November 2018

Green buildings: what are the financial benefits for investors? For Investment Professionals only

November 2018

Green buildings: what are the financial benefits for investors? Notice to investors in Australia. M&G Investment Management Limited (MAGIM) and M&G Alternatives Investment Management Limited (MAGAIM) have received notification from the Australian Securities & Investments Commission of the Class Order [CO 03/1099] exemption and are therefore permitted to market their investment strategies (including the offering and provision of discretionary investment management services) to wholesale clients in Australia without the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth). MAGIM and MAGAIM are authorised and regulated by the Financial Conduct Authority under laws of the United Kingdom, which differ from Australian laws.

For Investment Professionals only

• Investor shift towards energy efficiency and emissions regulation accelerating

• Certified buildings can generate higher distributable income, despite higher operating costs

• Margin discounts offered by active green lenders accretive to overall fund performance

• Green buildings can exhibit lower systematic risk through more stable income

• Should investment managers adapt underwriting assumptions for certified buildings?

Executive summary

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IntroductionWith the built environment responsible for almost 40% of energy consumption in the EU,1 real estate investors around the world are increasingly committing to more sustainable practices. Our study evidences that a portfolio of certified buildings experiences relatively higher operating expenses, but can also generate higher rental income and higher cash flows for distribution to investors.

We also highlight a growing trend among European lenders taking an active interest in sustainability through green lending initiatives, by providing a margin discount of up to 20bps to borrowers provided they commit to reducing energy usage within their buildings. We believe lower interest rate expenses could further enhance a fund’s distribution yield.

Lastly, we argue that a certified property portfolio carries less systematic risk, reflected in more stable occupancy rates and lower variation in operating expenses. Our results are based on the M&G Real Estate universe of continental European assets.2

The continued shift towards certificationGreen certification was first introduced in the 1990s, yet nearly three decades later the real estate sector is still learning about the financial implications.

Figure 1: Environmental certifications are used globally.

N.B. Countries in brackets refer to the certification country of origin.

1990 BREEAM

(UK)

1998 LEED

(US and Canada)

2002 HQE

(France)

CASBEE (Japan)

2008DGNB

(Germany)

According to the CBRE 2018 International Green Building Adoption Index, 19% of the 11 global markets monitored are now certified as ‘green’ (equating to 21 million sq m).3 This marks a significant increase compared to 6% in 2007, and reflects the shift in investor focus towards energy efficiency and tighter regulation on emissions.

Canada is leading the global real estate industry, with over 50% of the office stock in both Vancouver and Toronto now certified. In Vancouver, the city’s Greenest City 2020 Action Plan has set a target that all buildings constructed from 2020 onwards will be carbon neutral in operations. Clearly, this has placed pressure on developers and investors to rethink their building specifications and investment strategies, but it has also seen occupier demand for green buildings strengthen, as employers attempt to attract and retain staff with a better working environment.

In Europe, Stockholm has gained an international reputation as a business headquarters, attracting operations of several multinational corporations, including US online sales giant Amazon, Spanish engineering and infrastructure firm COMSA, and Finnish smart green walls innovator Naava.4 The Swedish capital was recognised by SparkLabs Global Ventures as ranking fourth globally in providing a supportive environment for tech start-ups in 2017.5

According to the CBRE 2018 International Green Building Adoption Index, tenant environmental awareness has matured in Stockholm and influences location choices with tech tenants increasingly more prepared to pay a premium to occupy a certified building.

1 Source: European Union. 2 Stabilised assets in the M&G European Property Fund only. Excludes developments. 3 Main ‘green’ rating schemes by country: Germany (DGNB and LEED), Netherlands (BREEAM-NL), Sweden (LEED), France (HQE, BREEAM or LEED), Sweden, Poland and Luxembourg (BREEAM). 4 Invest Stockholm, ‘Why Companies Like Amazon Love Stockholm,’ May 23, 2017. 5 Bernard Moon, ‘Top 10 start-up ecosystems in the world 2016,’ November 5, 2016.

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While Europe is some way behind Canada in terms of its green credentials, no more than a decade ago certified buildings made up less than 1% of stock in most major cities. Today, green buildings make up 18% of stock in Frankfurt, followed by Stockholm (13%), Amsterdam (11%) and Paris (9%).6

Figure 2: Percentage of certified buildings by city

% Certified buildings (area)City Type 2007+ 2016

Vancouver BOMA / BESt / LEED 29% 52%

Toronto BOMA / BESt / LEED 15% 51%

Sydney NABERS / Green Star 1% 47%

Melbourne NABERS / Green Star 1% 29%

Warsaw BREEAM / LEED 1% 21%

Manhattan LEED 0% 20%

Frankfurt DGNB / LEED 0% 18%

Stockholm BREEAM / LEED 1% 13%

Amsterdam BREEAM / LEED 0% 11%

Paris HQE / BREEAM / LEED 0% 9%

London BREEAM / LEED 0% 9%

Source: CBRE, International Green Building Adoption Index 2018.

The bottom line – what are the performance benefits?A key concern of real estate fund managers in relation to sustainability efforts is the impact on a portfolio’s bottom line. So, do environmentally sustainable properties offer financial benefits to investors? The analysis that supports this idea is set out below. The hypothesis was also tested in recent academic work using underlying data from US REIT cashflows split into certified and non-certified buildings.7 We sought to replicate the study using data drawn from the projected cashflows of our European property portfolio.

M&G Real Estate’s certified buildings account for a quarter of its European investments (% AUM).8 Their ratings range from Good to Excellent. Efforts are in progress to increase the share of green buildings to 50% by 2020.

Our findings have shown that the certified share of M&G European assets achieve a higher rental income (+53bps). We also found that certified buildings experience higher operating costs (+31bps), likely because ‘smart’ buildings tend to feature sophisticated technology in exchange for greater ambient control. On balance, we find that the rental revenue premium compensates for the increase in operating expenses, resulting in a higher distributable income to investors (+19bps).

Figure 3: Yield premium: certified vs. non certified buildings

Rental income/ % NAV

Operating expenses/ % NAV

Distributable income/ % NAV

Yield premium: certified vs non-certified buildings

53bps 31bps 19bps

Source: M&G Real Estate, November 2018.

Margin discounts offered for energy efficient real estateAs commitments to sustainable real estate practices have increased, it is no surprise that real estate lenders have become more active in this area. According to the UN Environment’s Inquiry which surveyed major European banks, eight out of the 10 banks questioned have already adopted some form of green lending for commercial real estate. Despite this activity being in its infancy, the lending departments of banks have been more active than any other banking department. Banks have increasingly recognised the importance of sustainability in protecting against obsolescence and value loss, thereby reducing risk for both borrowers and lenders alike. To address this issue, a new strategy of ‘green tagging’9 has emerged, leading Europe’s major banks to scale-up financing of energy efficient real estate.

6 CBRE, International Green Building Adoption Index 2018. 7 Devine and Yonder, ‘Decomposing the Value Effects of Sustainable Real Estate Investment: International Evidence’, 2017. 8 Assets under management. 9 Systematic process whereby banks identify the environmental attributes of their loans and underlying asset collateral as a tool for scaling up sustainable financing.

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Figure 4: Real estate green lenders are industry leaders

Source: Which banking departments already use a definition of green. UN Environment Enquiry, Green Tagging: Mobilising Bank Finance for Energy Efficiency in Real Estate, December 2017.

One of the first major schemes was the £1 billion green lending initiative by Lloyd’s Banking Group, launched in May 2018. It aims to incentivise borrowers through a margin discount of 20bps on purchases over £10 million, with the borrower required to deliver on a number of green commitments. These include reducing energy intensity in buildings, engaging with tenants on sustainable behaviour and providing energy performance data to the lender.

Other lenders have now followed suit in evolving and growing their green practices and are likely to play an integral role in responding to the growth in investor demand for certified buildings. Both Berlin Hyp and ABN AMRO now offer discounts similar to Lloyd’s on loans for green buildings, while ING have stated that as of 2018, they will only provide finance for office buildings in the Netherlands that meet Green Energy Label requirements.10

Mainstream green lending remains in the early stages, and further collaboration between the real estate and banking sectors is needed to standardise products. This should lead to greater market transparency and develop the evidence that greener buildings can be accretive to overall fund performance. If major lenders continue

to offer both competitive and discounted financing for certified green buildings, real estate portfolios with a larger share of sustainable assets are likely to incur lower interest expenses overall, thereby further enhancing a fund’s potential distribution yield.

Green buildings tend to exhibit lower systematic riskIf certified buildings are typically associated with higher rental values and lower tenant incentives, this also lends itself to a more stable income profile that is less sensitive to changes in economic conditions. Historic data based on M&G Real Estate’s European assets is not yet sufficient to prove this hypothesis, but recent analysis using US REITs suggests that certified buildings are often more resilient to market-wide shocks.11 This is reflected in more stable occupancy rates and a lower variation in operating expenses. As such, portfolios with a higher share of sustainable real estate are likely to have lower systematic risk.

At the property level, this creates a number of additional questions around the role of the investment manager and assumptions used to underwrite green and non-green buildings. While the more conservative approach is always best practice when appraising real estate assets, should the present value of future cash flows for certified buildings incorporate both lower incentives and lower void rates than that of non-certified buildings? Academic literature has already argued that sustainable buildings are associated with lower tenant incentives and re-leasing costs over time.12 It is probably too early to conclude, given the current limited depth to performance data, but should green certification across Europe reach the levels already seen in Canada, this is likely to be a major determinant of value for future real estate acquisitions.

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10 UN Environment Inquiry, ‘Green Tagging: Mobilising Bank Finance for Energy Efficiency in Real Estate, December 2017. 11 Devine and Yonder, ‘Decomposing the Value Effects of Sustainable Real Estate Investment: International Evidence’, 2017. 12 Devine and Kok, ‘Green Certification and Building Performance: Implications for Tangibles and Intangibles’, 2015.

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ConclusionIn this study, we reviewed the financial benefit to investors of owning certified green buildings relative to non-certified buildings. We also observed that lenders are gradually assessing collateral on energy efficiency, offering reduced margins for more efficient buildings. The combined effect of higher rental income and lower interest rate expenses achieved by certified buildings (% NAV), benefits investors in the long term by generating higher distributable yields despite higher operating expenses.

Next stepsThis is our first attempt at identifying the bottom line drivers through which sustainable practices contribute to real estate fund performance. However given the limited green sample available, we aim to repeat the study with a larger certified universe, namely our UK assets under management.

The types of analysis we aim to follow:

• Rating level: We aim to identify the financial metrics distinguishing as Good, Very Good and Excellent buildings. This analysis will test whether the certification score is reflected in a fund’s performance.

• Rating type (New Build or In-Use): Certifications across Europe are further split by rating type including New Build, reflecting the quality of green specifications of a new or recently renovated building. Alternatively, certifications can be of the In-Use type, reflecting the quality of the building services (Part 1) and on-going sustainable practices by both property managers (Part 2) and occupiers (Part 3). This analysis may have implications on strategy; is it more financially beneficial to invest in the specification of Excellent New Build buildings or in an Excellent In-Use building, where the operators/tenants develop action plans, manage, monitor, evaluate and improve its sustainability?

• Sector: We aim to identify which sector among certified retail, offices, industrial or residential assets offers the best financial benefits to investors and why.

• Assessment criteria: With each certification covering different environmental impact reporting requirements, we aim to assess whether the financial performance of certified buildings is reflected in the selected standard assessment criteria (See Figure 5).

Figure 5: Certification assessment criteria

BREEAM (UK) LEED (US and Canada) DGNB (Germany) HQE (France)

Assessment criteria ManagementHealth and well beingEnergyTransportWaterMaterialsWasteLand Use and EcologyPollutionInnovation

Sustainable siteWater efficiencyEnergy and atmosphereMaterials and resourcesIndoor environmental qualityInnovation and design process

Ecological qualityEconomical qualitySocio-cultural qualityProcess qualitySite use

Eco-constructionEco-managementComfort Health

Target Buildings New buildingExtensionExisting buildingMajor renovationShell and core

New buildingExtensionExisting buildingMajor renovationShell and core

New buildingExtensionRenovation

New buildingRenovationIn-Use

Scoring UnclassifiedPassableGoodVery goodExcellentOutstanding

CertifiedSilverGoldPlatinum

BronzeSilverGold

PassableVery GoodExcellentExceptional

Source: M&G Real Estate, November 2018.

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Case study: Greenwalk• 23,800 sq m office building, in the city’s western

business district, acquired for €126.5 million

• Let to Phillips, the global technology company and various multinational insurance companies

• ‘Excellent’ rating on both HQE and “BREEAM In-Use”, creating competitive advantage over other buildings in submarket, and helping occupiers to comply with their own Health, Safety and Environmental Management requirements

• 2017 environmental achievements include reduction of energy consumption by 10.9% and CO2 emissions by 12.2%, compared to three years ago

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ContactVanessa Muscarà Associate Director: Property Research +44 (0)20 7548 6714 vanessa.muscara@mandg.com

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