Deep Dive: ESG moves down private real estate’s priority list

Sustainability and DE&I have taken a back seat to more urgent macro issues. Will organizations be able to get back on track?

ESG has become such a prominent theme in private real estate that it is discussed on most panel sessions at industry conferences. One remark at this year’s PERE Asia summit in February stood out.

When John Pattar, Asia head of real estate at private equity giant KKR, was asked about how high inflation and rising interest rates were affecting the implementation of ESG practices, he responded: “From our perspective, ESG issues are a business issue and an objective you should have long term, regardless of what’s happening in the world.”

Pattar, however, went on to acknowledge the challenge of prioritizing ESG when more urgent geopolitical and macroeconomic issues are at hand: “Short term, it might drop down the list of importance, because you’re dealing with day-to-day, quarterly problems.”

The deprioritization of ESG in private real estate is not a topic many people in private real estate will discuss openly. But the signs of deprioritization can also be seen elsewhere.

Onstage, Pattar himself cited industry institute ULI and consultancy PwC’s Emerging Trends in Real Estate Asia Pacific 2023 survey, which showed that among the 14 most problematic issues for real estate investors, climate change had the lowest rating two years in a row. On a scale of one to nine, with nine being most problematic, climate change was rated 4.74 in this year’s survey. By contrast, interest rates were the highest-ranking issue at a rating of 7.0.

Meanwhile, approximately half of US and Asia-Pacific respondents in commercial real estate broker CBRE’s regional Investor Intentions surveys, published in January, said they were reconsidering or delaying the adoption of ESG criteria because of a worsening economic outlook.

“No one I speak to believes they are deprioritizing ESG. But, anecdotally, I would say that hiring in the space has hit a hiatus,” provided the organization already has its ESG team in place, Matthew Hardy, global head of ESG initiatives at executive search firm Ferguson Partners, tells PERE.

“My take is that the issues are still important to our clients, and they are still grappling with how to meet decarbonization targets, how to manage DE&I issues, how to handle governance requirements, asset rebuild versus refit, etc. But if those issues take a little longer to solve, so be it. Financial viability will always win out. ESG is on every board agenda. But capitalization, navigating the economic and geopolitical obstacles and survival, come first.”

Indeed, ‘adjusting ESG strategy for macroeconomic complications’ ranked number one among five key issues raised in ULI and Ferguson Partners’ Global Sustainability Outlook 2023 report, published in January.

“Balancing the pressure to remain profitable through economic difficulties against the need to dedicate capital for long-term environmental gains will be one of the biggest challenges for real estate in 2023,” the report stated. “Ongoing high inflation, construction costs and energy prices, in addition to looming recessionary conditions across the globe, threaten progress around sustainability in the coming year by stealing real estate companies’ focus and deteriorating the business case for any sustainability upgrades.”

Moreover, increased finance costs this year have stoked fears about less capital being directed to essential retrofitting initiatives and upgrades, according to the report.
To get under the skin of the issue, PERE heard from 10 managers, advisers, industry associations and executive search firms on the reasons for the regional disparity in the prioritization of ESG and DE&I, the implications of this deprioritization and the outlook for organizations to regain focus on ESG and DE&I initiatives in the future.

Regulation is coming

One of the biggest factors behind the regional disparity in prioritizing ESG is the regulatory environment, according to Stéphanie Bensimon, head of Ardian Real Estate, the real estate arm of the French private equity firm. “European countries are really leading the way,” she says, with both the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation having gone into effect over the past few years.

“We see that in Europe, the regulators put environmental factors, especially with regard to climate and carbon emissions, as being very important and, therefore, we see this has a huge impact on how investors are looking at investments, generally speaking.”

Top five sustainability issues affecting real estate decision making:

  1. Adjusting ESG strategy for macroeconomic complications

  2. Embedding transition risk in transactions and valuations

  3. Harnessing the power of collaboration

  4. Addressing global flood challenges

  5. Responding to government influence

Source: ULI/Ferguson Partners’ Global Sustainability Outlook 2023 report

Indeed, compliance with relevant regulations or government targets ranked third among the main drivers of a real estate organization’s stated ESG goals, behind alignment with the company’s own ethics and goals and customer and shareholder demand, according to CBRE’s Strengthening Value Through ESG report, published in February.

In the US, Building Performance Standards – state and local benchmarking laws that require all commercial buildings over a certain size threshold to meet carbon and energy performance improvement targets by a specific deadline – have been introduced to reduce greenhouse gas emissions in the real estate industry. To date, 31 cities, one county and two states enacted BPS prior to 2022, while eight are on track to do the same by the end of 2023. New York City’s own BPS, Local Law 97, will go into effect in 2024. “Regulation is coming,” says CBRE global chief economist Richard Barkham.

“The nuance between regional prioritization on sustainability efforts is largely driven by legislative differences,” agrees Kristy Heuberger, co-head of the Americas at Chicago-based manager LaSalle Investment Management. Like Bensimon, Heuberger also believes legislation in Europe – which she considers to be “years ahead” of where it is in Asia or the Americas – is driving significant action for property investors in the region.

“While we haven’t seen as much legislation on the federal level [in the US], it’s clear that in order to stay ahead of the curve, sustainability and climate risk need to be part of your investment practices now,” she adds. “So you can be prepared when these laws do come into play, and also for the inevitability that more core buyers are going to be folding these considerations into their investment thesis in the near or medium term.”

Despite limited federal regulations, other efforts are underway to implement ESG standards across the US, notes Roxana Isaiu, chief product officer at GRESB. “A lot of initiatives in the US come from industry associations and from the commercial side.”

Industry associations like the NAREIM, REALPAC and ULI, for example, are convening their members to discuss how the pathways developed by Carbon Risk Real Estate Monitor, an EU-funded research project, can be best translated and applied to the US. “These organizations have taken it upon themselves to basically bring together large groups of institutions to define those requirements themselves,” Isaiu explains. “So, it’s more industry driven than government driven.”

Social factors

Meanwhile, Barkham attributes the lower levels of ESG adoption in the US to the country’s social beliefs. “On average, in the Americas, the population as a whole is less convinced about the need to take action on climate change,” he says. “I think it reflects social attitudes more broadly, [rather] than just the events in the real estate market. These broad social engagement, social change types of issues, do take a little bit more of a back seat, typically, when the economy is doing badly – and it’s not particularly doing badly at the moment, but it is probably heading for a recession.”

As for Asia, Barkham believes people in the region are more inclined to think about economic growth as a higher priority than mitigating climate change because of lower levels of wealth and income per capita.

US real estate owners, however, have an additional reason to be less focused on ESG than their Asian counterparts, having been hit harder by office sector woes. Whereas the office occupancy rate is back to approximately 100 percent in Asia-Pacific and 65 percent in Europe, it hovers around 50 percent in the US, according to Barkham. On the higher office occupancy rates in the first two regions, he explains that Asian cities are the most densely populated, with small homes and relatively short commutes, while European cities are somewhat less dense, but still have smaller houses and slightly longer commutes.

“But in the US, you’ve got great big sprawling cities with large houses and long commutes,” Barkham remarks. “And, I hate to say it, the average American office is not a very pleasant place. It’s very generic, very boring, very sterile. And that’s one of the reasons it’s affected the return to office and affected the broader situation in the office market.”

In fact, many US office real estate owners have stopped making any improvements to their buildings. “Our tenant rep brokers are reporting the fact that they do have tenants who are interested in taking leases,” Barkham says. “In order to lease space, they need some co-operation from the landlord in terms of fitout, in terms of negotiation. But landlords are not even negotiating because of events in capital markets.”

Non-regional considerations

There are also non-geographic considerations as to why some real estate organizations are less focused on ESG at the present time. For Heuberger, much depends on what stage a company is at in terms of its adoption of ESG practices. If an organization has not yet begun that process, “this is a tough time to introduce something new,” she notes. “Thinking about sustainability initiatives, decarbonization, getting your arms around climate risk, that is not short term. It is a long-term effort and kicking off a new, pretty meaty, long-term effort, this might be a challenging time to do it. For companies who are already active, I don’t think you’re going to see any change.”

“What’s going to happen in the next year is more important than what’s going to happen in 10 years in people’s minds at the moment”

Richard Barkham

Owners not already active in ESG are more likely to look at the current environment and consider pausing adoption, she says. “But investors like LaSalle, who have been thinking about this and putting it into practice for years, will continue to find ways to move the ball in the short term so we’re not derailing our long-term plans.”

The size of the company is another factor, Heuberger adds. “I understand the fact that companies the size of LaSalle have the resources to focus on the acute issues at hand and continue to devote time or resources to foundational strategies, as we call it, such as DE&I or sustainability.”

By contrast, “smaller companies might have more of a challenge,” she says. “Sustainability efforts may see a short-term pause among some smaller owners. But, in the long term, these efforts will continue to be necessary to stay competitive.”

Staying competitive

The deprioritization of ESG and DE&I will continue for the duration of the recession, Barkham predicts: “I don’t know that it’s going to be a hard recession. But it could be a long-ish run; it could last into 2024.”

He does not expect deprioritization to be permanent, however. “I think it’s related to the current stresses in the property market, that people are trying to figure out where the economy’s going,” he says. “What’s going to happen in the next year is more important than what’s going to happen in 10 years in people’s minds at the moment. But that won’t last.”

One factor keeping some building owners on track is the need to stay competitive, with pressure coming from occupiers, Barkham observes.

“You’ve got a situation where the economy is disrupted, barriers are falling, there’s some credit crunch going on in the capital markets,” he says. “But occupiers are wanting to lease buildings where at least some of the measures to mitigate carbon emissions have been taken. And I don’t think landlords will be able to be competitive when we get through all of this without really addressing those tenant requirements.”

Indeed, more than 30 percent of occupiers were willing to pay a premium for a building with features that reduce energy consumption, according to the CBRE ESG survey. Where an asset lacks such features, 20 percent would ask for a discount and nearly 30 percent would exit or reject the building, the report stated.

Large corporate tenants are increasingly seeking leases in ESG-compliant assets, Bensimon agrees. “I think it’s something that they will ask for more and more and it will go from being a ‘nice to have’ to ‘a must’ if you want to achieve good rents, if you want to achieve good traction.”

In the face of short-term concerns, Heuberger stresses the importance of not losing track of long-term initiatives and pushing back on ESG and DE&I issues becoming deprioritized. “I think business leaders are definitely grappling with a lot of things in this turbulent environment, and understandably, their focus is on these acute issues,” she says. “But as good leaders, in addition to being focused on addressing those acute issues, we also have to continue to think about the future and prepare for the future. It’s not just about the next six months.”

Even a short-term loss of focus can be damaging for long-term initiatives like ESG and DE&I, Heuberger asserts. On the latter, “I think leaders today understand creating diversity takes time and that doesn’t happen overnight,” she says. “And some of what you’re doing in the industry, that’ll take years to come to fruition and you don’t want to be behind later. So you just can’t take that on and off.”

By contrast, organizations that continue to focus on sustainability and DE&I during volatile times will have a competitive advantage, she adds: “The market will stabilize at some point and those who have continued to make progress during market uncertainty will be ahead of the curve.”

Playing catch-up

Barkham does not believe the time lost from a short-term delay in ESG initiatives will have longer-term repercussions. “I think there’ll be a catch-up period when we come back on balance,” he says.

Moreover, industry laggards will benefit from early adopters of ESG practices and firms that already have done a lot of the legwork, adds Bensimon. “In our organization, for example, it took us a lot of time, just from a technical point of view, with regard to how we decarbonize assets,” she says, noting that 100 percent of Ardian’s real estate assets are now in some stage of decarbonization.

“Financial viability will always win out”

Matthew Hardy
Ferguson Partners

“I think all the countries that will have to catch up, they will learn from the others, because we have for sure lost a lot of time by trying to do things and also not standardizing things from one country to another or even from one organization to the other.”

In Bensimon’s view, the private real estate industry will not make progress on ESG until organizations collectively move forward together: “I do believe that we have a responsibility as investors to communicate our best practices because that’s the best way for the industry to catch up more quickly.”

But in their joint report, ULI and Ferguson Partners believed “the real estate industry is not moving fast enough.” The groups pointed to a Savills report showing 85 percent of commercial real estate buildings in Europe not meeting current energy efficiency standards, and Green Finance Institute data that only 1 percent of buildings undergo energy efficiency renovations each year.

Evidently, the industry has a lot of catching up to do and – with various deadlines and target years looming – increasingly less time to do so.


One positive impact

In one respect, at least, macro issues have helped to move the ESG agenda forward

Although prices have somewhat moderated since the start of Europe’s energy crisis last year, “the shocks still remain and there are lingering effects from that,” says GRESB’s Roxana Isaiu. That has raised awareness, not only among landlords and managers, but also tenants and users of buildings, about the risk of energy costs potentially spiking overnight because of exogenous factors, she observes.

“I think that has put a spotlight on the fact that energy efficiency and building efficiency does protect you against long-term risks, but also short-term risks,” Isaiu adds. “So, I think the effects of the shocks are now translating into action plans and investment plans to invest in energy efficiency measures, to look at alternative sources of energy. And the whole idea of where we get energy from and who we rely on for that is very relevant and very present.”

Jeffrey Shen, co-founder and co-chief executive at Hong Kong-based manager ESR, adds that most countries in Asia-Pacific are facing an energy shortage, particularly with regard to green energy. Hence real estate organizations in the region are increasingly seeking renewable energy investments to address environmental concerns while also improving returns. “In Asia, I think most of the major countries are pushing that from the government and institutional level,” he says.