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Going Green: Can Investors Capitalize on Sustainable Buildings?

Real asset Investment Series. Part I: Green Real-Estate

In the report "Environmental Sustainability Principles for the Real Estate Industry", the World Economic Forum ("WEF") concludes that the construction sector, which in 2020 was responsible for approximately 39% of global greenhouse gas emissions, must be placed at the centre of climate change mitigation efforts.

As environmental, social and governance (ESG) principles continue to gain traction in the financial world, investing in "green real estate" and "green infrastructure" has also gained considerable visibility on the radar screen in recent years. A growing number of investors, demanding more sustainable building methods to prevent future energy crises, are turning to green buildings to fill their portfolios with assets that meet changing societal and consumer expectations, as well as new investment standards to qualify as "sustainable investors," such as UNPRI standards.

Core Facts and Figures

Investment in building energy efficiency has climbed to more than $180 billion in 2020, an 11% increase from the previous year. It is estimated that the green building market will be worth more than $770 billion by 2030 and that $5.2 trillion will be needed to decarbonize the built environment over the next decade alone. In total, the new green building market will represent a $24.7 trillion investment opportunity by 2020.

Green building holistic concept

Green building (also known as green construction or sustainable building) is a holistic concept that assumes the built environment can have profound effects, both positive and negative, on the natural environment and occupants. While there are many different definitions, green building practices refer to both a structure and the application of environmentally friendly and resource-efficient processes throughout the life cycle of a building: from planning through design, construction, operation, maintenance, renovation and demolition. The practice of green building is an effort to amplify the positive effects and mitigate the negative effects throughout the life cycle of a building.

The investor can choose from a wide range of opportunities, from research to development of low-carbon building materials, new infrastructure - designed, for example, to conserve and recycle water more efficiently - large-scale urban retrofits and new sustainable construction projects.

Green building certifications gain momentum

Strict labels are used to certify infrastructure and properties designed to be environmentally friendly. Globally, there are more than a dozen certifications that buildings can obtain, with different areas of focus. For example, the Building Research Establishment Environmental Assessment Method (BREEAM) and Energy Performance Certificate (EPC) certifications in the United Kingdom, as well as the Leadership in Energy and Environmental Design (LEED) and Energy Star certifications in the United States, focus on energy conservation and efficiency, while the WELL Building standard was developed to assess how well buildings meet health and wellness standards.

Green Premium opportunities

For a long time, green building was perceived as an approach exclusively for high-end projects, establishing its reputation as expensive and ultimately less profitable. But recent researches show that although building materials and construction may indeed cost more, green buildings make their money back in long-term efficiency and market desirability. According to the U.S. Green Building Council, upfront investing in green buildings can increase asset value by 10%. Lower long-term costs also balance higher expenses at the start. For example, LEED-certified buildings have maintenance costs 20% lower than traditional commercial buildings; when buildings are retrofitted to green standards, their operational costs decrease by up to 10%.

The International Finance Corporation (IFC) report reveals that fitting out commercial property with green technology could decrease operational costs by up to 37%. In personal private property, owners of green homes report saving an average of 15% to 20% on utility bills. For buildings that incorporate recycling measures, the waste output can be reduced by 90% while using 30% less energy, leading to a 5% increase in NOI compared to typical buildings

The income implications for investors are clear: green buildings will command higher rents and higher capital values while incurring lower monthly operating and maintenance costs.

Certified rent (premium) compared to uncertified rent (2016 – H1 2021)

Brown Discount risk or opportunity

In recent years, the real estate industry has largely debated the "green premium", but has put less interest in researching the "brown discount". Because buildings with good environmental performance are typically newer, quality assets, it can be difficult to identify the sustainability premium. Nevertheless, there is ample evidence that green buildings command higher rents than comparable non-green properties, indicating the considerable potential for investors to invest in the "brownfields discount" for properties with relatively poor environmental performance. Therefore, the absolute value of the green premium is a function of the gap between the market valuations of green and brownfield properties.

Potential for obsolescence, also known as the brown discount constitutes a real estate market emerging risk, for existing buildings that don’t “green up”: Just as green buildings that outperform the market may show a value premium, brown buildings that underperform relative to their market may show a discount.

Older properties are considered riskier than new energy-efficient or net-zero properties, which will require less maintenance and significantly reduce their operating costs, thereby reducing risk. Older buildings represent depreciable assets, while newly constructed properties that meet or exceed eco-friendly requirements represent valuable assets.

From brown discount to brownfield premium

The gap between brownfield and greenfield premiums will continue to widen in the coming years as older buildings lose value. Investors will have to deal with the brown discount due to deferred maintenance in order to maintain the balance of risk in their portfolios, and homeowners will be forced to upgrade their properties for purchases and refinance in order to support the value of their homes and avoid potential reductions in the sale and rental prices. As mass production and demand for high-end green homes are built and absorbed into the market, the spread of risk will intensify. This trend will also impact lenders and could result in potential write-downs of discounted loan portfolios, making them less marketable and less desirable due to additional collateral risk.

In conclusion

Given the scale of the opportunity, investors can play a critical role in helping to unlock the transformative potential of the building sector to achieve the energy transition and increase resilience to climate change. But urban gentrification and encroachment on agricultural land pose a serious threat to future land use policies.

Green building does not have to be a purely environmental investment option; the cohort of new sustainable investors could also help unlock a clearer alignment between the social and environmental value of green buildings. Investing in brownstones - older buildings in transition - will combine the triple "E-S-G-" benefit of achieving the energy transition and maintaining reasonable financial returns, while incorporating greater social equity and better "social" returns for investors.

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