ESG issues are a growing priority for investors, making it increasingly important for REITs to thoroughly disclose how they are performing.
REITs at all stages of implementing environmental, social, and governance (ESG) best practices are trying to solve a common challenge: how to better navigate the growing assortment of reporting frameworks and standards to more effectively convey their ESG story to stakeholders.
ESG is no longer a box that investors simply check off the list. A company’s ESG goals, initiatives, and performance are under greater scrutiny as investors take a deeper dive into company reports, industry indexes, and third-party analysis.
Investors are also using ESG performance to evaluate risk and the focus on sustainable or socially-oriented investments is only expected to intensify, with some industry observers predicting it could warrant nearly as much attention as investment returns in the future.
“Without question…I think it will be an increasing focus over the next couple of years,” says Bradford Stoesser, senior managing director and global industry analyst at Wellington Management.
The evolution and expansion of environmental stewardship, social responsibility, and good governance has spawned a proliferation of tools and resources that include industry indexes and benchmarks, guidance for reporting frameworks, and a variety of third-party data providers.
One of the challenges for analysts is sifting through an abundance of data from a growing range of sources. “Each portfolio manager is going to have their own philosophy and processes to investing, and they are going to have their own methodology on how they incorporate ESG into their process,” Stoesser says.
For example, Stoesser’s real estate team utilizes third party resources, such as GRESB, Sustainalytics, and MSCI Inc. They also conduct their own proprietary evaluation of companies in conjunction with the firm’s ESG analysts. “We incorporate both qualitative and quantitative metrics into our process of evaluating the E, S, and G,” he says. Wellington’s real estate and other investment teams also leverage the firm’s relationship with the leading climate science think tank Woods Hole Research Center, which provides analysis on climate change related to a series of variables, including heat, flood, drought, wildfire, hurricane, water scarcity, and air quality.
Chase Savage, an ESG research analyst at Fidelity Investments, points out that asset managers are beginning to build their own data resources to develop proprietary ESG ratings in order to differentiate themselves from other market participants and provide outperformance for shareholders.
Yet those proprietary processes and scoring systems do make it difficult for REITs to know what data is relevant to the largest swath of investors. One way REITs are solving for that challenge is engaging with investors and asking questions about what they’re interested in to better determine where the commonalities or overlap lies, Savage notes.
In addition, the larger REITs often will report data through multiple reporting frameworks, such as UN Sustainable Development Goals (SDGs), Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB), in order to capture a wide array of investors, he adds.
The Story vs the Data Scorecard
Investors are taking both a qualitative and quantitative approach to analyze ESG strategies and performance. Understanding the story or philosophy behind a REIT’s ESG strategy is important to global investment advisor BlackRock, Inc., but the story also needs to align with the data, says Ray Cameron, head of BlackRock Investment Stewardship for the Americas.
Data provides insight into a particular point in time, which is why it is important to understand a company’s targets and goals. What are they trying to achieve, why are they trying to achieve it, and what are the resources needed to help achieve a particular goal? There are a lot of third-party data companies out there that can fill in gaps in data or metrics that investors are looking for, and if companies aren’t providing that information, then those gaps will be filled in by others or assumed. So, it is really important for companies to tell the stories themselves, Cameron explains.
For example, BlackRock is looking for alignment around priorities such as governance and whether there is diversity represented on the board, capital allocation, environmental risk, and human capital management.
“We are not looking at those specific principles or priorities in isolation, we are looking at the alignment across the organization,” Cameron says. For example, what incentives does a company have related to executive compensation so that management is incentivized to make the right decisions as they consider all of their stakeholders, and what impact does it have with respect to decisions around capital allocation and also how they think about climate-related risks and opportunities, he says.
Oftentimes, understanding that story requires engaging directly with the company through one-on-one or group meetings. “Companies may have strong data points regarding their ESG credentials, but most investors are finding that only relying on backwards looking data is not helpful in distinguishing the winners and losers of the future,” Savage adds. What investors want is to speak with sustainability teams, as well as having conversations with senior management, on material ESG issues.
“We are seeing more and more how ESG issues are not separate from the overall business. So, having senior management teams willing and able to engage is often a sign that a company may be better positioned to address ESG material risks and opportunities compared to its peers,” he says.
Drilling Down Into E & G
Investors and analysts are taking a deeper dive into each broad pillar of ESG, and they are willing to share some insights into their processes that might help REITs develop better best practices.
Environmental performance is a major focus for both REITs and stakeholders due to the increased focus on climate change, as well as the direct impact of energy and resource consumption on operating costs.
“When we see data, we don’t take it for granted. What we really want to look to see is what the data is telling us, and does it really include all of the emissions,” says Derk Welling, senior responsible investment & governance specialist, APG Asset Management N.V., a pension services provider in the Netherlands.
For example, a REIT might say in a company report that it has achieved a 30% reduction in emissions, with no supporting numbers. “We want to know how that 30% reduction is applicable to what share of the overall portfolio, and we want to understand the story behind it,” he says.
Additionally, many analysts would like to see more consistent and uniform reporting of environmental data for all assets within the portfolio. For example, REITs tend to seek LEED or BREEM certification for outperforming assets. Companies are usually quick to highlight their success stories and best-performing assets, but how are they investing in those assets that are not performing in order to make improvements?
One area where REITs lag other industries in achieving ESG goals relates to Scope 3 emissions, in part because it involves tenant data that can be more difficult to measure.
Greenhouse gas emissions are categorized into three groups or ‘Scopes’ by Greenhouse Gas (GHG) Protocol. Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating, and cooling consumed by the reporting company. For REITs, Scope 3 typically includes indirect emissions occurring within tenant-controlled spaces, which can be difficult to capture and obtain since in the United States generally there is no requirement for tenants to share energy consumption or emissions data with landlords.
Information on the entity performance of the tenant areas is important, Welling says. Further, companies should certify the complete portfolio if they have a plan that allows them to monitor the environmental performance on an annual basis, like BREEAM USA in-Use or LEED EBOM, he says.
APG also wants good transparency on where assets are located to better assess physical risk and transitional risk related to climate change. For example, New York has a new law that will go into effect in 2024 and 2030 in terms of kilograms of emissions allowed per square foot. This transition risk to new legislation will require companies to really pay attention so that there is sufficient capital expenditure in place to improve the portfolio to ensure that assets will ultimately stay below those required levels, he adds.
Investors also are sensitive to potential “green washing,” or misleading information that paints a company in a more positive light in terms of its environmental performance.
“There is always a concern about greenwashing, especially when it comes to companies that are not well versed in understanding the existential threat climate change and severe weather play in our economy, both in the immediate term and the long term,” Savage notes. Some companies are getting around this concern by attaching specific environmental goals to bond issuance or imposing step-up penalty fees on the interest rates they pay investors if they do not meet specific targets, he adds.
Governance, meanwhile, has been an early focus and continued priority for investors in the scope of evaluating ESG performance. For example, the first lens that BlackRock looks through when evaluating a REIT’s ESG performance is its governance.
“We focus on encouraging companies to adopt governance practices that lead to sustainability over time,” Cameron explains. That due diligence often comes directly from a company’s proxy statements, bylaws, and charter amendments.
Stoesser believes that being disciplined regarding capital allocation is crucial to creating value in real estate.
“You can destroy or create more value through poor capital allocation than you can through operating the properties well or poorly,” Stoesser says. As such, he focuses on management incentives to make sure they are aligned with capital allocation strategies and growing shareholder value.
Another area where REITs can improve governance practices is management compensation. There has been a race to the top in terms of management compensation that hasn’t always reflected the investment returns that stocks have achieved, he adds.
Social Initiatives Get Increased Attention
Social impact is the least reported and developed of the three ESG categories, but it is also getting increased attention. There is a lot of information that can be potentially captured in the social category, but investors are focusing on how REITs are managing their human capital.
Every company is thinking about how to attract and retain the brightest and best talent. So, from a social practice perspective, investors are focused on sound worker safety and labor policies, sound hiring practices, good training and development programs, good diversity and inclusion practices, gender and racial diversity, and community and neighborhood engagement.
“We think that the best S analysis is generally provided by management pertaining to human capital management practices and relationships with operating partners,” Cameron says. “We do find that our engagements with management teams and directors provide insights that simply can’t be captured through data. So, we do rely on a mix of qualitative and quantitative information, and it really hinges on better disclosures from companies,” he adds.
Investors are also tapping voluntary REIT disclosures and third-party data sources. “We use the company-level data that is provided to us, and we use third-party resources as a validation and to complement the information that we are getting,” says Steven Hason, managing director and Head of Americas Real Assets at APG Asset Management US Inc., a subsidiary to APG.
In addition, investors are looking at how companies are doing on their own and in the context of how they are doing relative to their peers, he adds. “We also have a high level of engagement with companies where we get a flavor of management’s philosophy on social policy. So, it is important for us to take the time to be, not an activist investor, but an active investor,” he says.
Ultimately, investors are interested in the story or a firm’s overarching strategy related to ESG. In addition, investors want to know how ESG initiatives are evolving. Are REITs trying to make change? Are they trying to make themselves better from an ESG perspective, and are they willing to engage in discussion about how they can improve?
“All companies do need to challenge themselves to do better from an ESG perspective, because the long-term gain is so important that taking that extra initiative to challenge themselves and the industry will provide great returns, beyond just financial returns,” Hason says.
According to Nareit’s ESG dashboard, GRESB, CDP and GRI are the most commonly utilized ESG frameworks by REITs. GRESB was established in 2009 by a group of large pension funds that wanted access to comparable and reliable data on the ESG performance of their real estate investments.
MSCI Inc. and Sustainalytics are commonly viewed as the two leading data providers for ESG ratings and data, while other third-party data sources offer more granular data within each category. For example, the CPA-Zicklin Index provides data on political lobbying for corporate governance, and the CDP is a non-profit based in the U.K. that gathers disclosure data on companies’ environmental impact regarding climate change, water security, and deforestation.
Nareit Expands ESG Reporting Sources
Nareit is continuing to stress the importance of publicly disclosing ESG efforts and is providing more tools and resources to help REITs in that endeavor.
REIT ESG disclosures fall into three buckets—voluntary disclosures, guidance frameworks for reporting, and third-party aggregators that look at what a REIT is publicly disclosing. “It is important for REITs to understand what they are putting out there in their own voluntary disclosures and how they are being evaluated by the third parties,” says Fulya Kocak, LEED Fellow and SVP for ESG Issues at Nareit.
“If REITs don’t disclose at all, especially the third-party aggregators will assume that it is not happening,” she says.
REITs are already doing things that they may not realize fall under the ESG umbrella, such as providing workforce training and maintaining strong governance policies. “What we would like REITs to do is understand where they are with all of these different aspects of environmental, social, and governance initiatives and policies, and start disclosing on their goals, efforts, and progress,” Kocak says. Equally important is for REITs to affirmatively include on their websites statements that they do not engage in certain actions being monitored by third party aggregators, such as not violating child labor laws.
“Even for REITs that are in the very beginning of establishing ESG policies, they can start reporting on their goals and their approach to ESG and build on that over time,” she adds. Some of the key resources that Nareit has produced to date to assist its membership in their public disclosure efforts include: The Nareit Guide to ESG Reporting Frameworks (PDF); ESG Dashboard; ESG JumpStart Program; and, REIT Industry ESG Report.
Overall, companies need to understand that there are two aspects of ESG. One is implementation and two is disclosing. “If you do the implementation and don’t disclose on it publicly, what you do is not always on the radar of investors, the public, or other stakeholders,” Kocak says. As such, it is important for REITs to address both implementation and disclosure, she adds.
Read more from September/October issue of REIT magazine, available now in an interactive PDF.