Real estate’s contribution to global emissions is widely acknowledged – the International Energy Agency estimates that 27 percent of energy sector emissions are created by the operation of buildings. Environmental, social and governance issues are prime concerns for private real estate managers and investors as never before, as is the importance of the social aspect of investment.
The real estate secondaries market faces some of the same drivers and pressures as other sectors, but with nuances that provide extra challenges.
The first ESG complication for a real estate secondaries investor is the advanced age of the assets. Marc Weiss, chairman of private real estate at investment firm Partners Group, says: “One of the biggest challenges for secondaries is the fact that, as a buyer, you are usually buying into older vintage year funds. Many older vintage year funds were set up at a time when sustainability was a nice-to-have, but not a need-to-have.”
Chris Reilly, head of real estate secondaries at Brookfield Asset Management, says: “Older vintage assets can definitely be more costly. In general, we tend to focus on newer assets and even with those, there is work to be done. Increasingly, we see that dealing with older assets just doesn’t make sense. For example, converting an older CBD office building to residential and being fully ESG-compliant is just not economically viable.”
Investors can be left holding less saleable assets if they do not comply with future regulations or the demands of investors and occupiers. However, estimates vary as to how profitable it is to be green certified.
For example, data company MSCI says green-certified office buildings in London attract a 25 percent sales price premium and that this premium is 35 percent in Paris. But in Asia-Pacific, however, research from advisory firm CBRE suggests the “green premium” is unlikely to be more than 5 percent.
Share of energy sector emissions created by the operation of buildings, according to the International Energy Agency
Sales price premium for green-certified office buildings in London, according
Sales price premium in Paris
Sales price premium in Asia-Pacific, according to CBRE
There is also the risk of running foul of legislation. Weiss says: “For example, in Europe, buildings are required to hit a certain EPC rating by 2030. If you have a fund manager with older assets, you should query what they are going to do to bring them into compliance. Or alternatively, what is the market going to look like to sell those assets? As a secondary buyer, those are the types of questions you need to ask.
“It all depends on the holding period; the closer you get to 2030, the more these issues are going to come to the forefront. If you have a fund that is liquidating assets in the next year, or two, I am not so sure it will be as big an issue.”
Michelle Creed, partner and co-head of real estate secondaries at Ares Management, says older assets can be an opportunity for secondaries investors with the platform to cope. She says: “While these portfolios potentially present higher risk, we see these funds as opportunities to engage directly with GPs and drive ESG implementation. Between the experience of both our secondaries and direct investment real estate teams, we can offer GPs solutions and real-world experience when evaluating ESG actions to take and add value.”
The approach to ESG matters differs widely depending on whether a transaction is LP-led, the sale of a stake in a vehicle by one of its investors, or if it is GP-led, such as fund recapitalizations and extensions. LP-led transactions are essentially passive, buying into an existing fund strategy and ESG practices.
For LP-led transactions, Reilly says: “My perception is that people probably don’t think ESG is a major consideration for secondaries because of the perceived distance from the assets. If you are just buying into a fund interest, then it is completely passive: you either buy or you don’t.”
The solution for ESG-concerned investors is to do as much diligence as possible on the fund and the assets and make sure that the entry price takes into account any potential green premium or brown discounts. Weiss says: “As a secondary buyer, you make returns by negotiating a discount and then staying invested and letting the GP do the value creation work. So, therefore, you need to understand how the GP thinks about these issues and then underwrite that accordingly.”
Reilly adds: “Traditional LP deals are also a bit more opaque in terms of the information you get and the timescale involved, which makes pricing tricky. You will only have the information available to investors and the sponsor’s stated ESG commitments.”
However, Creed sees it differently. She argues: “The main difference investing as a secondaries investor compared with a primary fund investor is that rather than allocating to a blind pool, we are able to underwrite an existing portfolio of assets. We see this as a tremendous asset for secondaries investors when evaluating and underwriting for ESG.
“With an existing portfolio, we can examine the underlying properties directly and make our own determinations surrounding ESG risks and opportunities. Additionally, we can stress test, in real time, whether or not GPs are executing on their purported ESG processes.”
The situation is rather different in GP-led deals such as fund recapitalizations, where new equity investors can come in and push the manager on ESG, especially if it has weight of capital behind it.
Reilly says: “We go about investing in secondaries in a more direct fashion and focus more on GP-led, recapitalization deals. We are typically the majority of the equity in the deal, so have more influence.
“We can also do more due to the size of our platform. For example – and we have done this in the past – if we buy logistics assets or recap logistics assets with a partner, we can leverage our renewable power team to evaluate putting solar panels on the assets and also leverage their buying power.”
For both LP-led and GP-led transactions, the entry pricing is crucial and investors need to add ESG diligence to their list of ‘to dos’. Reilly says: “When we are in the process of doing our diligence, if there are certain ESG goals we are trying to meet, we will underwrite those costs upfront which will obviously be reflected in the returns. And if we can’t make the returns work, then we won’t do the deal.”
Putting ESG into due diligence
A manager’s approach to ESG and its track record in this regard are important factors in the diligence process. Creed says: “Confirming that a GP’s ESG integration process is not only material but repeatable is paramount as a secondaries investor. Beyond confirming the existence of a systematic ESG diligence process, understanding not simply if, but how a GP is incorporating physical and transition climate risk into its underwriting is crucial for us.”
There are differences between regions; Europe is generally agreed to be somewhat further ahead of the rest of the world, especially with regard to regulation. However, other jurisdictions are catching up.
Partners Group’s Weiss says: “In Europe, it is about legislation while in the US there is more concern around green certification. There are also the governance considerations and whether the principals are in good standing. Additionally, there is a strong focus on DE&I here in the US, which is important to many institutional investors, but that is more about the manager than the assets.”
Recent tussles over DE&I in the US have been well publicized. Weiss adds: “In the US, ESG has become more politicized, so US managers have recently been tiptoeing around the topic. However, those with European and sovereign wealth fund investors have been more proactive.”
However, Reilly says: “There might be some variation between jurisdictions but I would say it varies more due to the size and sophistication of the managers. In general, larger and more experienced managers have better resources for ESG.”
Secondaries investors and managers are boosting their ESG resources in order to keep up with the pace of change. “It is also important that we remain ahead of expanding LP requests and a shifting regulatory landscape,” says Creed. “This past year, we hired a dedicated ESG professional to make sure that our processes, our engagement with GPs and our overall ESG focus continues to anticipate a rapidly changing market’s next move.”
A key question for investors in real estate secondaries is if ESG factors, whether related to the performance of managers or the underlying assets, are significant enough to stop a transaction. The answer seems to be that they could, but they do not.
Brookfield’s Reilly says: “ESG issues certainly could be a deal breaker for us, but that has not happened to date. In general, GPs are taking ESG seriously and taking action to implement it. What varies is the degree of sophistication.”
Nonetheless, private real estate fund managers clearly need to try to stay ahead of the curve on ESG if they are to secure recapitalizations or fund extensions. Meanwhile, LPs need to ensure they are investing with platforms with a clear process for dealing with ESG issues or risk losing out when they come to realize or sell their investment.