Performance over policy: how to gain value from ESG

An investor asks a manager to report the ventilation rates and air filter MERV ratings for the buildings in their managed portfolio.

The manager has never looked at this information and works quickly to collect it. Within two weeks, the manager and investor have a first-line assessment of the indoor air-quality performance of their portfolio and a dataset the investor can use to compare one manager to another. Most importantly, they have taken a step toward improving performance.

Without mandates or penalties and with the smallest reporting burden possible, performance measurement establishes a foundation for environmental, social and governance value creation.

Now, had the investor instead asked the manager to report their ESG policies, strategies, processes or targets, valuable manager resources would have been diverted to developing, adopting and communicating policies, strategies, processes or targets, which often do not increase understanding of or ability to improve actual ESG performance.

Having a policy, strategy or process on the books does not equate to implementing ESG – and certainly not to implementing it well.

What’s at stake is financial

Measuring environmental and wellness real estate features informs managers about risks and opportunities related to tenant attraction, experience and retention. Researchers, including Harvard TH Chan School of Public Health Associate Professor Joseph Allen, estimated an economic benefit of $6,500 per employee per year from an 8 percent increase in productivity associated with enhanced ventilation in office buildings. Andrea Chegut and her MIT colleagues found a 5-6 percent rent premium for office spaces with high vs low levels of daylight, while other past studies have reported a 79 percent return on investment and asset value increases of 1-4 percent for indoor air-quality investments.

When First Potomac Realty Trust’s vice-president of construction hired me out of the US Green Building Council in 2011 to establish a sustainability department for their public REIT, it was because he had been hearing that there was real business opportunity in this trendy new focus area. I dove into utility bills and we concentrated on measuring and reducing energy spend by improving design and procurement practices, completing lighting retrofits, and implementing demand response, real-time electricity monitoring, and operational improvements. In a billion-dollar portfolio, we found enough savings to pay for 14 of me.

Making the correlation

In his 2015 research paper, The Financial Rewards of Sustainability, Cambridge University professor Franz Fuerst found that the GRESB performance indicators, which evaluate year-on-year portfolio environmental performance data, including the energy and water consumption that directly impacts operating expenses and climate emissions, showed a strong correlation with significantly higher returns on assets and returns on equity. While Fuerst analyzed public REIT rather than private real estate data, his research elucidated the indispensability of performance measurement to ESG alpha.

Measuring occupant satisfaction using surveys has also long been considered a worthwhile activity that can help property managers capture value and reduce risk. Employee survey results likewise can be used to strengthen tenant experience value drivers like property personnel engagement, wellbeing and management capacity, as well as factors that influence those value drivers such as training and development, inclusion and culture.

While no dataset can perfectly represent all the nuances of complex topics like tenant or employee satisfaction, surveys have evolved and improved over time, and expanded to include more information on occupant and employee wellness. Glassdoor data can be a useful addition to employee survey results, rounding out the picture with information that traditional surveys may not capture. Though tenant and employee surveys existed before and independent of ESG, they provide key ESG performance data that are essential to ESG value creation.

Similarly, many investors request personnel information including hiring, promotion, departure and diversity statistics for general diligence purposes. This data can help investors and managers identify risks and opportunities related to talent engagement, inclusion, culture and retention.

Oregon State Treasury real estate investment officers had a practice of collecting such data as part of their diligence processes well before the Oregon Investment Council formally integrated ESG into its investment policy. While not related to ESG or diversity questions, this data has allowed Oregon officials to ask managers questions like, “Why do women not seem to last longer than a few years at the mid-level?” as Oregon State Treasury real estate investment officer Sam Spencer recounted in a September 2020 interview for NAREIM. So, performance measurement has allowed Spencer’s team to initiate more impactful conversations about pivotal ESG value creation opportunities like retention of mid-level women than would ESG policy or program information.

Further, the acute focus on performance measurement of programs like the US federal government’s voluntary ENERGY STAR for buildings, the National Australian Built Environment Rating System and the EU’s Energy Performance Certificates for building energy performance, helps managers reduce operating expenses, energy and water cost risk and negative environmental impacts – the tangible win-win outcomes that ESG at its best delivers.

Stay focused

Focusing on measurement roots and extending the measurement approach to new ESG factors is the path to ESG value creation. For example, measuring physical climate risks and integrating that information into management processes is more effective than developing a climate risk policy at driving risk mitigation activities that can increase resilience and protect asset value.

Similarly, public policy risk and opportunity are best managed, not by target setting, but by measuring the distance between current property performance and potential regulatory thresholds, projecting the cost of compliance and of noncompliance, and gauging possible incentives for outperformance. And measuring tangible wellness features, like automated external defibrillators and stairway usability, is more efficient and effective than adopting wellness policies at creating asset value.

A laser focus on measuring and improving performance is the key to manageable, effective and profitable ESG. Tracking performance metrics like those above, integrating them into due diligence and management processes, reporting on them at internal and investor meetings, and communicating benefits to occupants all help efficient continual improvement of ESG performance to create value and reduce risk.

Focusing on key performance indicators concentrates resources on efforts that increase net operating income and reduce risk to drive sustainable long-term returns. The social and economic instability of the past year makes it more important than ever for ESG to efficiently deliver financial and societal benefit.