January 2022 Edition - Are You Considering ESG In Your Due Diligence and Underwriting?
HAPPY NEW YEAR!! I hope that 2022 will be your most successful year to date and we can find the opportunity to work together to make that happen. This sets the bar high for 2022 considering that 2021 was a record setting year for the multifamily business. Across all of the earnings reports and the calls between the companies’ executives and financial analysists accompanying the reports, common themes emerged with the overall sunny outlook: average occupancy over 96%, cap rates below 4% and an impetus to build new apartment buildings at a greater rate than was expected at the start of the year. The Southeast and Sunbelt have been disproportionate beneficiaries of these trends as well as the investment flows. “Traditional gateway investors are tapping into golden opportunities across the Sunbelt.” (Eddy Obrien, managing partner and co-founder of Blaze Capital Partner). Markets throughout the Southeast and Southwest are among the strongest performers over the past 12 months. (Newmark 3Q21 US Multifamily Capital Markets Report).
Projections for 2022 are for the 2021 trends to continue with an increased intensity. One of the most significant concerns that we currently have is lack of inventory. Multifamily developers continue to develop new properties and fill them up as quickly as completed but we are still running behind as population growth in the Southeast continues to outpace supply. Whether you’re looking to invest in new construction or are looking to purchase Class A, B or C existing properties, your choices are limited. The market is getting tighter and tighter but we are seeing more institutional and larger investors becoming more “Responsible Investors” by implementing ESG considerations into their due diligence and underwriting processes.
“Responsible Investing” is widely understood as the integration of environmental, social and governance (ESG) factors into investment processes and decision making. ESG factors cover a wide spectrum of issues that traditionally were not a mandatory part of financial analysis but have financial relevance as companies strive to improve sustainability to support long-term performance.. These include an investor’s concerns as to how a property impacts climate change, how well the property handles water and waste management, how effective its health and safety policies are in the protection against accidents, how it manages its supply chains, and how it treats its staff and fosters innovation.
The term ESG was first coined in 2005 in a landmark study entitled, “Who Cares Wins.” Today, ESG investing is estimated at over $20 trillion in assets under management (AUM) or around a quarter of all professionally managed assets around the world. Its rapid growth is built upon “Socially Responsible Investment (SRI).” But, where SRI is based on ethical and moral criteria and uses mostly negative screens, such as not investing in alcohol, tobacco or firearms, ESG investing is based on the assumption that ESG factors have financial relevance. Many investors recognize that ESG information about a property is vital to understand the property and its owners. “Principles for Responsible Investment” (PRI) is a thriving global initiative with over $70 Trillion in assets under management. PRI’s role is to advance the integration of ESG into analysis and decision making through thoughtful leadership and the creation of tools, guidance and engagement.
Institutional investors were initially reluctant to embrace the concept of socially responsible investing, arguing that their fiduciary duty was limited to the maximization of shareholder values irrespective of environmental or social impacts, or broader governance issues. But as evidence has grown that ESG issues have financial implications, the tide has shifted. In many important markets, including the U.S. and the European Union, ESG integration is increasingly seen as part of fiduciary duty. Sustainability Accounting Standard Board (SASB) has helped to advance reporting and its relevance for investors. The idea that investors who integrate ESG risks can improve returns is rapidly spreading across capital markets. ESG data for investors is increasingly becoming more important to identifying properties that are well positioned for the future and to avoid those which are likely to underperform or fail.
Our multifamily industry is at the beginning stage of incorporating ESG into due diligence and underwriting. Climate change concerns have accelerated ESG incorporation into commercial lending. An agreement announced at the Glasgow Climate Pact in November of last year will likely unlock billions of dollars of investment in carbon reduction projects around the world. Tony Liou, President of Partner Energy sees this as an opportunity, given the residential and commercial real estate sector accounts for the majority of the energy consumption in the U.S.
“To truly tackle the growing issue of climate change and mitigate those impacts, while working to improve resilience, it makes sense that the biggest sources of energy consumption and resulting greenhouse gases must be addressed,” (Tony Liou). Despite industry participation in environmental accreditation programs and broader ESG initiatives, investors have been slow to incorporate environmental risks into underwriting, he said. But, over the past year or so the conversations about ESG have eclipsed all other topics in conversations, Liou said. “Unlike in the past when energy efficiency efforts focused on municipal and public buildings, today’s lenders and owners across the capital market, including both debt and equity, are talking about ESG and resiliency in their commercial real estate activities.”
In a 2021 CBRE Global Investor Intentions Survey, 60% of respondents state that they have already adopted ESG criteria as part of their investment strategies. With ESG now playing a much more prominent role, investors are embedding ESG considerations into every stage of their property lifecycle, from due diligence to acquisitions and from leasing to management.
CBRE’s report identifies the “Top 10 Things Investors Need to Know” regarding ESG.
Environmental:
1. Energy-saving considerations (Net-Zero Emissions):
“With operational emissions (energy used to heat, cool and light buildings) accounting for 28% of all global carbon emissions and embodied emissions (materials an construction process during the entire building lifecycle) generating a further 11% pressure in growing on building owners, operators and occupants to reduce their carbon footprint.”
2. The gap between green rental premium and brown rental discount is widening:
“As buildings with strong environmental performance tend to be newer, premium assets, it can be challenging to pinpoint the sustainability premium. Nevertheless, there exists considerable evidence that green buildings command higher rents over comparable non-green properties, indicating considerable potential for a “brown discount” for properties with relatively weaker environmental performance. The income implications for investors are clear: Green buildings will command higher rents and higher capital values, while incurring lower monthly operating and maintenance costs.”
3. Green construction materials are available and viable:
“In addition to the building and construction industries accounting for almost 40% of annual global carbon emissions, manufacturing of concrete and steel each account for about 5%. Viable alternatives, such as timber, are much more environmentally friendly due to carbon sequestration.”
4. Regulatory requirements will continue to tighten:
“The number of ESG regulations affecting property owners has soared over the past decade, as governments and industry bodies mandate green reporting standards.”
5. Effective risk and cost management can enhance resilience:
“In the context of ESG and real estate, resilience refers to risk and cost management that ensure buildings continue to operate in disruptive situations such as the pandemic and extreme weather events. Many of the biggest risks facing the built environment are climate related, with extreme weather frequently leading to significant property damage. Climate change is also contributing to higher utility costs due to more expensive energy production. The longer-term consequences of climate-related risks include policy and technological changes that can dampen the investment appeal of an asset. Older properties are particularly vulnerable, with poor energy efficiency leading to a “brown discount” in property values.”
Social:
“Real Estate is unique as an asset class in that it is an integral component of neighborhoods and communities, is occupied by a broad range of users (including families, students and companies), cannot be physically moved and influences the value and character of surrounding properties and land uses. With property being essential to the economic health of a region and the productivity of all who use it, real estate has a profound social impact on the communities in which it is located.“
6. Affordable housing offers attractive “impact investing” opportunities:
CBRE defines impact investments as “those that generate significant social and environmental benefits, while also providing strong financial returns. The main target demographic for affordable housing is families that earn less than 60% of the Area Median Income (AMI). “Workforce housing” initiatives being pushed by policymakers could expand the availability of affordable housing to many middle-class families, who make around 60% to 120% of AMI an are also struggling with rising home prices. Value-add multifamily asset investments that involve significant property upgrades generally provide returns in the low- to mid-teens, offer stable income and hold their value, often outperforming other real estate sectors during periods of economic volatility.”
7. Health and wellness is influencing building design and operation:
“Proper air ventilation and filtration are emerging as a key focus, not only to prevent the spread of illness but also to increase the energy levels and overall mental health of the occupants. Actionable items to improve airflow include higher ceilings for better air circulation. The pandemic has heightened awareness around hygiene, promoting landlords and facility managers to conduct more intensive and regular cleaning, especially of shared spaces and amenities such as elevators and common areas, and to provide protective products such as hand sanitizer, disinfectant and masks, and install signs and other information points advising building occupants on how to maintain cleanliness.”
Governance
8. Social responsibility is key to good governance:
“By creating a strong ethical and social platform, owners and property managers can strengthen operational resilience and be better positioned to withstand any crisis, such as periods of economic volatility, climate- and health- related risks, and disruptive competition.”
9. Benchmarking and reporting will be essential:
“As investors attempt to monitor and evaluate asset-level ESG performance, the use of benchmarking tools such as the Global Real Estate Sustainability Benchmark (GRESB) will become increasingly prominent. GRESB gathers and compares data on the ESG performance of real estate and infrastructure entities. Other initiative includes the Principles for Responsible Investment (PRI), which requires signatory investment managers to incorporate ESG criteria in their investment processes covering a minimum of 50% of the investor’s total assets under management. Investors will need to come up with a plan to incorporate ESG factors into all portfolios and think creatively about how they will aggregate the outputs for individual investments.”
10. Technology is critical to achieving ESG goals:
“As the focus of ESG strengthens, technology will play a key role in creating significant and long-lasting change within investors’ practices and portfolios by enhancing the collection and reporting of ESG data. These technologies include data management platforms to store and process ESG, data, monitoring platforms to streamline ESG review an delivery processes and Property Tech-based platforms to enhance the tenant experience.”
“Just-In-Case You Missed It” is a monthly letter prepared for multifamily owners and prospective owners. It is a compilation of multiple articles from multiple sources or a reprint of an article from a specific source (source credit given). Its purpose is to present both facts and opinions that may influence our multifamily business in the Southeastern U.S. If you have any questions and/or would like to discuss any of the comments above, my conclusions or your multifamily business, please contact me at your convenience. I can be a valuable resource to you without adding expense to your budget. I look forward to speaking with you and having an opportunity to meet with you. I am always at your disposal to assist you with your multifamily business. If you would like to review previous editions of my monthly “Just-In-Case You Missed It” letter they are posted on my website, www.rickbakermultifamily.com.
Respectfully,
Rick
G.F. Rick Baker, CCIM
Multifamily Specialist/Investment Advisor
www.RickBakerMultifamily.com
2504 Tinderbox Ln.
Greensboro, NC 27455
Cell: 336.549.6083
Email: rickbakermultifamily@gmail.com
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