Climate Change, ESG Moves Into CRE Underwriting

Global climate change negotiators from almost 200 governments over the past two weeks have put commercial real estate solidly in place to play a role in addressing carbon emissions.

A final deal announced over the weekend at the Glasgow Climate Pact is one that will likely unlock billions of dollars of investment in carbon reduction projects around the world.

Tony Liou, President, Partner Energy, sees this as an opportunity, given the residential building and commercial real estate sector accounts for the majority of the energy consumption in the United States.

“To truly tackle the growing issue of climate change and mitigate those impacts, while working to improve resilience, it makes sense that the biggest sources of energy consumption and resulting greenhouse gases must be addressed,” Liou tells GlobeSt.com.

Despite industry participation in environmental accreditation programs and broader ESG initiatives, investors have been slow to incorporate environmental risks into underwriting, he said.

But over the past year or so the conversations about ESG have eclipsed all other topics in conversations, Liou said. “Unlike in the past when energy efficiency efforts focused on municipal or public buildings, today lenders and owners across the capital stack, including both debt and equity, are talking about ESG and resiliency in their CRE activities.”

Resiliency Studies Influencing Decisions

Now Liou said the industry is at the beginning stage of incorporating ESG data into underwriting.

“The major push currently is trying to understand how to collect relevant data; we are beginning to see the data influence how properties are managed and underwritten.”

Here are a few examples:

“When we conduct a climate risk and resiliency study, we identify probable property-specific climate change and recommend adaptation measures that could reduce the impact of the hazard. These measures can be simple, such as if a property is in an area prone to wildfire, then removing dead plants and flammable materials from the property and trimming the trees around the perimeter, can help reduce this risk.”

These measures can be identified during due diligence and be categorized as an immediate repair item once the property is acquired.

“From an energy efficiency perspective, we identify cost-effective strategies or ‘low-hanging fruit’ to reduce the cost of energy at the property. Operating cost reductions impact the net income and can be considered when valuing a property.

“Additionally, identifying the carbon footprint of a property in relation to state and local laws during due diligence would help uncover any possible liabilities and reduce those risks. For example, under NYC Local Law 97, most buildings over 25,000 square feet will be required to meet new energy efficiency and greenhouse gas emissions limits by 2024. A GHG analysis and energy audit will help identify the cost impact of complying.”

‘Getting Serious’ About Net-Zero Goals

Liou said investors are “getting serious” about meeting NetZero goals, and are taking actions to achieve them. That includes efforts to reduce the built environment’s impact on a changing climate, and efforts to reduce a changing climate’s impact on the built environment.

A recent United Nations report noted climate change is responsible for these drastic weather events. “So, a way out is a concerted effort and setting aggressive goals to reduce greenhouse gasses,” he said. “Secondly, the capital side wants ESG considerations to be incorporated into the equation. Institutional investors are now using ESG performance and reporting to evaluate fund managers and are working to place capital, accordingly. That is driving the fund managers and operators to incorporate greater ESG measures into their real estate portfolio activities.”

Liou said that investors are examining asset managers to find those with sound due diligence and operations approaches. 

“Savvy asset managers look at the costs and how that will impact stakeholders, and the investor looks for assets that are reliable and operating correctly or have earned green building certifications⁠—such as LEED⁠—because they desire to invest in a solid asset.

During due diligence Partner Energy collects data on ESG, including the energy efficiency, and finds out about Energy Star scores or rankings that evaluate such items as high efficiency equipment or cool roofs. 

“That could also include on the sustainability side a building’s walk score, is it close to amenities like childcare or healthy food options, or how an asset fares against governance issues like compliance with local laws benchmarking energy audits or greenhouse gas emissions,” he said. “All of those considerations weigh on the investment side.

“Climate change is being incorporated into due diligence as real estate companies ask for us to identify the climate change risks that may exist for a specific property today. Once they know the risks and existing resiliency features that are in place, they can determine what else may need to be incorporated into the mix down the road.”

Types of Risk Vary By Property Types

Helping investors or owners understand the site-specific challenges or features that exist is important today, because not all assets are subject to the same climate change impacts, say, if a property wasn’t in an area subject to wildfires. They will then know what features are in place to protect the asset as well as what features are recommended to harden an asset against climate change.

If for instance, a property was prone to flooding, they will need to know if the property has good drainage, or if the building’s equipment or fuel tanks are secure or located in a basement. They need to know what can help to mitigate against climate change, Liou said.

However, the growing risks of climate-related property damage may induce more investors to follow the example of leading institutional investors in factoring market-level climate risk into decision-making.

“Real estate owners and investors need to know and understand what data exists, how that data is being collected and then tracking that data over time, so it can be incorporated into their underwriting process,” Liou said.

“That gives property owners more information and can help reduce the risk or hesitancy an investor may have about executing a deal or not. We collect the property information that exists now and help investors see the market-level climate risks over the life of an investment. When they know more it likely will help them be more comfortable with their investment decision over time.”