FEATURE: Greening the returns

With the industry's attention firmly focused on the current distress in the global real estate markets, it would be fair to assume that the green building and investment craze that dominated headlines over the past couple of years has faded into the background.

Most private equity real estate professionals and the corporations they sell and lease buildings to are, after all, busy trying to survive this downturn and cut costs. Adopting well-meaning, socially-responsible policies best suited to more affluent times when firms had cash to spare is not necessarily at the top of executives' inboxes. Coupled with plummeting energy prices, it is easy to presume that green and sustainable real estate investing has been put on hold for the foreseeable future.

Assertions of green's demise though have been greatly exaggerated, and are definitely premature.

Of course, all businesses are hurting and focused on making it through today's economic mayhem, but few are throwing their green credentials in the trash as a consequence. Indeed, as the recession in the US and UK takes hold, there are many real estate investors who believe the current downturn could be an opportunity to put themselves ahead of the private equity real estate game. Owners of green buildings are expected to outperform – or at least minimise their losses – relative to less sustainable properties.

And by investing in green, sustainable properties today, most argue they are future-proofing their portfolios (and returns) for tomorrow – not just the long-term. The colour of money, they argue, is definitely still green.

What is green?

Green or sustainable real estate can mean a myriad of different things to different people, from changing a light bulb to a more energy efficient model to building a $1 billion skyscraper with insulating floor-to-ceiling glass, ice cooling systems and under-floor displacement ventilation units that emit cleaner air back out into the environment. Thankfully, two rating systems are emerging as the world's leading tools for assessing the “greenness” of a building – the US' LEED certification and the UK's BREEAM certification – and it is to these that PERE refers when talking about sustainable properties.

But whether you invest in green real estate through dedicated closed-ended property funds, or ensure your entire real estate portfolio is green, the majority of private equity real estate players agree the sustainability agenda is about mitigating risk.

“This is about opportunity and importantly about handling risk,” says Hines' executive vice president Kenneth Hubbard. “How do you deal with the downside? How do you retain tenants and attract new tenants, how do you prepare your assets for exit and how do you manage the regulatory environment and institutional expectation? Sustainable investing is about these four key issues, and they all come down to managing risk.”

Retaining the tenants

The real estate investment community has generally been slow to get on board the green revolution. According to a February 2009 RREEF research document entitled “How green a recession”, less than a fifth of non-residential buildings certified by the United States Green Building Council, which developed the LEED system, have been constructed for the speculative rental market (see pie chart, p. 32). Corporate owner-users and government agencies occupy the lion's share of green buildings accounting for 60 percent of all tenant use, with schools and universities contributing the next largest shares. Multi-tenants, as RREEF describes the speculative market, make up just 17 percent of all tenants in commercial LEED certified buildings.

That trend though is changing. RREEF adds that green activity among third-party owners and speculative developers is increasingly rapidly. Between 2000 and 2002, private developers and investors owned just 3 percent of all LEED certified properties. Between 2006 and 2008, that figure had increased to 26 percent.

Part of the reason behind this rapid greening of the real estate investment community, is down to the growing realisation that greener properties do attract higher rents and better quality tenants. Although the quantitative evidence is still in its early days of collection, several studies have been conducted questioning whether sustainable buildings can command higher rents than conventional, non-green properties.

A March 2009 report by the Royal Institution of Chartered Surveyors (RICS) and Professors Piet Eichholtz, Nils Kok and John Quigley reveals that there is a rental premium for green buildings. Studying 1,360 green-certified offices buildings in the US they found that, for Energy Star-rated offices, there was a 3 percent premium in relation to rental values. When occupancy levels were also taken into account though, the effective rental premium doubled to 6 percent.

Another study due to be published by the UK's Building Research Establishment (BRE) at the time of press, will also show for the first time the speed at which green buildings are leased. The survey will look at the “rate of change” of tenants in buildings in the UK and Europe and how long those properties stay empty on the marketplace. Martin Townsend, global director of BRE's rating system BREEAM, says the results are “significant”, adding that his team took bets on the scale to which green buildings would out-perform conventional properties. “We all fell well short of where the results came in,” Townsend says. “We were very surprised. Green buildings performed significantly better.”

Tenants are choosing greener properties over and above non-sustainable buildings. It may be down to the fact that the corporation has pledged to become greener in its operations, or simply because greener buildings are traditionally newer, better quality buildings, with lower energy costs. It could also be for less quantitative reasons such as staff productivity. The University of Colorado Environmental Center estimates that 150 billion workdays and $15 billion of productivity is lost each year in the US due to poor building quality. Whatever the reason, tenants are willing to pay a premium for the privilege of renting a green building.

Tenants are also willing to pay for the privilege of buying a green property as well.

The RICS report goes on to show that greener buildings sell, on average, for 16 percent more than their conventional cousins. What that implies is that upgrading the average non-green building to green certification could increase its capital value by some $5.5 million. The cost of building green properties though is less, with basic certification adding between 2 percent to 3 percent to construction costs. Higher green certification, according to CBRE's report “Who pays for green”, adds between 5 percent and 7.5 percent to construction, while achieving zero-carbon status – above the highest standards of even LEED and BREEAM – can add up to 12.5 percent to construction costs.

When it comes to exiting a green building investment, most agree greener buildings sell for more money and more quickly. As Nick Axford, head of European research for CBRE in London, says: “When you look at exit yields, investors have to ask themselves how attractive their building is going to be to the market in five, seven or 10 years? What will future occupiers think about it?”

Exiting into a market where greener buildings are increasing in numbers could affect the sale price of conventional buildings if occupiers view them as sub-standard, Axford notes. “Investors in long-term assets such as real estate should always be alert to the fact that buildings depreciate, and that things which might be considered trivial or peripheral today may be extremely important by the time they come to sell that investment.”

Dedicated to green

It's a factor that has prompted London-based private equity firm Climate Change Capital to launch a dedicated real estate vehicle. The fund held a first close on £50 million (€33.5 million; $45.6 million) last October, has already made its first acquisition in the UK city of Birmingham (see 5 St Philips Place box). Esme Lowe and Tim Mockett, managing directors of Climate Change's property team, said green buildings are by definition currently the best performing properties in a market, “and that's what will attract the tenants”.

“Sustainable products can help to achieve the best returns,” says Lowe. “If you have an older building you are likely going to have accelerated rental depreciation. That's the downside risk that we believe a lot of people are not necessarily understanding or pricing correctly.”

Mockett adds: “When you come to sell an asset you will appeal to a wider range of the investment community. We would expect that you should be able to sell it for more money and you should be able to sell it more quickly, it's very simple. We don't trade returns for green, all our assets have to perform commercially – this is occupier-focused downside protection that is expected to capture future upside.”

There are just a handful of dedicated vehicles on the market targeting green property strategies. Credit Suisse last month raised CHF300 million (€199.3 million; $270.8 million) for its Swiss-focused Real Estate Fund Green Property, which will be converted into an open-ended listed fund within five years. US developer Jonathan Rose launched the $100 million Rose Smart Growth Investment Fund I three years ago, while Hines closed its Hines CalPERS Green (HCG) real estate fund with the California pension fund, California Public Employees' Retirement System, in 2006 with $120 million of equity. AXA Real Estate Investment Managers is also planning two 20-year green funds, to be focused on wider green energy and real estate opportunities.

Stephen Smith, global head of AXA REIM's asset management and transactions group, says green is more than just creating a separate pool of “green” assets. “This is an integral part of our business plan. It's not just about being a good citizen – we know that we are future-proofing our portfolio. Anyone who ignores this dynamic ignores it at their peril.”

Hubbard strongly agrees: “This is part of everything Hines does, and for the industry it should be a holistic approach. Sustainable real estate is not a separate discipline or separate approach to real estate investing, it is a business opportunity. Sustainability is a value proposition and a best practice throughout Hines.”

Drivers of change

Opportunities though only last for a short amount of time before they become the market norm (with more “normal” returns), and given the pace of regulation and legislation surrounding sustainable real estate, professionals suggest it won't be long before investors are forced to invest more “greenly”.

As PERE went to press, Philadelphia mayor Michael Nutter pledged that Philadelphia would be the US' greenest city by 2015, with plans to reduce energy consumption in all buildings in the city by 10 percent. New York mayor Michael Bloomberg has also introduced bills for tougher energy efficiency laws in the city, which could mandate energy audits for buildings over 50,000 square feet and require “cost effective” retrofits. In 2006 in the UK, new commercial buildings were required to be 28 percent more energy efficient, with all commercial buildings now having to have an energy performance certificate. Tougher carbon emission limits are expected in 2010.

The pace of regulation governing the sustainability of commercial real estate is not expected to slow, even given the current economic downturn. But it's not just lawmakers that fund managers need to be paying attention to – they also need to listen to their investors.

The $270 billion Dutch pension asset manager APG is in the process of surveying its fund managers about the sustainability of their real estate portfolios. Asking questions such as the importance of sustainability in investment decisions, the survey is a way of “starting a dialogue with our fund managers about green issues”, says portfolio manager Richard Paoli.

The pension – one of the largest foreign investors in US real estate – says it does not want to narrow its focus by investing in green real estate funds only, but is aspiring to have an entirely sustainable property portfolio in the longer term. “Green doesn't reduce returns,” adds Paoli. “If you have properties that have high energy efficiency features and are certified, it's logical to believe these assets will be valued better than assets without those characteristics.”

It is, Paoli contends, about making sustainability a “fundamental component” to all APG's investment decisions – something all fund managers will have to address, with or without distressed real estate markets to distract them.

Green Profile:
5 St Philips Place, Birmingham, UK

5 St Philips Place, Birmingham, UK

Green and distressed investing don't have to be mutually exclusive real estate strategies. Climate Change Capital's first property acquisition for its green real estate fund, which held a first close on £50 million last October, combines the two game plans.

Acquiring the mixed-use property at 5 St Philips Place, Birmingham, Climate Change plans to work with the main tenants – including the UK government – to raise the building's environmental standards to BREEAM “very good” or “excellent”.

As well as improving the property's carbon energy performance, the London-based firm will improve the building's energy efficiency, lighting, water and waste systems within the next one to two years. All this comes on top of the fact Climate Change purchased the property for a 40 percent discount on its price just three years ago. The six-storey property, which has more than 67,000-square-feet of office space and 13,000-square-foot of retail, was originally built in 2003 and bought by the Bank of Ireland a year later for £38.5 million, according to data provider Real Capital Analytics. In October 2006, it was resold for £49 million to New Star Property recording a per square foot price of roughly £610 and a cap rate of 4.4 percent. In March this year though, Climate Change secured the property for £31 million, according to market sources – a price per square foot of around £386.

Green Profile:
1180 Peachtree, Atlanta, Georgia

In 2006, Hines sold its development at 1180 Peachtree, commonly known as the Symphony Tower, in Atlanta's midtown area to GE Pension Trust for $272.6 million. The building had been developed as part of Hines' joint venture with the California Public Employees' Retirement System (CalPERS).

1180 Peachtree, Atlanta, GA

The 41-story Class A office property had been developed with green in mind, and was the first high-rise office in the South East of the US to be certified gold for LEED core and shell. It also has an Energy Star label, using recycled local and regional materials during construction and 20 percent less water than typical buildings.

Marked on the Atlanta skyline by two sweeping glass fins that extend up the building's north and south walls, 1180 Peachtree has 670,000-square-feet of space – two-thirds of which has been leased to law firm King & Spalding. The property's fins are lit from the inside at night, and in a bid to allow more natural light into the building, more than 90 percent of the property has daylight views. The office block was sold by Hines to GE Pension Trust in September 2006, after the building was completed in February of that year. GE paid $407 per square foot for the property – the highest price ever commanded in Atlanta for an office building and a record that stood until July 2008. According to Hines, the property is 42 percent more energy efficient than the national average building, with energy cost savings of $1.22 per square foot.