The REIT Stuff

The REIT Stuff

At a time when many companies are looking for any excuse to market themselves as "sustainability" leaders, why is an industry that's been investing millions in green building over the past five years hiding its involvement?

The reasoning appears simple.

Fund managers of REITs — real estate investment trusts — know that as regulations and energy prices increase, and sustainability continues to be a buzz word, energy-efficient buildings will save and make money. In addition, although green building has proven attractive at luring tenants, REIT investors are traditionally more conservative. Some fund managers say they're concerned that broadcasting their investments in green building will scare off shareholders.

While it may seem there are only one or two REITs overtly focused on environmental responsibility, many other trusts make features such as energy efficiency a key priority — they just wouldn't dream of applying narrow descriptors such as "green" to their investment portfolio.

Equity Office Properties (NYSE: EOP) is a prime example. A founding member of the Chicago Climate Exchange (CCX), the REIT has been a U.S. Environmental Protection Agency Energy Star partner and award-winner for five years. The trust has committed to installing cogeneration systems across its property portfolio — over 124 million square feet of office space in major U.S. metropolitan areas. Fifteen installations, 10 of which are in California, have already been completed. The REIT's commitment to energy efficiency has resulted in an estimated average of $2 million of savings per year.

The company’s spokespeople are happy to share information with other energy innovators on the EPA’s Web site, to be quoted in magazines extolling the virtues of energy efficiency, or to provide details of their cogeneration plans for use in best practice guides. But there is scant mention of EOP’s energy policies on its Web site or annual report, and it has no interest in selling itself as "green" to the average investor. It leaves that to socially responsible investment advisors like KLD, which recently added the REIT to its Domini 400 Social Index.

Averting a Crisis

For several years, Arden Realty was the only REIT with a formal and vocal commitment to the environment.

An early adopter of energy-efficient design, Arden in 1999 retrofitted and implemented computer-based energy management systems for the lighting, heating, ventilation and air conditioning systems in 70% of its properties. The measures allowed the company to reduce annual energy costs across its building portfolio — 18.5 million square feet in southern California — by $4.8 million.

Arden continued the program, posting regular internal rates of return of 20% to 80% on each project, and less than a five-year payback for the overall portfolio. For having the most Energy Star-certified buildings in a single portfolio, Arden was honored for three consecutive years with EPA’s Energy Star Partner of the Year award.

"We had the foresight to do a lot of these things before there was an energy crisis, and then we were in a position to tell the world that we’d already made these considerations," says Scott Lyle, president and CEO of next>edge, Arden’s energy consulting subsidiary.

In contrast to other REITs, Arden has historically promoted its stance on energy both on its Web site and in its annual report. The visibility spurred the creation of next>edge in 2000.

“The driver for next>edge was two-fold: first, we felt we had unique perspective as a group that also owned and operated real estate; and second, other owners heard about what we were doing and really wanted to know how to do it themselves,” Lyle explains. “We were getting calls from peers for best practices, so we saw both a financial opportunity and an opportunity to be a part of educating the industry.”

On May 2, Arden was sold for $4.8 billion to General Electric Real Estate. While it no longer qualifies as a REIT, Arden and next>edge will continue to operate under the GE umbrella — and serve as a case study for aspiring green REITs.

“I think it’s better now,” Lyle says. “As little as a year ago, we weren’t having as detailed of a conversation about energy. And before the energy crisis, we weren’t having it at all. Issues of energy usage and how that ties into building operational costs have made it tangible for owners. And then there’s global warming. And now it’s not just global warming — it’s national security, economic security and economic survival.”

Lyle says energy efficiency and social responsibility are concerns the investment community is beginning to embrace, and more REITs are likely to begin discussing such subjects.

“If you look at the fact that CalPERS and CalSTERS have launched initiatives to look for assets that reduce energy consumption, and that companies like Ford, Honda, Toyota, Nike and GE are creating social accountability programs, you can tell that the investment community is starting to pay attention and that companies recognize that not only their investors, but customers and employees, expect them to be responsible,” Lyle says.

A New Class of Trusts

One REIT starting to be more vocal about its environmental record is Trizec Properties Inc. (NYSE: TRZ), which is acquiring 13 Arden properties as part of the GE Real Estate deal. In the late 1990s, Trizec introduced its Energy Excellence Program, which has saved the REIT an estimated average of $16 million per year in energy expenses.

Likewise, two large national REITs decided in 2004 that their investors were ready to hear about green building, and that a firm policy on energy efficiency might even attract new investors. Both Hines and Liberty Property Trust (NYSE: LRY) REITs are offshoots of large, multi-national development firms that had already developed and built several green buildings.

Among Hines’ owned and managed Energy Star-certified buildings, 70 are major U.S. office buildings that account for 22% of the total square footage of all non-governmental office buildings in the EPA’s Energy Star program. The Hines REIT, launched in 2004, currently holds about 6 million square feet of office property throughout the United States. The company says it’s committed to growing that portfolio throughout the next year.

Liberty Property Trust is one of few REITs to focus on the U.S. Green Building Council’s LEED (Leadership in Energy and Environmental Design) rating system instead of the EPA’s Energy Star program. Liberty’s Plaza at PPL Center in Allentown, Penn., was one of the first LEED Gold-rated office buildings in the United States, and Liberty currently has five LEED-targeted developments in progress.

In 2005, the increasing acceptability of social and environmental responsibility concerns in an investment setting inspired the launch of the Rose Smart Growth Investment Fund — the first REIT explicitly devoted to “smart growth.” The fund was launched with $100 million in initial investment from Jonathan Rose Cos. LLC, a network of affiliated planning and development firms.

Real Estate Realities

Along with increasing acceptance of green building standards and socially responsible investing, the past few years have brought a shift in how investors and analysts think about REITs in general. As property values skyrocket across the United States, some REITs and their investors have begun to feel their assets would be worth more in a privatized structure, even with the extra tax burden (REITs aren’t subject to corporate tax). A Real Estate Forum report, based on Real Capital Analytics figures, recently stated that, of the $261 billion of core properties that traded in 2005, $131 billion went to private buyers.

“The market is simply undervaluing the stock compared to what management believes is the real value of their assets. It’s a classic buyback situation,” Gregory Pressman, partner in the real estate arm of New York City law firm Schulte, Roth & Zabel LLP, said in a report.

Though some REITs may be unable to provide the high returns they think they deserve in a hot real estate market, it’s doubtful the trend will have much effect for specialized REITs like the Rose Smart Growth Fund. Jonathan Rose Cos. deals mostly with nonprofits, and investors may be just as committed to its ideals as its returns.

Similarly, for-profit companies such as Hines and Liberty, which hold a combination of private and publicly held assets, can benefit from the tax breaks and market growth provided by the REIT structure while maximizing profit on the private side. Timber companies are increasingly catching on to this notion and converting forestlands into REITs to benefit their manufacturing operations.

Though some environmental watchdogs have criticized the government for allowing “big lumber” to wiggle out of taxes, REIT conversion is also what is allowing the West Coast timber giant Potlatch Corp. (NYSE: PCH) to keep its Forest Stewardship Council-certified forests profitable and poised for growth.

REITs are increasingly trying to distinguish themselves in ways that draw more investors and raise share prices. Lyle says he thinks there is certainly a market for REITs focused on green building, but whether or not there is a market for dedicated “green REITs” might be a moot point.

Investors concerned with environmental and social responsibility are likely to do their homework and find the REITs in line with their values. Those who aren’t concerned will choose the best-performing REITs. With trusts active in the EPA’s Energy Star program outperforming non-participants by over 18%, according to Innovest, the two hypothetical investments may be one and the same.

This article has been reprinted courtesy of Sustainable Industries Journal. It first appeared in the June 2006 issue of that publication.