Behind The Surge In ESG Commitments
Environmental, Social and Governance—known in the industry as ESG—practices aren’t new. Over the last decade, commercial real estate players have increasingly considered the environment and sustainability when underwriting investments and operating properties, but the pandemic has catalyzed rapid growth in ESG adoption. In 2020, public funds, private equity firms, high net worth investors and nonprofit companies aggressively increased ESG commitments, and many are acknowledging the critical role that ESG practices will play in the future of real estate investment.
Companies Increase ESG Goals in 2020
The pandemic pushed ESG policy and practices into the spotlight. According to research from JLL, mutual funds and EFTs invested $288 billion globally in sustainable assets from January through November 2020, a 96% increase over 2019. The UN also noted that corporate net-zero pledges increased three-fold year-over-year.
“We have absolutely seen an increase in commitments over the course of 2020. The number of corporations that committed to science-based-targets, for example, equaled the previous five years combined and the fund flows into US ESG funds, according to Morningstar eclipsed $50 billion, up from $21 billion in 2019,” says Lori Mabardi, senior director of ESGR research at JLL. “The global conversation around the need and urgency to shift from a shareholder economy to a stakeholder economy has been underway for some years but reached a new apex in 2020.”
At the Morningstar Investment Conference in September 2020, Blackrock became exemplary of the trend when the company’s CEO Larry Fink announced plans to integrate ESG metrics into 100% of the firm’s portfolio by the end of the year. This year, he reaffirmed the importance of ESG policy in his 2021 letter to CEOs. “Over the course of 2020, we have seen how purposeful companies, with better environmental, social and governance profiles, have outperformed their peers,” he wrote. “It is clear that being connected to stakeholders—establishing trust with them and acting with purpose—enables a company to understand and respond to the changes happening in the world. The more your company can show its purpose in delivering value to its customers, its employees and its communities, the better able you will be to compete and deliver long-term, durable profits for shareholders.”
Individual investors support the touted benefits of ESG on the bottom line. Avanath Capital Management has focused on ESG investing since its inception, and in January, the firm closed its fourth discretionary fund with $760 million in equity commitments, exceeding its initial target of $550 million. “We focus on investing in underserved communities across the US, many of which are minority communities,” John R. Williams, President and CIO, says. “We then improve upon these communities by incorporating sustainable features and social programming that enhances residents’ lives. We have always taken a holistic approach to investing and deeply believe that it results in better outcomes for all, residents and investors. This is why we continue to focus on ESG and are committed to it being a key component of our investment strategy.”
San Diego-based Comunidad Partners has also committed to ESG investment practices, believing that these policies benefit communities and the environment and also produce strong financial results. “We’ve been able to demonstrate empirically that positive social and environmental returns translate into alpha in financial returns,” Antonio Marquez, managing partner at Comunidad Partners, explains. “We’re at the precipice of ESG being adopted as a legitimate pro-social, for-profit strategy in our industry. The increased interest particularly from institutional capital is enabling validation, liquidity and scale for ESG as an investment strategy.”
Before the spectrum of CRE players focused on ESG, REITs had already planted deep environmental programs. According to Nareit’s June 2020 ESG report, 89% of REITs were already publicly reporting ESG metrics in 2019. This was a significant step toward industry-wide ESG adoption because REITs collectively own about $2 trillion in real estate and help finance 2.8 million homes in the US.
But, the commitments to ESG run even deeper than environmental reporting and sustainable practices. Many companies are also recruiting ESG executives to establish policy and achieve these goals. Last year, for example, Blackstone hired Eric Duchon as global head of real estate ESG in a newly created position to build and scale existing environmental, social and governance efforts, and JLL appointed Guy Grainger to the newly created role of global head of sustainability services and ESG. These moves reflect the growing interest in ESG throughout the industry. “We have seen an exponential increase in the number of potential and current investors who are asking questions about sustainability, as well as in the level of detail requested,” Elena Alschuler, Americas head of Sustainability at LaSalle Investment Management, says. “It’s no longer enough to show investors our ESG policy and list of green certified buildings. Now investors are asking LaSalle to explain our goals, progress metrics and data validation processes; how we incorporate sustainability into our investment process and asset operations; and our internal governance and accountability structure for these activities. We are also getting more questions about climate risk and resilience, and our investment and tenant screening policy.”
Inside ESG Investment Strategy
ESG investment can have a broad definition. It includes the environment and sustainability as well as social impact investment in underserved communities and a commitment to inclusion and diversity, both at the corporate level and within underwriting and investment practices.
Climate change has been the primary driver of interest in ESG policy. That isn’t so surprising, considering that energy efficiency at the property level produces immediate and easily recorded cost savings. “It is becoming widely known that climate risk is indeed a financial risk. When we look at the extreme climate events that cause $1 billion in damage, we have seen a quadrupling over the last four decades. According to NOAA, in the US, from 1980-1989, we incurred $178 billion in damages from extreme storms. In the last decade, from 2010-2019, that number rose to $811 billion,” Mabardi says. Alschuler adds that the ‘E’ in ESG—meaning environment—has been the most critical aspect of ESG policy for real estate owners and investors. “It has impacts across business units and is therefore increasingly being incorporated into everyone’s roles and typical business processes,” she says. “Best practices in ESG add value and mitigate risk. As research continues to reveal the full value of ESG, we see more correlation between ESG and value.”
Interest in the other components of ESG—social and governance—has increased tremendously in the last year. “For many years Governance has been a topic—in particular, for public funds as it pertains to their public securities holdings,” Dan Cashdan, president and senior managing director of JLL Capital Markets, says. “Over time Social issues with regard to DE&I have worked their way into investor underwriting, if not specific decision making, beginning in 2021 there has been a flood of interest and apparent commitment or engagement on the topic of Environment—really climate change. The subjects are in many ways independent—and yet easily interwoven. A challenge is to make real sustained progress one each both independently and collectively.”
In the wake of increasing violence and discrimination against BIPOC communities, companies have also targeted the social aspect of ESG policy within their investment decisions. “Somewhat independently the US has experienced a wakeup call with respect to social matters and specifically race—equity, social justice and so on. This is a massive topic that seems to be getting renewed attention based on events that took place over the course of 2020,” says Cashdan. Mabardi agreed that social impact gained momentum in 2020, driving the ESG agenda. “Gen-Z is right behind the Millennial generation and is expected to account for 30% of the workforce by 2025,” she says. “This generation is very purpose driven and puts environmental and social justice top of mind. They will work for and buy from the companies that take these matters to heart.”
Social impact investment is the core focus on Avanath Capital and Comunidad Partners’ ESG platforms. These investment firms continued to expand internal ESG programs last year. Avanath launched Amplify to create an ESG model that would serve as an example for the industry. “The platform’s goal is to extend the success of Avanath’s authentic social commitments and programs to build a best-in-class environmental, social and governance program that serves as a model for the industry,” says Williams. “We also believe that through our robust reporting on ESG metrics that we can set benchmarks for best practices for the industry.”
Comunidad Partners launched a virtual healthcare program at its workforce housing properties, expanding its services to residents. “Our social programs focus on three areas: equity and economic advancement, health and wellness and education. We execute on these focus areas by integrating a variety of social programs such as jobs and vocational skills programs, virtual healthcare that provide better access to medicine and health services and after-school programs, among many others that help build income and lower household expenditures to drive resident wealth,” says Marquez. “We believe that in doing so we can reduce turnover, increase retention, and enhance the overall value of our properties.”
In 2020, companies across the spectrum of the CRE industry doubled down on ESG commitments. Mabardi says that this includes corporations and investors as well as cities, all of which are doing everything from establishing a team, committee or leadership to focus on ESG; setting goals, both in terms of the environment and diversity; creating a framework to measure goals; making strategic investments; and achieving net-zero carbon within the portfolio. “It feels we may have reached a tipping point, where we have the tools, the technology, the pricing and the pressure to meet this moment and achieve meaningful change,” she says.
Still, in terms of strategy, climate change continues to take center stage. Most companies’ ESG announcements in 2020 focused on the environment. “Mainstream companies are announcing their commitments to decarbonization, the importance of ESG and using it as part of their branding strategy,” says Alschuler. “More companies are announcing Net Zero Carbon targets including more than 50 companies that make up the Climate Pledge committed to Net Zero carbon by 2040. The Net Zero Asset Owner’s Alliance and its 35 investor members are committed to transitioning their investment portfolios to net-zero GHG emissions by 2050. Both companies and investors have increased their commitments and/or their timelines for action.”
Will Companies Hit New Targets?
The big question now is not the level of interest in and adoption of ESG policy, but rather if companies will be able to hit the—in some cases—aggressive benchmarks that they have laid out. “Environmental and Social issues are not simple to solve, and reaching meaningful goals will take real commitment; that said, in a lot of ways, it can be seen as a critical investment in doing the best you can to future proof your business in an ever-changing world,” says Mabardi. In terms of meeting those goals, Cashdan says, “Time will tell.”
But, investors are working fervently to meet these targets. Williams says that Avanath is regularly tracking all of its ESG policies against established benchmarks. “We have even begun to incorporate the ESG best practices that we have honed over the last several years into our due diligence process and recently launched an ESG advisory council. Each of these components aids in ensuring we are meeting and often exceeding our goals,” he says.
At Comunidad, Marquez says that the firm leverages technology and data to ensure that they are meeting internal goals. The firm also has proprietary technology developed for the sole purpose of meeting standards. “We are extremely data driven so we are tracking and reporting on our ESG goals with a proprietary platform we built from scratch because we couldn’t find anything in the tech application market that addressed our needs,” says Marquez. “We have also created a proprietary system that tracks key performance indicators and an impact scorecard based on a scoring algorithm and then maps all of our KPIs to UN SDGs on metrics related to environmental, social, and governance practices.”
Internal tracking is essential to meeting targets, but Alschuler adds that the industry is also headed toward increased transparency around ESG goals. “Many companies and investment managers are making big commitments and setting intermediate targets to benchmark their performance in reaching these goals,” she says. “As we all ramp up our efforts to slow and mitigate climate change, frameworks such as GRESB and the EU Taxonomy/SFDR will help prevent greenwashing and make sustainability progress more transparent and accountable to investors.”
There is also a bifurcation in tracking ESG impact. Environmental metrics are easier to report and illustrate than social metrics. That is where the industry will find the biggest challenge. “The environmental component of ESG is relatively easy to track. If you start using a grey water system or solar panels, you can see decreases in water or electric costs as well as how these shifts can work to make a property more sustainable over the long term,” says Marquez. “Social impact is much more difficult to track and set benchmarks as it relates to residents, resident outcomes, and the overall community. This makes tracking this data a bit more challenging.”
Williams agrees that measuring social impact is the biggest challenge for the sector. The firm has looked to outside experts to help establish and measure social benchmarks. “Over the years, we have made it a focus to address this challenge and come up with innovative solutions to truly measuring impact,” he says. “We previously worked with the University of Southern California to conduct a study of our after-school programs at one of our communities in Long Beach, which was used to create initial benchmarks and measure the true impact of our social programs over the long term.”
All experts agree that achieving ESG targets will only get easier as more companies embrace ESG policy and adopt technology and strategies to support growth. These policies are only gaining momentum, and with them will come more infrastructure and transparency.
ESG Practices in 2021 and Beyond
The pandemic catalyzed adoption and expansion of ESG policy, but there is more growth ahead. Experts agree that attention to ESG will continue to gain momentum in 2021 and beyond, particularly if large portions of the country continue to experience natural disasters—as we already saw in Texas earlier this year. “We believe that ESG adoption and investment will continue to grow over the next five years and well into the future,” says Williams. “This increased focus on ESG is something in which we have been advocating for some time and something we are extremely pleased to see in the industry. Impact can truly positively enhance property performance and we are excited to see more institutional capital allocating to this sector.”
The future of ESG adoption will also gain momentum as the broader financial industry incorporates environmental and social metrics as a measure of performance. Mabardi says this has already started to happen. “We’ve also seen a shift on Wall Street, and the SEC indicating that companies will be graded and measured on how they are doing against ESG key performance indicators,” she says. “In fact, the CFA has just announced a new ESG module, and so analysts are going to keep getting better versed in how to value companies against their ESG actions and outcomes. Lenders, and insurance companies are also moving in the direction to include ESG in their decision making and pricing. All of these drivers will mean action.”
However, Alschuler says that long-term adoption and expansion will depend on several factors, including capital and returns. “We should watch the extent to which investors drive ESG growth through requiring sustainability goals and performance improvements,” she explains. “How heavily will sustainability weigh in capital allocation decisions? How will investors balance sustainability goals and financial return expectations for funds that have sustainability objectives but are not explicitly designed to be impact funds? The answers to these questions will determine the pace of progress.”
While there are some challenges and questions ahead, the outlook is bright for continued adoption and expansion of ESG policy, particularly among institutional capital sources. In turn, this adoption will lead to better compliance and transparency. “We anticipate institutional investors to continue to increase allocations and, accordingly, more fund managers will adopt ESG policies due to increased investor appetite, which is on net a good thing,” says Marquez. “The challenges today are transparency, data and benchmarking, but these are also opportunities to demonstrate what we’ve known for over a decade, which is that ESG can translate into meaningful outperformance and help manage investment risks.”
That is really the key. Outperformance is, of course, the ultimate driver of increased ESG commitments—and improved returns will ensure that ESG stays in the spotlight both in periods of economic dislocation—as we saw in the last year—and economic growth.