It is not news to readers that sustainability has risen up the agenda for investors when considering investment strategies. How this has materialised in practice is creating a divergence between sustainability “leaders” and those starting their journey. As we progress through a period of uncertainty across all our local markets, some may believe sustainability could start to drop in significance when it comes to investor decision making. In fact, the opposite is true.
We have seen senior management double down on sustainability, using this period to reassess strategies within existing portfolios. Investors, developers and landlords who continue to pursue sustainability ambitions while navigating the turbulent market will be the winners in the longer term. Sustainability presents the opportunity for investors to differentiate themselves among their peers and sustainable buildings are considered the new prime. Any asset that is not deemed sustainable is now “non-prime” and more likely to be at risk of a brown discount, either in valuations or during marketing. In challenging markets, differentiation is key to success, and the flight to prime ensures resilience.
Funds
There are a growing number of real estate fund products now disclosing under Articles 8 and 9 of the EU’s Sustainable Financial Disclosure Regulation, which is fast becoming a differentiator as it demonstrates to limited partners the fund’s commitments to environmental and social considerations. Once EU taxonomy disclosure becomes mandatory, we will see this reflected at asset level as well as at fund level. The upcoming UK Sustainability Disclosure Requirements will bring further focus.
The objectives of fund products have also seen sustainability criteria added to traditional investment considerations. These objectives may have sustainability key performance indicators focused on environmental or social targets – or both. Examples may include energy reduction targets; net zero carbon goals; green labels; carbon capture; social real estate provision including housing, childcare and retirement living; community engagement initiatives; and accessibility.
Investment
With proposed increased regulation in the UK including EPCs, biodiversity and embodied carbon, business plans now need to account for heightened transition risk around legislation. Once legislation is introduced, it is not only a question of an asset being sustainable or not, but whether it complies with legislation.
Several investors are starting with compliance as a first step; but those who look to go beyond regulation and see it as a stepping stone to supplementing a longer-term strategy are leading the industry with best practice.
When it comes to risk return profiles, sustainability changes our traditional understanding. Investors are having to adapt their approach to risk, resulting in an increase in value-add strategies such as asset enhancement, repositioning and change of use. Some investors are becoming more willing to take development risk to deploy capital and secure better returns. Long income funds would have been viewed as low risk whereas now, due to the long income nature of leases, there is an increased obsolescence risk in the absence of tenant collaboration and mechanisms for intervention (for instance, green leases) or capital allocations.
We have also witnessed a geographical bias relating to progressed green infrastructure. Those cities with a greener grid provide an easier path to achieving net zero carbon objectives, and are obvious targets for investors. JLL has undertaken research which assesses 32 global cities and highlights those leading the way with the most advanced sustainability policies. Will this become a new consideration for investors when finalising fund strategies and locations to invest in? Another could be climate resilience, looking at locations most exposed to climate-related disasters and adaptation policies. This is a wake-up call to governments and local authorities without a robust sustainability strategy, as it could detract from inward investment from investors prioritising sustainability across their portfolios.
Possessing a house view becomes key when developing a successful strategy for integrating sustainability into both investment and asset management decisions. A prevalent trend is that only those leaders in the space have committed to a position on underwriting the risks and opportunities effectively. Some have even published their house view. Those less advanced are still focused on the risks associated with increased upfront capital expenditure. A bigger picture view is required to capture the real value proposition presented by sustainability, and underwriting the upside associated with interventions needs to be considered.
Asset management
Moving to implementation, delivering and scaling a sustainability strategy is an obstacle the real estate industry is facing. Some of the main challenges include data collection, capital allocations for transitioning assets, assessing compliance, underwriting (understanding the value implications – including the upside) and scaling stakeholder engagement. Assessing an asset in isolation is relatively straightforward, but undertaking this exercise at scale is less so. Tech solutions, data collection, tenant engagement, upskilling and proactive management are key to successful implementation.
Due diligence
Sustainability is now an additional part of due diligence when acquiring an asset. When it comes to acquiring, it is critical to have a process around assessing the impact of that asset on the wider portfolio. Setting out go/no go criteria, underwriting and creating a streamlined procedure to understand the required due diligence should form part of an onboarding process. Increased due diligence, particularly regarding net zero carbon, frequently features in investment processes and impacts deal liquidity. These additional steps are having an impact on an investor’s board approval process. Equally, multiple levels of approval may appear at various points in the acquisition process.
Sustainability has influenced investor processes so significantly that a well thought-out strategy is now essential. The additional considerations have added to the responsibility and expectations of professionals across the industry, and we must embrace the changes in order to succeed. In the end, sustainability presents the opportunity for differentiation and leadership, and failure to keep up presents ever-increasing risk.
Janey Douglas is head of sustainability, UK national investment, at JLL
