How equity investors measure the financials behind sustainability

Across the world, real estate owners have made progress in making their portfolios sustainable. However, quantifying the impact of green practices on real estate investments remains difficult.

How does sustainability translate into actual performance? The answer is not always clear-cut. Numbers relating to cost savings are not difficult to find. For example, after buying 475 Sansome in 2012, Toronto-based real estate investment advisor Bentall Kennedy implemented waste diversion, energy and water conservation measures and a tenant engagement programme at the San Francisco office building.

The firm has disclosed that since then, the property’s energy costs have fallen – declining by $77,000 in 2017 alone – and led to an increase in net operating income of $418,000 over the 2012 to 2017 period.

Savings: The 475 Sansome building in San Francisco. Bentall Kennedy’s sustainability measures
have significantly cut energy costs at the property.

But calculating the overall financial impact of sustainability measures on the return on a property investment is far from straightforward. “A lot of times, there’s this desire to say, there’s this direct line from sustainability to this performance, and there’s a lot of factors that go into asset performance,” says Molly Bordonaro, managing partner at Portland, Oregon-based real estate investment manager Gerding Edlen. “We are absolutely certain that everything we do around sustainability drives value into the asset, in terms of how we’re able to market, lease and generate higher rents.”

However, the location, quality and size of the property also are important factors. Bordonaro therefore speaks about the impact of sustainability on the firm’s assets in broader terms. “We certainly position our properties as different in the marketplace,” she says. “We tend to be able to lease our buildings faster and we tend to be able to drive higher value in terms of rents or net operating income.”

The most significant impact on value, however, is Gerding Edlen’s high tenant retention rate, where approximately 60 to 65 percent of the tenants in their apartment properties renew their leases per year, compared with the market average of approximately 45 percent.

“The market is yet to adopt a mature and transparent approach to monetising and valuing sustainability benefits, although a positive shift in this direction is becoming more evident,” researchers Surabhi Sheth and Saurabh Mahajan wrote in a 2014 report from the Deloitte Center for Financial Services. However, “there is increasingly clear evidence that buildings (re)designed with green features will depreciate less quickly than others and will be more likely to meet the growing demand of a more discerning occupier and investor market,” the authors said.

In fact, in markets where green buildings are common, properties that lack sustainability features often tend to have a “brown discount”, implying a potentially lower rental rate or sale price than the market average, the authors said.

Indeed, real estate owners need to take sustainability into account in order to keep their properties from becoming obsolete, says John D’Angelo, managing director at Deloitte. “At some level, it has to do with assets continuing to be relevant or continuing to hold value in a marketplace. When it first became a term, it was more of a touchy-feely, feel-good thing and now it’s just hard-nosed asset relevance.”

David Antonelli, executive vice-president at Bentall Kennedy and portfolio manager of Multi-Employer Property Trust, the company’s open-end real estate fund, says that with tenants demanding more from buildings they occupy, properties with environmental and wellness features will tend to be more profitable.

“Sustainability should be considered for its merits as a revenue generator, given its importance in the evaluations that present and prospective tenants are making about where to reside,” says Antonelli. Meanwhile, operating cost savings and enhanced revenue make sustainable buildings 8 to 10 percent more valuable than other properties, according to Antonelli.

One common misconception about the financial impact of sustainability deals with cost savings, when in reality the benefits are more far-reaching. Aside from cost savings, “sustainability investments result in even broader payback in the form of higher rental income and occupancy, improved valuation, easier and lower-cost financing, lower operating expenses, property tax rebates and discounts on insurance premiums”, Sheth and Mahajan wrote in the Deloitte report.

Moreover, cost savings have less of an impact on overall returns than the “top-line benefits” of higher rental and occupancy rates and higher property values over time, they noted. Meanwhile, the higher loan-to-value ratios of loans available to LEED-certified buildings have the most significant impact on the post-retrofit internal rate of return on the overall building investment.

After an existing office building is retrofitted with measures such as energy and water efficiency and waste reduction, the IRR of an overall building investment increases by 98 to 220 basis points post-retrofit, according to the report.


Another misconception is that sustainable practices cost more than standard improvements. “Research demonstrates there isn’t a significant incremental cost of greening an existing building compared to the cost of mending a building exterior,” Sheth and Mahajan wrote. More awareness and education on sustainability practices has also helped to reduce the costs of green certification.

“To a large extent, the hesitance toward sustainability adoption can be attributed to the lack of awareness about returns versus costs.”

Overall, many real estate managers still have a way to go when it comes to adopting sustainability measures. “If you set the bar as who’s best in class, who are top quartile, it’s 20 percent maybe by AUM that really have their act together,” says D’Angelo. “They’ve got expertise, there’s somebody who’s thinking about it every month.” He points to the annual GRESB real estate assessment survey, which assesses the sustainability performance of real estate assets globally and estimates up to half of managers “scramble” every year to compile the data needed to complete the survey, while the remainder simply don’t even have the data.

“If you’re doing right, it shouldn’t be a scramble,” he says. “The data should be at your fingertips because you’re using it as part of your day-in and day-out management process.”

Yet another misconception is that sustainability measures are incompatible with closed-end funds, since a manager would not be able to see the upside of that investment, and therefore generate an appropriate return, within the life of the fund.

“We see results very early on,” says Bordonaro, whose own firm manages closed-end funds. Indeed, Gerding Edlen saw cost savings of $11,700 in 2017 from a co-generation system installed at The Eddy, one of its residential mixed-use properties, according to a 2017 report on the firm’s Green Cities II Fund. The asset was just completed in 2016. And not all sustainability measures involve expensive upfront costs. From 2016-17, Gerding Edlen partnered with a local utility company and three other organisations to launch a pilot “Eco-Concierge” programme at one of its apartment properties in Chicago. This included a web-based gamification platform used by tenants to earn points by logging their sustainable actions and consequently be eligible for prizes. The sustainable actions connected to the game resulted in the equivalent of average utility bill savings of $70 per player, while the programme was implemented at the property at no cost to the firm.

Dan Winters, GRESB head of America, agrees the impact generated by sustainability measures can be seen far more quickly than many people assume. “Marginal investments to reduce operating expenses are immediately reflected in NOI, while achieving an Energy Star or LEED rating signals asset quality at key financial moments of truth – leasing and sale transactions.”

For example, at a 6 percent cap rate, a property acquired for a value-add fund can gain nearly $17 per square foot in value for every $1 per square foot in operating expense savings, according to Winters.

He expects as more real estate managers incorporate green practices, not only will the environmental performance of the firms improve over time, so will their financial performance.

In real estate, water and energy will be “some of the biggest spend on a regular basis on an asset level,” says D’Angelo. “If you can move the dial on environmental performance, there’s going to be a return.”