A bird's eye view of real estate risk disclosure
Opportunistic and value-add real estate investment strategies are topping the charts in both number of funds seeking capital as well as in total equity amounts targeted. This is evident in PERE Research & Analytics' Q3 Fundraising Report (PDF). And according to Preqin’s Q3 2016 Fundraising Update (PDF), Q3 alone saw 13 value-add and eight opportunistic funds hold a final close, which equates to more than six times that of their core counterparts.
What does this higher-risk investor appetite mean for real estate sustainability disclosure and performance? Some investment managers express hesitation to report environmental, social and governance (ESG) performance of their funds operating in the upper spectrum of risk, often presuming that sustainability negatively affects returns or that this type of investor communication is better suited for core real estate funds.
Private equity participants in the 2016 Global Real Estate Sustainability Benchmark (GRESB) Real Estate Assessment cover the full spectrum of investment strategies. From core funds to opportunity funds, it assesses every property type and risk profile including development, lease ups, capital stack restructuring, re-development and other special situations.
The reporting holdout
Since 2013, over 260 opportunistic and value-add funds received a benchmark score from GRESB. The 2016 cohort comprises 155 funds: 119 value-add and 36 opportunistic funds. Value-add funds averaged a GRESB score of 52, with 10 funds achieving the top GRESB 5-Star rating (four of which hail from the U.K.). Opportunistic funds showed better than expected, with six funds equaling or besting the overall GRESB average score of 60.
So, what’s the holdout? Short hold periods. Quick sales should not be barriers to implementing efficiency improvements or to disclosing ESG performance. Rather, higher risk funds are truly ideal candidates for ESG implementation particularly because value-add and opportunistic investment strategies acquire properties with the greatest potential for wholesome asset improvement and downside risk mitigation.
These investment strategies seek alpha through asset repositioning, including both capital improvements and upgrades to management talent and procedures. Cosmetic and structural renovations are done with an eye toward increasing rental income streams and attracting high credit tenants. Property management improvements target operating expense reduction and reducing or eliminating tenant turnover.
The investment objective is to capture the resulting value appreciation relatively quickly — generally over a two- to three-year intended hold period. This short ownership time may cause fund managers to hesitate when deciding whether to introduce marginal investments in energy, water and waste efficiency improvements, or to invest in the data tracking processes required to provide portfolio-level ESG performance to their investors.
Here’s the catch: These assets are intended to be sold into the core market, where there is significant demand for more efficient assets. In today’s hyper-efficient market, any investment that affects cash flow, risk or leasability is precisely capitalized.
Acting with confidence
Fund managers act as fiduciaries and require confidence when determining the potential monetary payback from property upgrades, including investment into efficiency upgrades. Efficiency projects expect the projected return on investments to realize through:
- Yield at the point of sale via increased net operating income (re-leasing strategies) and/or a lower-risk capitalization (cap) rate, and
- significant operating expense (op-ex) cost savings during the hold period.
At an 8 percent cap rate, every $0.10 per square foot gained in net operating income (NOI) through op-ex cost reductions and increased rent results in $1.25 per square foot of asset value.
Such capitalization has been documented in more than one empirical study (PDF); favorable cap rate treatment due to risk reduction accentuates these gains. While major retrofits can be expensive and time consuming, fund managers often can realize gains through operational upgrades coupled with low-cost efficiency improvements focused on minimizing building energy and water consumption.
And not all of the improvements in building efficiency involve actual capital outlays: According to the International Facility Management Association, energy consumption for HVAC systems can be reduced up to 20 percent through detection of mechanical faults, ongoing commissioning and ensuring optimal systems operations. These operational improvements reduce property expenses yet do not require capital outlay for retrofitting, thus providing investors an immediate return on investment.
Incorporating the framework
During the earlier stage of acquisition due diligence, leading private equity firms often perform energy audits and analyze utility consumption patterns to benchmark the building before implementing their asset-specific investment strategy. Whether it is a change in property management personnel or the pursuit of cap-ex improvements, having baseline data detailing existing conditions allows asset managers to measure the financial effects of their investment program.
GRESB recognizes the ability of leading organizations to acquire and report this utility data as solid management practice that increases confidence in investment outcomes while reducing risk.
With more than half of opportunistic fund participants earning a GRESB Score above 50 in 2016 (58 percent for value-add funds), it’s clearly possible for private equity fund managers pursuing higher-risk investment strategies to integrate sustainability in their investments, to participate in GRESB, to acquire the operating data necessary to deliver a full assessment and to demonstrate measurable portfolio improvements.
Even if a value-add or opportunistic fund initially scores low on the GRESB Assessment, this should be viewed as a beneficial opportunity for identifying and implementing management improvements that can add to NOI growth.
Institutional investors seek fiduciaries that can deliver high returns at fewer units of risk. Annually assessing a fund using the GRESB framework helps institutional investors identify fund managers using superior risk management techniques.
With the widest set of potential fund investment choices in the value add and opportunistic space, private equity fund managers must be ardent about their strategic positioning when capital raising. Year-over year participation in GRESB geared to gaining business intelligence into the market, identifying gaps and making informed business decisions that set the course for continual fund improvement is an appealing element to any fund strategy.