Business case assumptions for mass timber construction appear to be evolving as more real estate players begin to account for embodied carbon in their greenhouse gas (GHG) emissions profiles. Paul Morassutti, vice chair, valuation and advisory services, with CBRE Canada foresees investors and lenders will increasingly focus on the physical and transitional risks of climate change, in turn upending some conventional views of costs and value.
“Our criteria for what makes a great asset is changing,” he observed earlier this month during the online release of his firm’s 2022 Market Outlook report. “Consider the amount of carbon sequestration in these (mass timber) buildings together with the carbon avoidance you get from not building with steel or concrete. Then layer on the fact that tenants love these buildings.”
Discussing some rapidly emergent expectations for the environmental, social and governance (ESG) performance of real estate portfolios, Morassutti and other industry insiders, who were called on to share their views as part of the online presentation, noted the broadening scope of sustainability efforts in step with an expanding field of interested parties. Objectives and targets are shifting from operational savings via energy and water efficiency to more comprehensive strategies to achieve GHG reductions and, ultimately, net-zero emissions. Accordingly, asset managers will have to respond to changing valuation criteria and reporting demands, and will need new instruments to allow them to do so.
Integrating sustainability and financial factors
Among the top ESG trends for 2022, Morassutti cites some looming weighty influences. For example, all of Canada’s major banks have now signed on to the Partnership for Carbon Accounting Financials (PCAF), a global alliance of more than 230 financial institutions that have agreed to apply standards for measuring and reporting the GHG emissions of their loans and investments. In complementary global initiatives, Montreal was recently chosen as one of two host cities, along with Frankfurt, for the International Sustainability Standards Board (ISSB), which is tasked with developing disclosure standards for climate-related risks and opportunities intended to guide investors and the capital markets.
“Today, GHG emissions have no discernable impact on the availability or cost of financing, but that is set to change,” Morassutti advised. “Lenders will have to report on and include GHG emissions for the assets on which they lend. The price and availability of debt will reflect this.”
That’s also expected to come with new approaches to valuation as appraisers account for what Morassutti terms “green premiums or brown discounts”. Commenting on that emerging demand during on an online event jointly sponsored by PwC Canada and the Toronto chapter of the Urban Land Institute (ULI) last fall, Colin Johnston, president, research, valuation and advisory with Altus Canada, acknowledged that he and his peers are still grappling with how some of the qualitative aspects of ESG translate into capital value. However, he pointed to some tangible metrics, like building certifications and performance scores, which are already taken into consideration.
“It’s easy for me to think about a LEED Platinum office building. I can see that it can generate higher net rent. I can see that it has a shorter lease-up horizon, and then I can see that translating into value,” Johnston explained. “I cannot, at this point, tell you necessarily that that building’s getting a quarter-point better cap rate, but I can tell you that it’s driving better income.”
Looking to the brown discount or climate risk side of the equation, Bryan Reid, MSCI’s executive director of real estate research, outlined some of his firm’s efforts to model physical and transitional climate impacts during this winter’s online forum to release the Canada Property Index 2021 investment returns. Drawing on data from the MSCI subsidiary, Real Capital Analytics, he traced the significantly differing risk profiles of three industrial assets — located in New York, Maryland and Arizona — that transacted with an identical 5.2 per cent cap rate in the fourth quarter of 2021.
“Maybe there is the potential for market pricing to start to adapt and reflect some of these risks as climate risk becomes a little bit more well understood and a little bit more consistently measured and priced,” Reid mused. “Undoubtedly, it’s something we’re seeing investors allocate a lot more time and effort to, so definitely something that we will be keeping an eye on.”
“It’s very interesting data, this progress on transition risk,” agreed Michael Brooks, chief executive officer of REALPAC and special advisor to the United Nations Environment Programme Finance Initiative (UNEP FI) through its Property Working Group. “There are powerful forces at work in the real estate market and big issues for investors.”
New costs precede envisioned paybacks
Asset managers participating in the PwC/ULI-sponsored panel discussion last fall generally suggested they’re in a transitional period. While projecting they’re on the cusp of reaping higher returns from investments in sustainability, they’re facing some pressures in the interim, whether that’s added costs or the complications of proving performance.
“The reality, at least now, is there is a cost to this and it will be reflected in your returns,” said Ashley Lawrence, managing director and head of Canadian real estate with Brookfield Asset Management. “Over time, as it becomes more prevalent and more standardized, or everyone is doing the same thing or trying to achieve the same thing, I think you’ll see that lift.”
Andrew Duncan, chief investment officer with RioCan Real Estate Investment Trust confirmed that has been his company’s experience over the past five to six years since embarking on an ambitious sustainability program. That’s seen the REIT gain recognition as a top performer in GRESB, the ESG assessment and benchmarking program for commercial real estate portfolios, and Green Lease Leaders, among its industry achievements.
“In 2016, the issue was: this is table stakes from an investor’s standpoint and it may not save us, but cost us money at this point,” he recounted. “We are starting to see savings and we are starting to see returns on investment, but you’ve got to have the stomach to commit to it.”
“It’s really easy to integrate environmental sustainability into new builds and there is a business case associated with it,” added Jaime McKenna, managing director and group head of real estate for Fengate Asset Management. “The biggest challenge we have is legacy assets —getting to older assets and building an economically viable business case.”
Meanwhile, booming industrial demand may provide further momentum to curb emission intensity as asset managers build new facilities and realize revenue gains to help underwrite some of the envisioned improvements. “We are figuring out how to put in rooftop solar and other technologies — what we call behind-the-meter — so that we can be off the grid and we can share that benefit with our occupiers,” Michael Turner, president of Oxford Properties, reported during the recent CBRE-sponsored online presentation.
Rippling through to the economic impact of such spending, Benjamin Tal, deputy chief economist with CIBC World Markets, reiterated that investments in productivity can be a hedge against inflation.
“If I give you a 10 per cent pay increase and you are 10 per cent more productive, that’s not inflationary. So if you can enhance productivity, you really can protect from inflation even if wages go up,” he maintained. “We see a situation in which companies are starting to react. We see companies investing in technology.”
Barbara Carss is editor-in-chief of Canadian Property Management.
