There are a number of reasons why large office investors have included environmental, social and governance (ESG) guidelines and Leadership in Energy and Environmental Design (LEED) certifications in their investment criteria. That includes government contracts, good PR, and genuine concern for the planet. Above all, it is good for the bottom line.
“Most investors raising capital from pension funds and endowments have ESG policies because their investors are demanding it,” said Russell Ingrum of Fort Worth, Texas, vice chairman of capital markets at commercial real estate services company CBRE. Ingram notes that the focus on the environment has become dominant in the development community because the office tenants want it or the equity investors in the projects demand it. Most large U.S. corporate tenants are looking for sustainable real estate, with energy companies leading the trend, he says. So it’s become popular wherever there are many Fortune 500 corporate offices, which is most of the major US markets.
A study by commercial real estate services firm Cushman & Wakefield analyzing the impact of LEED certification on office buildings found that they rent faster, generate a rent premium and trade at higher values than uncertified office buildings of the same class.
Since 2015, rents for LEED-rated office buildings have averaged $4.13 per square foot, or 11.1 percent higher than rents for non-LEED-rated buildings, Cushman & Wakefield found. LEED-certified assets outperform during recession recoveries and outpace the RevPAF growth of non-LEED assets by at least 49 percentage points during both the 2008-2009 global financial crisis and the COVID-19 periods. These properties tended to have had lower vacancy rates than their non-LEED counterparts in the wake of the COVID-19 pandemic. Since the pandemic began, these buildings have seen accelerated tenant demand and a 92 percent increase in occupancy, while occupancy in non-LEED certified buildings has declined by 88 percent.
In addition, LEED-certified office buildings achieve significant valuation premiums compared to non-certified properties. For example, the sale of LEED-certified Class A urban office buildings generated a price premium of 25.3 percent per square foot over non-certified buildings, while LEED-certified Class A suburban buildings recorded a premium of 40.9 percent.
According to data from Cushman & Wakefield, LEED certification also reduces the ceiling for non-certified office properties by 40 to 80 basis points. In addition, since the beginning of the pandemic, the spread premium for LEED-certified office properties has increased noticeably in both the gateway and secondary markets.
According to CBRE’s Ingrum, investors are less willing to pay a premium for LEED certification when both a certified and non-certified building are rented to credit tenants. Overall, however, he agrees that the demand for green buildings is stronger than for non-certified facilities.
“While we currently do not see any measurable premiums in pricing the acquisition of LEED certified assets, ESG criteria are becoming more weighted in decision making and there is a strong likelihood that identifiable premiums will be paid for ‘green’ assets (in the future) . ” notes Mark Godfrey, Head of Institutional Valuations at CBRE.
For example, CalSTRS, the California teachers’ pension fund, incorporates ESG considerations into its risk analysis for its real estate investment decisions and ownership policies and practices because it is a long-term investor and can hold an asset for many decades.
“This is of paramount importance to institutional investors as they consider which office buildings will compete for top tenants over the long term,” said Alan Pontius, senior vice president and national director of office, industrial and healthcare divisions at real estate services firm Marcus & Millichap. “Most pension fund advisors and REITs can be expected to make acquisitions that meet these criteria.
In addition, many office buildings will be removed from the list of potential investments as targets to achieve carbon neutral status come into view unless owners pursue a retrofit strategy, adds Pontius. This trend is being driven by tenant demand and the rapid development of investment criteria for real estate funds.
Institutional investors are also taking the lead in incorporating environmental sustainability criteria into their new developments, Godfrey notes. Canada-based investment firm Ivanhoe Cambridge, for example, is improving the efficiency and resilience of its real estate investments with a goal of achieving net-zero carbon emissions across its portfolio by 2040.
The Cushman & Wakefield study found that achieving LEED certification increases construction costs by 7.43 to 9.43 percent. Due to the high carbon footprint of producing steel and concrete, it is extremely difficult to make new buildings carbon neutral, according to Ingrum, who notes that it is much easier to retrofit existing plants to meet sustainable standards.