The Sustainability Edge in Real Estate Investing

Commercial real estate can have a significant impact on the environment and an increasing number of real estate industry professionals are incorporating sustainability practices into corporate strategy and building management. Kimberly Ryan, Portfolio Manager for Wells Fargo Private Bank’s Social Impact Investing (SII) REIT strategies offers her thoughts on the benefits of integrating sustainability and ESG analysis into the REIT investment process.

Why is sustainability important for real estate management teams to address?

U.S. buildings account for 41% of primary energy consumption and 74% of all electricity consumed domestically.[1] They account for more annual energy use than the U.S. transportation sector and produce more greenhouse gases than any other country in the world except China. Greenhouse gas emissions from U.S. buildings are expected to grow faster than any other sector through 2030.[2]

Further, regulators are getting involved. In California, regulators have set a goal of having all buildings reach zero net energy – that is, consuming only as much energy as can be generated on-site by renewable sources – by 2030.[3]

We believe this presents a huge economic opportunity for real estate management teams to retrofit, upgrade and redesign to better position their assets for a lower-carbon economy.

Are there financial benefits that accrue to companies and management teams that prioritize sustainability?

Improvements in building efficiency can provide real cost savings to landlords and tenants. Some of the more impactful initiatives include the installation of more efficient LED lighting; upgrades to heating, ventilation and air conditioning (HVAC); smart metering; reductions in water consumption; and waste management.

Above and beyond any cost savings, however, sustainably-managed structures typically command higher rents, and experience lower vacancy and higher tenant satisfaction.[4] This positively impacts property valuations and may also play a role in portfolio strategy as management teams evaluate whether to dispose, renovate or acquire properties as a way to generate higher returns on investment.

As an investor, how do you evaluate the sustainability performance of a real estate operating company?

We take a broad view of sustainability, focusing not just on the environment, but also on broader social and governance issues. Some examples include:

We evaluate performance by reviewing a company’s environmental disclosures and talking with management about its specific goals for energy, water and waste management. We examine current progress toward these goals as well as future opportunities. Building certifications and the use of ‘green leases’ can serve as an additional avenue into management’s thinking on sustainability.

We pay attention to tenant health and well-being. This is an emerging area of interest, and industry leaders are innovating to create healthier environments for tenants. Initiatives may include improved air quality, green cleaning, exposure to natural light and access to healthy food, to name a few.

How might these factors differ when analyzing different types of real estate?

Our issue focus varies depending on the subindustry. For example, when assessing a data center REIT, one of the main environmental issues we will consider is the company’s management of water and electricity use, as data centers require significant amounts of water and electricity to operate. We will assess how exposed the company is to areas of high water stress, programs to reduce dependence on municipal sources of water, and efforts to improve energy efficiency. In contrast, when analyzing the ESG performance of a single family home rental REIT, we focus on customer satisfaction and service as key factors. We will investigate how well a company is serving its customers, maintaining the quality of the rental property and ensuring terms and conditions are clearly communicated to its tenants.

How would you describe the Social Impact Investing (SII) team’s philosophy when it comes to real estate investing?

In general, we are looking for well-managed firms with good growth prospects, sustainable cash flows, and disciplined capital deployment, trading at reasonable prices. All of our strategies (equity, fixed income, REIT) employ a combination of fundamental, quantitative, and ESG assessments in their investment processes. We manage well-diversified portfolios with low turnover and we try to avoid controversy. We look at financial metrics that are specific to real estate as well as more common measures as shown below.

Our long-term investment approach aligns well with a focus on sustainability, as the benefits of these initiatives take time to manifest. Just as a homeowner may decide to replace windows with double pane glass or add solar panels to the roof to reduce utility costs, real estate managers also expect to reap the benefits of building efficiency upgrades and tenant amenities over the long term. As investors, we understand it takes time for companies to see their efforts generate and return value to shareholders.

The SII Team launched two REIT strategies in September 2017. What do you see as differentiating these SII strategies from traditional REIT strategies?[5]

The two strategies similar to other REIT strategies in that they are composed of publicly traded US equity REITS diversified across property type and geography. Where we differ in our investment process is that we integrate ESG analysis alongside quantitative and fundamental analysis which helps us identify risks and opportunities that other managers might miss.

What this means, practically speaking, is that a company with a management team that delivers strong financial results yet fails to invest in projects or initiatives to mitigate long-term challenges like the environmental impact of its properties may not qualify for Social Impact Investing’s strategies. Conversely, those that proactively address environmental impacts will make for better candidates and may warrant higher weights in the strategies.

Closing Thoughts

We believe by evaluating a company’s intention and analyzing its performance around sustainability, we gain critical insight about its future risks and opportunities. There is evidence to suggest that real estate companies realize tangible financial benefits whether in the form of lower costs, improved cash flows or higher property valuations.

Managers of residential and commercial real estate have a financial incentive to care about sustainability. Real estate is energy, water and waste intensive and practices that promote better management of these challenges should be mutually beneficial to companies and investors while spilling over into society in a positive way.

 

Article by Kim Ryan, CFA, Senior Portfolio Manager for the Social Impact Investing team, part of Wells Fargo Private Bank  https://www.wellsfargo.com/the-private-bank/solutions/social-impact-investing and based in San Francisco, California. She co-manages equity and real estate strategies and manages the team’s analysts. The team’s investment process combines quantitative, fundamental security and environmental, social and governance (ESG) analysis. Ms. Ryan is a member of the Wells Fargo Bank Proxy Committee.

Most recently Ms. Ryan was a partner, senior portfolio manager with Nelson Capital Management. In that role, she served as a member of the investment and corporate engagement committees. Before joining Nelson Capital, Ms. Ryan spent 11 years as an investment manager and equity analyst with Wells Fargo Private Bank. She was a member of the Growth Equity Team and over the years covered stocks in the consumer, technology and telecommunications sectors.

Prior to her time at Wells Fargo, Ms. Ryan worked in the consumer healthcare and investment banking industries. At Deutsche Banc Alex Brown, she was an analyst on numerous corporate finance deals, primarily in the media industry. She has been in the financial industry for more than 20 years.

Ms. Ryan holds the Chartered Financial Analyst® designation and is a member of the CFA Institute and CFA Society of San Francisco. Ms. Ryan holds a B.B.A. from the University of Notre Dame with a double major in Finance and Government.

Article Footnotes

[1] U.S. Department of Energy Buildings Energy Data Book. March 2012. Chapter 1 and Table 1.1 Buildings Sector Energy Consumption.
[2] Buildings and Climate Change, US Green Building Council., http://www.eesi.org/files/climate.pdf
[3] California Energy Commission, Background on the 2016 Building Energy Efficiency Standards.
[4] Avis Devine and Nils Kok, “Green Certification and Building Performance: Implications for Tangibles and Intangibles”, Journal of Portfolio Management (2015)
[5] The SII team offers a Sustainable REIT strategy and a Faith Based REIT strategy. The key difference between the two is alignment. Both strategies exclude REITs with exposure to private prisons or casinos. The Faith Based strategy also excludes REITs that serve the healthcare industry since there may be unwanted activities in those facilities.

Definition of Terms:

Price-to-FFO Ratio: Price to FFO ratio is price to Funds from Operations ratio.

Price-to-AFFO Ratio: Price to AFFO ratio is price to Adjusted Funds from Operations ratio.

Net Asset Value: Often presented on a per-share basis, Net Asset Value (NAV) is the value of a company’s common equity calculated by applying an updated market value to the company’s real estate portfolio & other operating assets and deducting all liabilities, including preferred equity.

Occupancy: A measure, usually in a percentage, of the amount of real estate space currently being rented versus the total amount available for rent, for a given portfolio

Financial leverage: A measure of a company’s use of debt. Broadly defined as Total Liabilities divided by Total Assets

Dividend Growth: Dividend Growth measures annual growth rate of the split-adjusted indicated dividend per share.

Estimate dispersion: The degree to which the highest earnings estimate differs from the lowest estimate, as a percent of the average (‘consensus’) earnings estimate at a given point in time.

Estimate revisions: The degree to which, positive or negative, earnings estimates change relative to the average earnings estimate at a given point in time.

Short interest: A ratio, normally in percentage, of the total amount of shares being sold short versus the total available float of common stock.

Risk Considerations

Investing in REITs has special risks, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.

Sustainable investing focuses on companies that demonstrate adherence to environmental, social and corporate governance principles, among other values. There is no assurance that social impact investing can be an effective strategy under all market conditions. Different investment styles tend to shift in and out of favor. In addition, a strategy’s social policy could cause it to forgo opportunities to gain exposure to certain industries, companies, sectors or regions of the economy which could cause it to underperform similar portfolios that do not have a social policy.

Disclosures

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The information and opinions in this report were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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