ESG Investing in Commercial Real Estate

Introduction to ESG

0:00I want you to close your eyes for a second, unless you're driving, obviously, and just picture the global financial system. Okay. And I don't just mean stock tickers or, you know, guys shouting on a trading floor. I mean the actual stuff, the assets. The physical thing. The skyscrapers in Manhattan, the logistics hubs in Singapore, all those massive bond portfolios. We are talking about trillions of dollars of concrete, steel, and capital. It really is the physical backbone of the economy. Right. Now imagine a prediction that said by 2024, more than half of all of those assets under management globally, we're talking trillions upon trillions, would be governed by a single specific label.

0:40A label that dictates what gets billed, who gets the money, and who gets left behind. It sounds almost like a hostile takeover, doesn't it? Like some sci-fi plot where a single algorithm just takes control of everything. It really does. But it's not sci-fi. It's the single biggest shift in asset management in our lifetime. We're talking about ESG. Environmental, social, and governance. Now hold on. I can practically hear the collective groan from here. Before you hit skip, because you think we're about to launch into, I don't know, a lecture on recycling bin stuff.

1:11That is not what this is. That is not what this deep dive is about. Yeah. We are looking at a structured literature review by Daniel Coakley that frames ESG not as a charity project, but as a high-stakes puzzle in the world of commercial real estate. And that distinction is so crucial. Coakley isn't looking at this through, say, an activist lens. He's looking at it through a cold, hard investment lens. Okay. And the sources we have today, they paint a picture of a sector that is being squeezed by regulators, bullied by tenants, and frankly is just completely confused by its own data.

1:45It's a mess, isn't it? It is a chaotic mess, but there are billions of dollars at stake inside that chaos. So here's our mission for this deep dive. We are going to cut through what Coakley calls the alphabet soup of regulations. We need to answer the questions that actual investors are whispering in boardrooms, you know, when the PR cameras are off. The real question. Does building green actually make money? Is the data behind these ratings even real? And are we saving the planet or just creating the world's most expensive pile of paperwork?

2:17The evidence is surprising. It's not nearly as black and white as you'd think, as green is good, greed is bad.

ESG Explained

2:23Let's get into it. First, we have to lay the groundwork. I think most people hear ESG and they immediately pivot to the E. They think solar panels, carbon footprints, you know, energy efficiency. And that's the visible part. Sure, that's the E. But for a real estate investor, the other two letters are becoming these massive liability risks. Go on. The S social, that's all about your impact on the community, the health of the people inside your building. I mean, if your building makes people sick, that's a social risk that quickly becomes a financial risk. And G, governance.

2:53That's the silent killer. How is the company run? Who's on the board? Are they ethical? Are they transparent? You can have the greenest building in the world, but if the board is corrupt, the asset is toxic. Okay, but let's be real. Corporations don't usually do things just out of the goodness of their hearts. Hmm. Where is all this pressure coming from? Is it just public sentiment? No, no. Public sentiment is the least of it. It's more like a pincer movement. On one side, you have the tenants, big corporate occupiers.

3:23Think Google, Amazon, Deloitte. They've all made these very public promises to hit net zero targets. They literally cannot sign a lease for a building that ruins their carbon accounting. So if you own a quote-unquote dirty building, you're not just saving money on upgrades. You're actually locked out of that top-tier market. Completely. You're fighting for scraps. Then on the other side, you have the heavyweights. You know, institutional investors like BlackRock and Vanguard. Coakley points out that these guys are flexing their muscles. They are acting as control agents.

3:54Control agents. How? Are they, like, calling up the CEO? Sometimes. But mostly, they just use proxy voting. They don't need a law to be passed. They just tell the board, adopt an ESG strategy or we vote you out. It's moved from a nice-to-have to a do-this-or-you're-fired situation. But here's where the headache starts. You have this massive pressure to comply. But the rulebook, well, I mean, is there even a rulebook? There are about 600 rulebooks. And that's the problem. I was looking at the visual in the source material, you know, with all the different frameworks.

4:27You've got GRI, SSB, TCFD, GRESB. It looks like someone spilled a bowl of Scrabble tiles on the floor and said, there, that's your regulation. That is the alphabet soup that Coakley is talking about. It's just this fragmented ecosystem. You have financial ratings like Moody's. You have corporate specialists. And then you have the actual physical building certifications like LEAD or BREEM. And do they at least talk to each other? Rarely. So a developer is trying to figure out which form to fill out while an investor is trying to compare two different portfolios.

4:57And nobody is speaking the same language. Which, you know, naturally makes people suspicious. Exactly. When the rules are this confusing, people just assume it's all smoke and mirrors. Okay. So we've got this chaotic, high-pressure environment.

Financial Benefits of ESG

5:10But let's get to the core question, the one every listener cares about, whether they're managing a REIT or just checking their 401k. Does it pay? If I pivot my portfolio to green real estate, am I getting rich or am I taking a haircut for the planet? This is where we have to sort of reframe how we think about it. If you look at the broad literature, the strongest financial argument for ESG isn't about generating massive new returns overnight. It's not a lottery ticket. It's not a get-rich-quick scheme.

5:40Not at all. It's about risk mitigation. So it's a defensive play. It's a shield, not a sword. Precisely. It's insurance. There was a pivotal study by Dunn and some colleagues from 2018. They looked at stocks with the worst ESG exposure versus the best. The stocks with poor ESG scores had 15% higher volatility. 15%. In the stock market, that's not a rounding error. That's a roller coaster. It is. And they had 3% higher betas. Yeah. Bake that down for us. What is beta in this context? Beta is a measure of systematic risk.

6:11So how much a stock moves compared to the overall market? A higher beta means when the market sneezes, your stock catches the flu. Got it. The data suggests that poor ESG scores are a predictor of future crashes. Lawsuits, regulatory fines, scandals. If you ignore the G and the E, you are statistically more likely to hit an iceberg. That makes perfect sense. It's like driving a car without doing any maintenance. You save a little money today on oil changes, but the breakdown on the highway is going to be way more expensive.

6:42And we saw this play out in real time during COVID-19. There was a fascinating analysis by Clayton on commercial real estate resilience. I saw this in the notes. They look at the Houston office market in 2020, right? Which, let's be honest, was probably the worst time and place to own an office building in recent history. It was a bloodbath. Oil prices crashed. The pandemic hit and nobody was going to the office. But here's the really interesting part. Even inside that disaster, returns for different office buildings ranged from minus 13% to positive 2.4%. Wait, hold on.

7:13So some buildings actually made money while their neighbors were bleeding out in the middle of a pandemic. Yes. And the researchers attributed that huge variance to future-proofing. Buildings that were healthy, efficient, adaptable, you know, high ESG buildings. They weathered the storm. They had better air filtration, better layouts, better tech. The obsolete ones didn't stand a chance. So ESG acts as a kind of quality filter. When the tide goes out, it shows who was swimming naked. That's a very vivid way to put it, but yes.

7:44But there's also an offensive play here specifically with operational efficiency. This isn't abstract stock market stuff. This is simple math. Green buildings use less energy and water. So your utility bills go down. Your net operating income goes up. Simple as that. Correct. And Coakley calls this the virtuous cycle. You implement ESG, your costs go down, your rents go up. That gives you more cash flow to reinvest in more ESG upgrades, which further improves the asset. It just feeds itself. And I imagine the banks love that cash flow.

8:14They love it, and they reward it. This brings us to the cost of capital argument. We have data from Eichels and others showing that environmentally certified buildings get cheaper loans. They found a reduction in mortgage spreads of about 24 to 29 basis points. Okay, pause there. For anyone who doesn't speak banker, basis points can sound insignificant. 29 basis points is, what, roughly 0.3 percent? Why should we care about 0.3 percent? It sounds small until you apply it to a skyscraper. If you have a $100 million loan, that 0.3 percent difference is very real money.

8:47In that study, it translated to savings of roughly $147,000 to $206,000 a year. Wow. Just on interest payments. Okay, so over a 10-year loan, that's up to $2 million of pure profit just for having the right certification. Exactly. That goes straight to the bottom line. So when you stack it all up, lower operating costs, cheaper debt, less volatility, the financial case is actually very robust. But let's zoom in to the street level. We've been talking portfolios and interest rates. I want to talk about the actual buildings. You walk into a lobby, you see that platinum plaque on the wall, lead, bream, whatever it is.

9:20Does the tenant actually care? Or is that just for the landlord's ego? The evidence suggests they care enough to open their wallets. We call this the green premium. I like the sound of that. How much of a premium are we talking? A study by Devine and Koch looked at 300 North American buildings, and they found rental yields were 8% to 10% higher in certified buildings compared to non-certified ones. A 10% bump in rent is massive for a landlord. It is. And occupancy rates were higher, too.

9:51But, and this is the scary part for property owners, the flip side is even more powerful. It's called the brown discount. The brown discount. That sounds like something you'd find in the clearance aisle of a grocery store. It's so much worse. It's the risk of your building becoming a stranded asset. A stranded asset. Yeah. As regulations tighten, like the minimum energy efficiency standards in the UK or local law 97 in New York, if your building can't meet the grade, it effectively becomes illegal to rent. Illegal to rent, so you're just sitting on a pile of bricks you can't monetize.

10:23Exactly. Top-tier tenants won't touch it because of their own ESG goals. The government might fine you for operating it, and the cost to retrofit it might be higher than the building's actual value. It becomes a liability. It's just a concrete paperweight. Basically. But I want to throw a wrench in this machinery for a second. We assume tenants want green buildings because they're virtuous. But there's a study by Kempineer that highlights what they call a vicious cycle of blame. Oh, I love a good blame game. Who's pointing fingers? Everyone. Developers say we only build what investors fund.

10:54Investors say we only buy what tenants want. And tenants say, well, we can only rent what's available. But the study points out this massive behavioral gap. You can build the smartest, greenest building in the world. But if the people inside it leave all the lights on, blast the AC with the windows open, and run, I don't know, server farms in the closet? Then the building isn't green at all. It's just a high-tech energy hog. The data shows that without behavioral change from the users, that green premium doesn't always translate to real-world energy savings.

11:28So a smart building isn't smart if your woozer is. Well, if the user isn't smart. I wouldn't go that far. But let's just say unengaged. Fair enough. Okay, so we've established the money is there. We've established the demand is there. The risk is real. But I want to go back to the start.

ESG Ratings and Greenwashing

11:45That alphabet soup of ratings. If trillions of dollars are moving based on these ESG ratings, surely the ratings themselves are accurate. I mean, we're talking about major financial institutions. They must have this down to a science. You would hope so. But this is where the deep dive gets a little disturbing. The reliability of ESG data is questionable at best. Define questionable. Are we talking margin of error or more like a random number generator? A lot closer to random than you'd be comfortable with. There was a study by Charlin in 2022 that compared how different rating agencies scored the exact same companies.

12:20They found the average agreement, the correlation, was only about 5.4%. 5%? Wait, hold on. If I go to three different credit bureaus, my credit score is going to be basically the same. You're telling me if I go to three ESG raters, I get three completely different answers? Almost completely different. To put that in perspective, the study compared it to the wine tasting industry. Wine tasting. Which is famously subjective. Notes of oak and berries. Exactly. But even wine critics agree more often than ESG analysts do. One agency might rate a company as a sustainability hero, while another rates the exact same company as a villain.

12:56How is that even possible? Are they looking at different data? They're using different rulers. This is what's called measurement divergence. One agency might measure carbon intensity per square foot. Another might measure it per dollar of revenue. So if you're a tech company with huge revenue but a small office, you look great on one and terrible on the other. So you can basically just shop around for the rating that makes you look best. In theory, yes. And then you have something called the halo effect. This is a psychological bias where analysts let a company's financial performance sort of bleed into their ESG score.

13:29So if a company is making a ton of money, the analyst just assumes they must be good at everything else, too. Like, they're rich, so they must be ethical. Precisely. It creates a distortion. It also leads to a size bias. Large companies have massive compliance departments. They have the budget to fill out the 500-page questionnaire. So they get better ratings simply because they are better at paperwork, not because they are actually greener. That just sounds like a bureaucracy trap. We aren't rewarding impact. We are rewarding administration.

14:00And that leads us straight into the murky world of greenwashing. I feel like I see this everywhere now. Every mutual fund claims to be saving the planet. And investors are buying it. But look at the data. A study by InfluenceMap in 2021 analyzed over 700 equity funds that were marketed as ESG or climate-themed. They found that 71% of the broad ESG funds were not aligned with the Paris Agreement goals. 71%. So if I put my money in a green fund thinking I'm helping solve climate change, there's a three in four chance I'm actually not.

14:32That is what the data suggests. Even among the specific climate-themed funds, over half weren't aligned. How do they get away with that? Is that fraud? It's not fraud. It's just, well, it's lazy indexing. Often what they do is just underweight energy sectors. They sell off Exxon. They buy a bunch of big tech and call it a low-carbon portfolio. But they aren't actively funding the companies that are recrofiting buildings or building new infrastructure. They are just avoiding the so-called sin stocks. This feels disheartening. We've established a clear financial incentive to be green. Again, cheaper loans, higher rent, less risk.

15:05But the yardstick we're using to measure it is broken. How do we fix this? Well, the industry knows this is a problem. The shift we're seeing now is moving away from generic box ticking toward a concept called materiality. Materiality. Like in the accounting sense. Yes. In accounting, something is material if it actually affects the bottom line. The argument is that we need to stop trying to measure everything for everyone. Right. Carbon emissions matter a lot for a concrete manufacturer. Maybe less so for a software company.

15:36Exactly. But for a software company, data privacy and water usage for their cooling servers are absolutely critical. Materiality means focusing on the specific risks that actually move the needle for that specific asset type. So stop asking the real estate developer about their supply chain in the jungle and start asking them about flood risk and energy efficiency. And there's an even deeper concept gaining fraction called double materiality. Which is what? It's looking at the two-way street. So financial materiality is how does the changing world climate change regulation impact my company's bank account?

16:09Okay. And impact materiality is how does my company impact the world? Ah, so it's realizing that you can't survive as a business if the society around you collapses. Exactly. And we are seeing transparency improve on this. The source highlights the Global Real Estate Transparency Index, or GREDI. The UK is actually noted as a leader here. What is the UK doing differently? They've introduced beneficial ownership registers, so we actually know who owns the buildings and those minimum energy efficiency standards we mentioned earlier.

16:40If you can't measure it, you can't manage it. Correct. But we have a long way to go. Right now, checking a building's price history is easy. It's on Zillow or CoStar, checking its true carbon footprint. That is still detective work. So let's bring this all together. We've covered a lot of ground today. We have. On the one hand, the financial argument for ESG in real estate is surprisingly solid. If you get it right, you get cheaper capital, you get that green premium on rent, and you protect yourself from becoming a stranded asset.

17:11The market rewards green. The business case is undeniable. You'd be foolish to ignore it. But on the other hand, the map we're using to navigate this territory is just. It's full of holes. The ratings agencies disagree with each other more than wine snobs. The paperwork favors the biggest companies. And a shocking amount of green money is just standard investing with a fake mustache. That is the reality. We're in the messy middle. We're transitioning from a kind of wild west of voluntary marketing to a regulated, data-driven market.

17:43And transitions are always chaotic. So for you listening right now, whether you are an investor looking at a REIT, a tenant signing a lease, or just someone wondering why your city's skyline is changing, this matters. This alphabet soup is effectively becoming the new zoning code for global capital. Absolutely. It is determining what gets built, what gets renovated, and what gets left to rot. I want to leave you with a thought to chew on. We talked about how 71% of so-called ESG funds aren't aligned with the Paris Agreement, and how rating agencies have just a 5% agreement rate. It raises a big question about intent versus reality.

18:15It does. The money is moving, that's for sure. But are we actually financing a greener future? Or have we just created the world's most profitable bureaucracy? Is the green premium paying for better buildings, or is it just paying for better lawyers to fill out the forms? That is the billion-dollar question, and until the data cleans up, we won't really know the answer. Thanks for diving deep with us today. Always a pleasure. We'll see you on the next one. Keep asking questions.