BUILT TO LAST? – ESG PERSPECTIVES FOR LISTED PROPERTY
When you think of the impact of industry on the environment, property may not immediately come to mind. Yet according to the Environment and Energy Study Institute, this seemingly benign sector is responsible for more carbon dioxide (Co2) emissions than any other industry.
When you think of the impact of industry on the environment, property may not immediately come to mind. Yet according to the Environment and Energy Study Institute, this seemingly benign sector is responsible for more carbon dioxide (C02) emissions than any other industry.
ENVIRONMENTAL (AND CASH FLOW) SUSTAINABILITY
“In 2010, buildings accounted for 32 % of total global final energy use, 19 % of energy-related greenhouse gas emissions (including electricity-related), approximately one-third of black carbon emissions and an eighth to a third of F-gases … This energy use and related emissions may double or potentially even triple by mid-century…” – Intergovernmental Panel on Climate Change Report on the property sector.
To mitigate this, the listed property sector has moved strongly towards constructing green buildings. Interestingly, it is far better for the environment to revamp an existing building than to knock-down and rebuild. Many South African blue-chip companies have recently built flashy, new “bragging rights” green head offices at a huge cost to the environment, leaving behind empty A-grade office blocks that could have been refurbished – a travesty in a market with vacancies at over 10%.
A COMPELLING CASE
The business case for green buildings is self-evident, given the sharp rise in electricity prices. Prospective tenants look not just at rental but at total occupancy cost, of which utilities (electricity and water) are a major component. Environmentally and spatially inefficient buildings can soon become functionally obsolete due to high operating costs per employee, which makes them unviable. Consequently, green office buildings can command a higher rental as they lower the total occupancy costs per employee. There are other benefits too, such as a better work environment and healthier staff. Green buildings trade at a higher multiple, command higher rents and provide better returns1. Listed property funds in South African have increasingly been making the buildings they manage more efficient (e.g. by installing solar power/hot water systems). However, this has not been of the scale and level of differentiation to be an investable theme, as it is overseas. In spite of this, together with the SA REIT Association, we have made a concerted effort to improve the environmental, social and governance (ESG) disclosure practices of their members, including reporting in terms of the Global Real Estate Sustainability Benchmark (GRESB) listed property assessment. We are pleased to note an improved uptake of the GRESB assessment this year as South African REITs are starting to see the benefit of disclosing their ESG performance. We will continue to drive the investor agenda for enhanced ESG reporting practices.
AT THE MALL
There is less emphasis on the green attributes of shopping centres, which make up half of our listed property portfolios. Although higher utility costs are forcing shopping centres to become more efficient, there is much room for improvement in this regard. Unfortunately, the big retail tenants for whom shopping centres are designed are as much to blame as the landlords. For example, they could lower their high lux lighting levels, introduce more natural lighting and reduce their air conditioning usage.
Real estate investors are also concerned with the sustainability of the cash flows generated by the buildings they buy. Buildings must not become obsolete when leases expire. Financial gearing must be at a responsible level and should not boost short-term earnings at the expense of the long-term. Short-term performance is often improved by skimping on maintenance and capex, pushing up costs or delaying revenue streams. Ill-considered acquisitions are also used to boost earnings in the short term, although they destroy value over time. We do not pay for once off earnings, believing that sustainability in all its forms is what ultimately matters most.
THE STATE OF GOVERNANCE
Property has long held the reputation of being the JSE’s governance “bad boy” and is regarded by many as a dubious “cowboy” sector. On our proprietary governance scorecard, the sector is rated poorly compared to other sectors on the JSE. However, we are pleased to note that this appears to be turning around. Property is increasingly becoming a substantial sector that is professionally managed and is no longer run by dodgy developers. Governance has also improved, although there is still much work to be done in this regard. We are actively engaging with industry participants to address this.
Remuneration is another area in which we frequently engage property companies. Many funds have compensation schemes that only enrich management (as opposed to shareholders) when markets go up, not because they have added any real value. In addition, performance standards are often soft or inadequately disclosed. Lastly, property companies do not have the same degree of management complexity as their industrial and financial services counterparts, yet benchmark their pay to them. Management has a perverse incentive to raise capital to grow assets even if this does not enhance shareholder value.
THE MANCO PROBLEM
Management companies (mancos) are subject to conflicts of interest as their fees are based on fund size, which means that they are incentivised to grow even when this destroys value. Furthermore, there are frequent related-party issues as the manco is often a vendor of properties to the fund. Mancos - and not shareholders - can extract the bulk of the control premium offered in a takeover. We penalise funds that have mancos and are pleased to report that there are now fewer of them.
Ultimately, when property companies go wrong, they can go very wrong. Bad governance, including excessive and unaligned remuneration, can cause sub-optimal outcomes for investors. With this in mind, property investors ignore ESG at their peril.
1 Devine A, Kok N, Green Certification and Building Performance: Implications for Tangible and Intangibles, The Journal of Portfolio Management, Special Real Estate Issue, 7th Edition (2015)