Preqin sits down with RSM Canada’s Mark Jakovcic, partner, and RSM US LLP’s Scott Helberg, senior manager and real estate analyst, to discuss why real estate GPs and LPs should consider ESG, and how to effectively implement ESG policies into their investment decisions.

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Preqin: To what extent is ESG a key element of the decision-making process for real estate investments?

Jakovcic: Environment, social and governance investing—known as ESG—is increasingly becoming a differentiator in the real estate industry. ESG programs foster the ability to identify and assess risks in asset acquisition projects, as well as across broader investment decisions and strategies. These criteria are increasingly considered by asset managers and investors.

ESG is more frequently being used as a risk management tool, as well. For some additional upfront costs, ESG provides an opportunity to make large operational savings during the life of an investment. For example, an investment in energy efficiency can potentially be a good strategy. Commercial and residential buildings account for a third of global greenhouse gas emissions and consume up to 40% of global energy. Well-developed ESG programs can therefore enable real estate investors to manage the risks associated with climate change.

Preqin: Why should real estate players increase their focus on ESG?

Helberg: Investing preferences are going to be crucial in this highly competitive market. Millennials are on track to inherit $30 trillion in assets over the next few decades, and they've emphasized social responsibility and climate change issues more than previous generations. It’s important that GPs have ESG policies and procedures in place in order to attract that capital.

Another benefit that maybe isn't as apparent is the karma-building effect of an active ESG policy. Being able to connect with the community and demonstrate the positive impacts of your policies might actually help you later on.

Preqin: How can private real estate professionals most effectively implement ESG into their investment decisions?

Jakovcic: Rather than focusing on a sweeping range of ESG factors, GPs need to focus on understanding the factors that are material to them and that are likely to impact the financial condition or operating performance of the company, as well as what matters to their investors. Real estate is primarily focused on environmental issues, but looking at it from a social pillar standpoint, you also have health and safety and working conditions. And from a governance standpoint, ethics and risk management are viewed with a critical eye.

A lot of GPs understand what ESG is and the various criteria required to evaluate their own organizations, but there are a lot of questions around uniform reporting, given that it doesn't exist at this time. To successfully launch an ESG program, companies should start by considering creating a vision or mission statement that defines the purpose of the program and what it means to them as well as to investors. Consideration needs to be given to which measurements apply and how to best report them, as well as their impact.

Helberg: As we're increasingly focusing on minimizing carbon footprints, evaluating the materials used is going to be a huge part of the development and construction process. For example, we are now looking at how to effectively utilize energy and focusing less on carbon fuels and more on electricity. There are a few options out there, but they might not work for everyone, depending on their location or what they're doing with the property.

Preqin: When it comes to ESG adoption, what differentiates investment in North American real estate from the rest of the world?

Helberg: Most would agree that Europe is the leader when it comes to ESG policy, standards and investor preferences. For example, U.K.-based REIT Great Portland Estates recently issued an ESG credit policy. Indeed, the EU itself has imposed policy to require disclosures from asset managers. North America is definitely behind in comparison: a lot more ESG reporting has been investor driven rather than policy specific. Until now, though. We have seen a 40% increase in ESG reporting among the top 100 public REITs in North America over the past few years. That said, while there are funds creating new investment vehicles specifically aimed at carbon footprinting and other ESG standards, North America is still behind Europe.

Preqin: Looking more closely at the North American real estate market, 2019 fundraising figures suggest increasing capital consolidation—only 187 funds closed but they secured a record $102 billion in aggregate. Do you think this trend will continue?

Jakovcic: We’re definitely seeing more capital consolidation and we do see this continuing. With heightened concerns about economic volatility and a downturn, investors are certainly looking at more conservative approaches to investing in real estate. This means middle market real estate funds will need to diversify their structuring and ESG reporting in order to attract capital.

Preqin: The number of North America-focused real estate funds in market is approaching a record level of 590. Do you expect competition in the North American market to intensify?

Helberg: Absolutely. We're close to record levels of dry powder, interest rates are continuing to decline, and on March 5, the U.S. 10-year Treasury rate dropped below 1% for the first time ever. With the volatility in the equity markets, investors are going to be looking to real estate as a much more stable asset choice.

Looking at the current COVID-19 outbreak, in the short term there won't be a lot of activity going on as people want to get a better understanding of the potential depth and impact of the virus on the economy. But looking at the big picture, as interest rates remain low, we do expect property prices to continue to rise and cap rates to compress as people look to invest in real estate. On the fundraising side, this could price out middle market fund managers that have to hit return and yield targets. And, as property values continue to rise, it's going to be easier for the larger fund managers to acquire those assets compared to the middle market.