By Fong Yee, Senior Product Manager, Sustainable Investing, FTSE Russell.

Green real estate: A building block for a low carbon economy?

Carbon intensive sectors are facing unprecedented scrutiny from governments, regulators, and markets. Since this can have a significant impact on liquidity and asset values – indeed, the effects are already becoming visible – it is a factor that investors cannot afford to ignore.

The real estate sector, which is characterized by long-lived and energy-intensive assets, is one such target.

The UN estimates that buildings account for over half of global electricity usage, about 28% of global carbon emissions, and over 10% of potable water consumption.

To keep global warming below 2 degrees as mandated by the Paris Agreement, the real estate sector alone will need to reduce total CO2 emissions to 36% by 2030.

As policymakers try to accelerate emission reductions across entire economies, building stock with poor environmental performance is a likely target for new policy measures. This creates significant policy risk for real estate investors who, in a worst-case scenario, could see substantial reductions in asset values and liquidity.

This is happening now: UK landlords can no longer let residential or commercial buildings with F- or G-rated energy performance certificates. New York City’s Building Emissions law (Local Law 97) aims to cut emissions from buildings by 40% (by 2030) by placing a cap on carbon emissions for buildings over 25,000 sq. ft. (2,300 sq m2).

The UN-backed Principles for Responsible Investment (PRI) expects decisive government policy measures globally by 2025 and has highlighted how these measures will have a clear impact on businesses and their investors.

It’s not necessarily bad news, though. In contrast to other carbon-intensive industries, the real estate sector benefits from a range of cost-effective, well-understood solutions to reduce energy use and achieve carbon savings.

Furthermore, there’s also is a growing body of evidence suggesting that strong sustainability performance contributes to better branding and higher asset values in the sector. Several recent studies see a correlation between greener buildings and higher occupancy rates, higher rental values and reductions in operating costs.

Our own analysis suggests that investors can be exposed to green real estate portfolios while limiting downside risk. The performance of the FTSE EPRA Nareit Green Real Estate Index Series, for example, suggests green real estate has provided increased exposure to real estate portfolios demonstrating strong sustainability performance while minimizing tracking error versus the market cap benchmark.

Source: FTSE Russell.

Challenges remain at the portfolio level as investor-focused tools for real estate have been limited. Unlike listed equities and, to a lesser extent, bonds, property investors have lacked comprehensive data that allows them to systematically factor climate concerns into real estate investment portfolios. Ultimately this is a problem of disclosure, and whereas listed companies increasingly provide information on ESG issues to investors, real estate companies lag other sectors.

Market leaders often disclose third-party assured data across a range of sustainability considerations but most do not. As an example, less than half of the largest 50 constituents of the FTSE EPRA Nareit Developed Index, which is designed to represent general trends in eligible real estate equities worldwide, report their carbon emissions. Disclosure levels will have to improve as investors demand better data. The industry will also need to develop innovative, alternative approaches to assessing real estate portfolios where data gaps remain.

Pressure for change, therefore, won’t just come from the policy angle. Investors are setting increasingly ambitious sustainability targets across their investment strategy and asset allocation and capital is starting to shift towards more sustainable assets/mandates. This will accelerate as data and financial products become more available.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)