Green building trends and drivers for U.S. commercial real estate investors

LEED AP Mital Hall and real estate expert Deborah Cloutier share their take on the state of green real estate.

Institutional investors in commercial real estate are faced with myriad challenges impacting their investment decisions, the most prevalent being interest rates that are higher today than in the recent past. According to the Urban Land Institute's (ULI) "2024 Emerging Trends in Real Estate" publication, high interest rates for long periods of time slow economic growth and reduce business investments.

Some investors feel there are opportunities out there ready to be seized, while others who are more hesitant, such as those dealing with core funds, are waiting for prices to fall to make a return on their investment. As a result, institutional investors are focused on investing in existing assets and taking actions that produce a quick ROI, increase marketability, reduce risk, comply with regulations, improve valuation and meet tenant demands.

Improving sustainability and reducing climate risk

Sustainability is a focus area for commercial real estate institutional investing. An important issue for fund managers is a combination of decarbonizing their portfolios and adapting their portfolios to reduce risk associated with climate change, per the ULI Trends publication.

Why do these factors play so heavily into commercial real estate investors' decision-making? Climate regulations and investors are fueling demand for low-carbon assets. There has been an increase in tenants' willingness to pay more for Class A sustainable spaces compared to non-sustainable spaces, with an average 7.1% premium in the U.S., according to real estate and investment management firm JLL, and an even higher premium in select cities in the Asia-Pacific region and Europe.

Investment in sustainable assets can create a competitive advantage, enhance brand recognition and increase access to capital and finance-and based on supply, the time to invest is now. According to an April report from the World Economic Forum, there may be a 30% supply gap in low-carbon buildings across 21 cities worldwide by 2025, and this gap could increase to more than 70% by 2030.

Risk mitigation as a core business function

According to our clients at RE Tech Advisors, where we represent over $1.5 trillion of assets under management, climate risk is a key priority associated with sustainability. Climate risk is looked at from two angles: transition and physical risk.

Transition risk

Transition risk refers to the risks associated with transitioning to a low-carbon, more sustainable economy. These risks include regulations, geopolitical reputation and consumer demand.

Policies and regulations are important drivers for investor decisions. For example, European regulations and reporting requirements, such as the Sustainable Finance Disclosure Regulation, impact investment decisions in the United States. Several environmental regulation initiatives are under way in the U.S., and investors consider these when assessing transition risk.

One such initiative is the U.S. Securities and Exchange Commission's (SEC) new regulations on climate disclosures, currently pending adoption due to litigation. The SEC's new rules would require companies of a certain size to publish sustainability-related information describing any climate-related risks that are likely to have a material impact on the company's business or consolidated financial statements.​

In the U.S., there are currently dozens of benchmarking policies and building performance standards combined at state and local levels, with some imposing material penalties for noncompliance. Noncompliance can lead to a lower ROI and higher vacancy rates.

According to CBRE research, failure to comply with these policies in some jurisdictions, including Boston, Denver and New York City, could decrease net operating income by 5.1%-5.8%. As new policies and standards are released, commercial real estate investors must navigate them to meet reporting and reduction targets, such as those associated with Scope 1 and 2 versus Scope 3 GHG emissions.

Physical risk

Physical risk refers to the tangible impacts of climate change, including flooding, fires, droughts and extreme heat. Over the past 40 years, the U.S. has seen an increasing number of multibillion-dollar climate disasters. In 2023, for example, 28 separate weather and climate disaster events with costs and damages of $1 billion or more took place. Climate disasters have caused large increases in premiums and bankruptcies, with insurance companies eliminating some coverage in states, including Florida and California.

To better understand and mitigate climate risk impacts on business operations and investments, commercial real estate investors are assessing risk through initiatives and projects like GHG inventories, establishing GHG reduction targets for portfolios at the corporate and fund levels, and exploring decarbonization plans.

With pressure mounting, investors are implementing portfoliowide emissions mitigation efforts with prioritized building-level improvements and portfolio changes using capital and operational expenditures. Tracking actual performance impact of these efforts is increasingly important to show progress toward goals and justification of fund use for improvements. Certifying building portfolios with evolving green building rating systems such as LEED can streamline performance improvement, especially with LEED v5, where there is an even greater focus on decarbonization and resilience efforts.

Data management

Data and data management play a crucial role in mitigating climate risk in commercial real estate. The types of data needed for this work vary, and the data can be overwhelming to source, integrate and then use for analysis. However, this work is important, as it can guide investment decisions, help assess risk, assist in resilience planning and support regulatory compliance.

With increasing climate reporting requirements due to regulations or capital provider inquiries, investors are interested in integrating ESG information with financial reporting, as ESG data is important for assessing companies' long-term financial outlooks. The International Sustainability Standards Board was created to support this through standardization, to minimize confusion and create alignment among different sustainability frameworks globally. However, a major challenge companies face in being able to report assured ESG data and to managing climate risk is related to the complexity associated with data management.

Common challenges with data management include availability of data, particularly whole-building utility data; quality and accuracy of data; data integration and standardization; and cost of acquiring data.

Addressing these challenges requires collaboration among stakeholders, including government agencies, research institutions, real estate developers and technology providers. For example, the Real Estate Roundtable, a public policy advocate for the commercial real estate industry, encourages federal agencies to improve the data upon which the real estate industry relies. This includes the Commercial Building Energy Consumption Survey, which provides data that the EPA uses to generate Energy Star building scores; and EPA's Emissions and Generation Resource Integrated Database, which helps determine carbon factors used by policymakers and companies.

In addition, associations and federal agencies such as the Building Owners and Managers Association, Institute for Market Transformation and the EPA have a campaign focused on whole-building data acquisition.

Access to capital

Top of mind for real estate investors is accessing low-cost capital to manage climate risk and to complete energy and carbon reduction projects. Governments, financial institutions, utility companies and various organizations are offering financial incentives such as grants, subsidies, tax credits or low-interest loans to encourage investments in climate-resilient real estate projects.

These incentives can help offset the costs of implementing green infrastructure, energy-efficient technologies and other resilience measures. The Better Buildings Financial Solutions program from the U.S. Department of Energy is working to identify how and when building owners should approach public and private financing sources to build their capital stack.

Green finance opportunities are filling a key role in bridge financing to pay for the planning of decarbonization projects. The Inflation Reduction Act authorized the creation of the Greenhouse Gas Reduction Fund, informally known as a national green bank.

Rising insurance premiums

Real estate investors are also focused on insurance premiums due to rising prices. Alternative risk transfer strategies are being explored to help minimize costs and safeguard capital expenditure reserves. These include credit swaps, insurance binders, highly protected risk and indemnity agreements. Building lasting risk management programs is crucial for insurance companies to remain profitable amid increasing losses and changing market dynamics.

Real estate owners are also evaluating which risks they can afford to self-insure versus those they need to transfer to third parties through contracts or insurance. Investors are looking to underwrite physical risk mitigation efforts, and they are working closely with brokers and insurance teams to find steps to lower rates. For example, insurance companies may offer reduced premiums or other benefits to real estate developers and property owners who implement measures to mitigate climate risks.

Takeaways

Due to mounting transition and physical climate risks, institutional commercial real estateinvestors are increasingly prioritizing sustainability and climate risk mitigation in their portfolios. To this end, investors are focused on understanding the impact of regulations, attaining regulatory compliance and underwriting physical risk mitigation through insurance.

The effective management of data has emerged as a critical factor in navigating this evolving landscape. Data-driven insights allow investors to seize opportunities to create value, foster resilience, differentiate themselves, meet changing tenant demands and contribute to a sustainable future for the commercial real estate sector.

Although more financing options exist today to support these efforts, understanding the availability and applicability of sustainability-oriented financing sources is complex. Approaches that investors can take to help navigate these options include

• Networking with industry associations and working groups focused on these topics.
• Staying informed about current and upcoming regulations that can impact portfolio and financial obligations.
• Understanding utility and municipal incentives, such as through Database of State Incentives for Renewables & Efficiency.
• Exploring the legal and financial terms of CPACE.
• Piloting and testing financial strategies within your portfolio.
• Reviewing industry reports, policy guidebooks, white papers and federal websites that provide insight and guidance on funding options, such as Financing Navigator.
• Using advisory consulting support.

By leveraging data-driven strategies and proactively exploring diverse financing options to implement risk mitigation measures, investors can significantly enhance the sustainability and resilience of their commercial real estate portfolios. Embracing these approaches will not only help meet regulatory requirements, tenant expectations and company goals, but also can yield higher risk-adjusted returns.

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