percent by 2050. Such requirements compel landlords to reduce building emissions.
The built environment is responsible for roughly 40 percent of greenhouse gas emissions and, whether through regulations or market forces as more tenants establish their own carbon reduction goals, there will likely be advantages for those names that have been early movers on advanced LEED-certified buildings and powering by renewables. Should the U.S. see a change in administration and more ambitious climate goals such as a carbon price, these trends could accelerate.
We have found that U.S. real estate companies are increasingly seeing the benefits of green investing, as more sustainable buildings typically generate higher rents, reduce operating costs, and, in the case of office and apartment buildings, increase worker and resident happiness. All of these factors can lead to higher asset valuations. We expect the U.S. to close the real estate sustainability gap with Europe over the coming years, with Asia, broadly speaking, taking more time to catch-up.
How has the pandemic changed the approach to ESG within the real estate sector?
Stoesser: The COVID-19 pandemic has brought social considerations, particularly worker health and safety, into greater focus. With the exception of hotel operators, worker health and safety has not historically been a significant focus for real estate companies. We expect this to change in the post-COVID-19 world as the companies incorporate guidance from health organizations such as the CDC for worker safety and support.
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As for the office sector, while the media has spilled a great deal of ink on the purported demise of real estate values amid the work from home shift, we think the real challenge will be how landlords and developers approach bringing workers back to the office safely after the pandemic. Many buildings may need to be retrofitted and redesigned to allow for a more socially distant flow of people and flexible work arrangements. Those REITs that lead in worker health and safety initiatives for their tenants may see outpaced demand in the future.
Stoesser: There is always room for innovation and improvement in sustainability measurement. A decade ago, LEED platinum or gold certification was relatively rare; today it is common in new builds. To become more sustainable and further reduce environmental impact, building and construction practices need to continue to evolve. We will see new materials, lighting, energy and waste systems that improve efficiency and lower emissions. Innovation changes the perspectives on what it means to be sustainable.
Metric standardization would certainly help. We have our own standards for best practices in our investments, but we recognize the challenge companies face, given the multitude of data sets and measurement systems industry-wide. Without common metrics, companies and investors struggle to make peer comparisons along sustainability lines. We often encourage the companies we invest in to improve their ESG and sustainability disclosures to preempt potentially inaccurate market assumptions.
What’s next for sustainable investing in the upcoming three to five years?
Stoesser: We expect the public markets to lead on sustainability, catalyzing changes in public policy and regulation, and the development of industry definitions of best practices. As investors increasingly see sustainability and ESG as material factors that can affect investment returns, management teams and boards are under pressure to deliver.
Governance considerations have long been a key component of investors’ corporate analyses; we expect environmental and social considerations to become just as integral in the next few years. We welcome deeper integration and disclosure of ESG issues, and we believe these practices will ultimately result in higher growth rates and richer valuations for select companies and enable more sustainable investment returns and portfolios.