Posted On Oct 16, 2018
Sustainability is becoming a fundamental issue for commercial real estate (CRE) owners, investors and renters, affecting long-term value generation and short-term profitability. CRE owners who develop robust approaches to sustainability for existing assets can derive competitive advantage and improve the performance of their portfolio, according to findings of the Deloitte report, Breakthrough for Sustainability in Commercial Real Estate.
Especially in mature markets, property value fundamentals are increasingly sensitive to sustainability factors, observes Jon Lovell, director of Sustainability, Deloitte Touche Tohmatsu Limited Real Estate, U.K. and leader of Deloitte’s global community practice on sustainability and the built environment. “Sustainability is becoming an important influencer of many tenants’ overall business strategy, while CRE investors are beginning to analyze the risks associated with obsolescence of assets when sustainability measures are not adopted,” he says.
Mr. Lovell’s observation is supported by findings from a 2013 United Nations Global Compact’s Global Corporate Sustainability survey, in which 63% of respondents reported they are aligning their core business strategy to advance their sustainability goals. Moreover, 93% of CFOs participating in a 2012 quarterly CFO Signals™ survey said they believe there is a direct link between sustainability programs and business performance.
The Financial Case for Sustainability Investments in Existing Assets
“Many CRE players view adoption of sustainability practices as an incremental cost and prefer to invest in dressing up the exterior of a building,” notes Bob O’Brien, partner and global and U.S. Real Estate Services leader for Deloitte & Touche LLP. “However, research demonstrates there isn’t a significant incremental cost of greening an existing building compared to the cost of improving or repairing a building exterior,” he points out. A hypothetical analysis undertaken by the Deloitte Center for Financial Services of retrofitting an existing office building with sustainable measures, including energy and water efficiency and waste reduction, found a higher internal rate of return (IRR) of approximately 155 basis points (bps) on average, on the overall building investment.
A retrofit during tenant turnover can yield immediate return on investment by attracting new tenants and possibly higher rents, and typically makes re-leasing empty space easier. In the more challenging case of retrofitting a building when there is little or no tenant turnover, which reduces economic incentive, CRE owners can recoup some of their capital costs by partnering with current tenants. “For example, tenants developing their own green strategies may be willing to accept higher rents to gain sustainability benefits,” Mr. O’Brien says.
Sustainability Initiatives That Drive Competitive Advantage
The Deloitte report found that well-placed and appropriate sustainability initiatives have a positive impact on both property performance and valuation. While some initiatives might be considered table stakes, those that can serve as game changers can lead to improved brand value and competitive advantage. By focusing sustainability efforts on the following areas, CRE companies can help differentiate themselves in the marketplace:
1. Embed environmental, social and governance (ESG) risk management into core investment processes. Supported by credible narrative and nonfinancial information to engage investors, sustainability factors should be an explicit component of:
―Investment appraisals and acquisition due diligence, taking account of regulatory, market and physical risks pertinent to the properties in question, which may require a longer-term risk outlook to identify possible impacts on exit yields, rental growth and capital expenditure.
―Capital investment and business planning decisions in relation to development projects and the routine maintenance, refurbishment and retrofitting of standing assets.
―Portfolio strategy with respect to the exposure of capital to sustainability risks (e.g., physical hazards, tenant migration, lease liabilities).
2. Improve measurement and reporting to manage sustainability risk. “Investor focus on structured reporting and adherence to accounting standards seems likely to increase in the future, with organizations such as the Sustainability Accounting Standards Board (SASB) likely to release real estate-specific standards by 2015,” says Surabhi Sheth, research leader for Real Estate at the Deloitte Center for Financial Services. The use of predictive analytics to analyze historical and current sustainability data (costs and benefits) can increase transparency, improve measurement, enhance the ability to report externally in a credible and reliable manner, and gain insights to potential future risks. “The right metrics can preempt potential sustainability risks and help companies take appropriate and timely steps to remediate existing ones,” says Ms. Sheth.
Integrated reporting can help property owners create an evidence-based narrative of how the integrated management of financial and nonfinancial (i.e., sustainability) capital through their investment processes creates value for their financial capital providers. “This provides an opportunity for CRE organizations to take ownership of their value creation story at a time when industry benchmarking initiatives are serving to force-feed inflexible metrics upon all manner of organization and asset types,” says Mr. Lovell.
3. Plan resource efficiency to enhance occupant satisfaction and investment returns. While a certification system such as LEED for Existing Buildings (EB) is a good starting point for sustainability adoption, CRE players should consider making a conscious effort to have a broader strategy, with enhanced focus on water and waste management measures. The following considerations can help companies develop a sustainability strategy:
―Focus on achieving deep energy savings, working closely with tenants to ensure that the benefits realized are captured for mutual advantage. According to the New Buildings Institute, deep savings implies a minimum 30% and a target 50%-plus energy reduction in existing buildings. CRE companies can use technology to achieve deep energy savings, eventually moving toward “zero-net” energy and similar standards, as well as energy management systems (EMS) technologies to measure, monitor and manage electricity usage. “Consider targeting tenants that lease multiple sites to implement these initiatives,” says Mr. Lovell.
―Understand the energy-water nexus and its potential business implications. For example, water preservation can include reducing water consumption and/or preserving water quality.
―Improve waste management practices. Companies typically tend to focus on waste reduction through solid waste disposal mechanisms. However, they should aim to achieve zero waste, which implies that “all discarded materials are designed to become resources for others to use.” Achieving zero waste will likely require a well-defined program of waste minimization, recycling, composting and material reuse.
Progress on sustainability in CRE, such as embedding the principles of Responsible Property Investment—which consider risks and opportunities relating to sustainability across social and environmental issues and financial returns— remains limited except for a small group of market leaders, according to Mr. O’Brien. “The takeaway for CFOs is that CRE companies can derive tangible benefits by embedding sustainability in their portfolio and asset management activities,” he says. “Furthermore, a lack of sustainability investments can impact their ability to sell those facilities later, enter into new leases and drive cost savings via improved energy and water efficiency.