This was the year ESG became a political football, as politicians on the right railed against “woke capital” and those on the other side decried insufficient progress toward net zero. Caught in the middle was the world’s largest asset manager, BlackRock, which seemed to soften its assertive stance on climate and sustainability under pressure from US Republicans. Meanwhile, challenges to the very basis of ESG went mainstream, with a New York Times op-ed declaring “One of the Hottest Trends in the World of Investing is a Sham.”
That opinion piece concerned ESG funds of publicly traded stocks and the questionable criteria used to rate them. In real estate, the use case for ESG is in one sense clearer: a property’s potential vulnerability to worsening weather events is plainly material to the decision to invest. And yet a 2021 survey by Preqin found that, among private asset classes, real estate managers were the most skeptical about ESG’s impact on returns, with 30 percent calling it “a major challenge to outperformance.”
Such skepticism aligns with the position of the 19 Republican state attorneys general who told BlackRock that ESG investing represents a breach of its fiduciary duty to public pension plans. BlackRock declined to comment, but according to real estate investment professionals who spoke with PERE, ESG has established itself as more than just a means of assessing environmental downside.
ESG – and V
“The role of ESG in real estate has evolved from identifying and mitigating risk to using ESG to drive value creation,” says Lisa Brylowski, vice-president at Brookfield Asset Management.
Brylowski oversees real estate ESG for the firm. “A few years ago,” she recalls, “customary pre-investment due diligence consisted of commissioning basic environmental reports and completing mandatory ABC reviews. Now, diligence has evolved to include evaluating climate change resilience, considering a multitude of social factors and undertaking extensive governance checks to fully understand the risk and opportunity set of a potential investment.
Priya Prasad Bowe, managing director and head of ESG at Oaktree Capital Management, expresses a similarly expansive conception. “ESG analysis is a tool for identifying risks and opportunities that might have been missed by more traditional analysis,” she says. “We believe that, contrary to the idea that ESG work is to the detriment of returns, it has the potential to generate value.”
According to Prasad Bowe, the backlash from red state governments has not led to second thoughts among institutional investors. “We have not seen US LPs backtrack from their sustainability commitments,” she says. “Meanwhile, LPs outside of the US continue to advance their sustainability objectives, seemingly agnostic to the American political and regulatory environment.”
“Contrary to the idea that ESG work is to the detriment of returns, it has the potential to generate value”
Priya Prasad Bowe
Oaktree Capital Management
As a pressing challenge to ESG, she points instead to the persistent lack of actionable data. She says: “In certain sectors, such as residential, access to individual tenant data is still very hard to obtain. Jurisdictions like New York City have made access to whole building data and cooperation with the utilities easier, but many parts of the country and asset types have a long way to go.”
In addition to the data itself, Prasad Bowe says the industry needs better tools to manage it, as well as agreement on how to use it to measure performance. “Right now, much of this data requires a pretty manual tracking process or lives in Excel, as the software platforms race to catch up to investor or regulator requirements,” she explains.
“We need ways to standardize and verify that data. There are many competing benchmarking platforms or regulatory regimes out there at the moment, and we need to figure out how they can all work together toward the same goals.”
“Only once the data is in place can we really focus on the bigger picture in ESG, or the value-add projects that are going to make buildings better.”
On the question of ESG’s compatibility with fiduciary duty, there is obviously disagreement across the country. At one extreme is Florida Governor Ron DeSantis, who in July proposed legislation that would bar the State Board of Administration from taking ESG factors into account and order managers “to only consider maximizing the return on investment on behalf of Florida’s retirees.”
At the other is the California Public Employees’ Retirement System, which in a recent report affirms “climate change is a global challenge and one we cannot afford to ignore as long-term investors, with inviolable fiduciary duty to our members. The consequences of inaction will be measured not just in the impact on workers and communities, but also on the companies we rely upon to generate the investments that pay benefits.”
Though ESG is the term of the moment, some form of socially responsible investing is nothing new for public pensions. A 2020 report from Boston College’s Center for Retirement Research points out that in the early 1970s, “several states passed laws to screen out ‘sin’ stocks, such as tobacco, alcohol and gambling.” Subsequent causes included divesting from apartheid South Africa, supporting unions and promoting homeownership.
What distinguishes ESG is that pension plans have adopted it on their own, with the goal of making market-or-better returns, as well as having a positive social impact. According to the Boston Colleges analysis of public pension investment performance from 2001 to 2018, “state mandates and ESG policies reduce annual returns by 70 to 90 basis points, albeit the coefficient of ESG investing is only marginally statistically significant.”
“I’ve seen a couple of academic studies that have documented reduced returns where pension funds are involved,” says Timothy Riddiough, a professor in the department of real estate and urban land economics at the Wisconsin School of Business, “there being a possible role for pension funds’ trading off returns to satisfy other objectives, like ESG.”
Riddiough, who has published on pension funds as private equity real estate investors, suggests “these investors seem to have a broader set of concerns and issues that they are dealing with, that at the end of the day seem to affect returns – lowering them below what you would expect, given the risk of these investments.”
At the heart of the issue is an uncomfortable question, particularly when it comes to managing underfunded pension plans: “what is the difference between social and private value?”
“There is a meaningful difference between them, potentially,” believes Riddiough. Decarbonization, for instance, is a desirable goal for society, “but having an open conversation about it is probably healthy, in terms of these tradeoffs.”
Riddiough gives the example of green buildings, more energy efficient but costlier to construct. He says: “There really isn’t any good evidence out there that I have seen that, from a private perspective, without subsidies, developers are able to recoup that investment. What that suggests, again, is that to achieve these social aims, it costs more and it affects return. We are not in a position where there is a free lunch, in terms of satisfying social objectives.”
The ways of the future?
For Brookfield’s Brylowski, “there needn’t be a tension between returns and responsible investing. We believe that acting responsibly is expected of us by our stakeholders and part of our fiduciary duty.”
“We are not in a position where there is a free lunch, in terms of satisfying social objectives”
Wisconsin School of Business
Since real estate consists of “the places where people live and work,” successful investing in the asset class means “creating environments that are safe, vibrant and valued by the people who visit them every day,” she says. “This means that sustainability is critical to what we do. Sound environmental, social and governance practices integrated throughout our organization are essential to building resilient assets and businesses and creating long-term value for our investors and communities.”
“ESG is defined broadly and encompasses so many different types of practices,” says Prasad Bowe, acknowledging a certain nebulousness. “The market is in the midst of a very healthy dialogue around what ESG really means. Over time, I expect we will see more differentiation and clear-cut definitions of each sub-practice under ESG; as that happens, some practices may become mainstream and others more niche.”
Brylowski agrees that, while ESG is here to stay, there could be a kind of sharpening of its internal distinctions as it matures. “ESG factors are constantly evolving and changing, but ESG is definitely not a passing trend,” she says.
“Going forward, there may be, perhaps, increasing separation between E, S and G factors, because within each of those verticals, material issues are becoming more specialized. At the same time, ESG is becoming more integrated across business verticals, with greater interaction between ESG, finance, legal, tax, operations and other corporate functions.”
Climate, the current number one priority, will remain a strong focal point, with emphasis on resilience and “greater scrutiny on measuring and disclosing greenhouse gas emissions,” Brylowski predicts. She also sees a potential growth area for ESG.
“We expect biodiversity to be an increasing area of focus, measurement and eventually reporting, and we are monitoring how it may affect our properties and investment strategy,” she says. Like the natural world and its denizens, sustainable investing continues to evolve under pressure.