Green Building Trends and Drivers for U.S. Commercial Real Estate Investors
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Loading... - Oline Fegth
- 19 Jul 2024
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Institutional investors in commercial real estate face numerous challenges impacting their investment decisions, with higher interest rates being a significant factor. According to the Urban Land Institute’s (ULI) "2024 Emerging Trends in Real Estate" publication, prolonged periods of high interest rates slow economic growth and reduce business investments. While some investors see opportunities ready to be seized, others, particularly those managing core funds, are waiting for prices to fall before making investments. Consequently, institutional investors are focusing on investing in existing assets and taking actions that produce a quick return on investment (ROI), increase marketability, reduce risk, comply with regulations, improve valuation, and meet tenant demands.
Risk Mitigation as a Core Business Function
According to RE Tech Advisors, where they manage over $1.5 trillion of assets, climate risk is a key priority associated with sustainability. Climate risk is viewed from two angles: transition risk and physical risk.
Transition Risk
Transition risk refers to the risks associated with moving to a low-carbon, more sustainable economy. These risks include regulations, geopolitical reputation, and consumer demand. Policies and regulations are crucial drivers for investor decisions. European regulations and reporting requirements, such as the Sustainable Finance Disclosure Regulation, impact investment decisions in the U.S. Various environmental regulation initiatives are underway in the U.S., influencing how investors assess transition risk.
One such initiative is the U.S. Securities and Exchange Commission’s (SEC) pending regulations on climate disclosures, which would require companies of a certain size to publish sustainability-related information describing any climate-related risks likely to have a material impact on the company’s business or consolidated financial statements.
In the U.S., numerous benchmarking policies and building performance standards exist at state and local levels, with some imposing material penalties for noncompliance. Noncompliance can lead to lower ROI and higher vacancy rates. According to CBRE research, failure to comply with these policies in certain jurisdictions could decrease net operating income by 5.1%–5.8%. As new policies and standards are released, commercial real estate investors must navigate them to meet reporting and reduction targets, such as those associated with Scope 1 and 2 versus Scope 3 GHG emissions.
Physical Risk
Physical risk refers to the tangible impacts of climate change, including flooding, fires, droughts, and extreme heat. Over the past 40 years, the U.S. has seen an increasing number of multibillion-dollar climate disasters. In 2023, for example, 28 separate weather and climate disaster events with costs and damages of $1 billion or more occurred. Climate disasters have caused large increases in premiums and bankruptcies, with insurance companies eliminating some coverage in states like Florida and California.
To better understand and mitigate climate risk impacts on business operations and investments, commercial real estate investors are assessing risk through initiatives like GHG inventories, establishing GHG reduction targets, and exploring decarbonization plans. Investors are implementing portfolio-wide emissions mitigation efforts, with prioritized building-level improvements and changes using capital and operational expenditures. Certifying building portfolios with evolving green building rating systems, such as LEED, can streamline performance improvement, especially with LEED v5’s focus on decarbonization and resilience efforts.
Data Management
Data and data management are crucial for mitigating climate risk in commercial real estate. The types of data needed for this work vary, and sourcing, integrating, and analyzing this data can be overwhelming. However, this work guides investment decisions, helps assess risk, supports resilience planning, and ensures regulatory compliance. Increasing climate reporting requirements, driven by regulations or capital provider inquiries, are pushing investors to integrate ESG information with financial reporting. The International Sustainability Standards Board was created to support this through standardization, minimizing confusion and aligning different sustainability frameworks globally.
Common challenges with data management include data availability, particularly whole-building utility data, data quality and accuracy, data integration and standardization, and data acquisition costs. Addressing these challenges requires collaboration among stakeholders, including government agencies, research institutions, real estate developers, and technology providers. Associations and federal agencies, like the Building Owners and Managers Association, Institute for Market Transformation, and the EPA, are focused on whole-building data acquisition.
Access to Capital
Access to low-cost capital is crucial for real estate investors to manage climate risk and complete energy and carbon reduction projects. Governments, financial institutions, utility companies, and various organizations offer financial incentives, such as grants, subsidies, tax credits, or low-interest loans, to encourage investments in climate-resilient real estate projects. These incentives help offset the costs of implementing green infrastructure, energy-efficient technologies, and other resilience measures. The Better Buildings Financial Solutions program from the U.S. Department of Energy identifies when building owners should approach public and private financing sources.
Green finance opportunities are filling a key role in bridge financing for decarbonization projects. The Inflation Reduction Act authorized the creation of the Greenhouse Gas Reduction Fund, informally known as a national green bank.
Rising Insurance Premiums
Real estate investors are also focused on rising insurance premiums. Alternative risk transfer strategies, such as credit swaps, insurance binders, highly protected risk, and indemnity agreements, are being explored to minimize costs and safeguard capital expenditure reserves. Real estate owners evaluate which risks to self-insure versus transferring to third parties through contracts or insurance. Investors are working closely with brokers and insurance teams to find steps to lower rates. For example, insurance companies may offer reduced premiums to developers and property owners who implement climate risk mitigation measures.
Institutional commercial real estate investors are increasingly prioritizing sustainability and climate risk mitigation in their portfolios due to mounting transition and physical climate risks. Effective data management has emerged as a critical factor in navigating this evolving landscape. Data-driven insights allow investors to seize opportunities, foster resilience, meet changing tenant demands, and contribute to a sustainable future for the commercial real estate sector.
Understanding and leveraging sustainability-oriented financing sources is complex, but investors can navigate these options by:
- Networking with industry associations and working groups.
- Staying informed about current and upcoming regulations.
- Understanding utility and municipal incentives through resources like the Database of State Incentives for Renewables & Efficiency.
- Exploring CPACE (Commercial Property Assessed Clean Energy) financing.
- Piloting and testing financial strategies within portfolios.
- Reviewing industry reports, policy guidebooks, white papers, and federal websites.
- Using advisory consulting support.
By adopting data-driven strategies and exploring diverse financing options, investors can significantly enhance the sustainability and resilience of their commercial real estate portfolios. Embracing these approaches will help meet regulatory requirements, tenant expectations, and company goals while yielding higher risk-adjusted returns.
