Real Estate’s Environmental Impact and Investment Potential
Humans spend approximately 90% of their time indoors, making the real estate sector a significant contributor to environmental challenges, accounting for about 30% of global greenhouse gas emissions, 40% of waste generated, and 12% of water consumption. Furthermore, this sector employs around 10% of the global workforce. Samuel Adams, an investor with insight into these dynamics, believes that real estate investment trusts (REITs) have substantial potential, particularly for companies that prioritize sustainable practices.
Samuel Adams and Sustainable Real Estate
Adams co-founded Vert Asset Management in 2014 alongside his wife, Sarah, after spending two decades with Dimensional Fund Advisors. Vert manages the Silver-rated Vert Global Sustainable Real Estate ETF (VGSR), which has achieved impressive results, outperforming 89% of funds in Morningstar’s global real estate category over the past three years, and ranking in the top 6% for five-year returns. Beyond managing investments, Adams is also a dedicated advocate for sustainable investing and has collaborated with Morningstar columnist Larry Swedroe on the publication “Your Essential Guide to Sustainable Investing.” In a recent discussion, Adams shared his views on the current landscape for REIT stocks and the positive impact of green buildings on company returns.
Current Opportunities in Real Estate
Leslie Norton inquired about the current investment thesis for real estate and whether there are cyclical opportunities. Adams responded that the sector has not yet fully rebounded from the 4% interest rate hikes in 2022, which led to an average decline in valuations of 25% to 30%. Despite this volatility, the median REIT continues to trade at a 20% discount to its net asset value. Consequently, major private equity firms, including Blackstone, are actively acquiring REITs, and the number of REITs in the UK has halved since 2019.
The Impact of Interest Rate Cuts on REITs
Norton asked how a potential interest rate cut could affect REITs. Adams acknowledged that the prevailing market sentiment suggests real estate struggles in high-interest-rate environments, particularly impacting home builders and developers. However, he noted that REITs are less vulnerable to interest rate fluctuations. Following the 2008 financial crisis, many REITs extended their debt maturities and now enjoy fixed rates on debt due in seven years or more. While development sectors may feel the pinch, the current high rental rates driven by inflation have allowed REITs to remain profitable, even if their stock prices do not reflect this success.
The Importance of Sustainability in REIT Investments
Norton probed into the significance of sustainability in REIT stock investments. Adams explained that the importance of sustainability is more evident in real estate compared to other sectors. Unlike comparing brands like Coca-Cola and Pepsi, investors can clearly identify which buildings are more sustainable based on energy efficiency, water usage, and waste generation. Research consistently shows that buildings with green certifications outperform traditional structures financially, as they tend to attract tenants with features like improved natural lighting and better indoor air quality, ultimately leading to increased revenues and lower operational costs.
Integrating Sustainability into Investment Practices
Norton asked how Adams incorporates sustainability into his investment strategy. Adams indicated that his focus is on identifying companies that enhance profitability through sustainability initiatives while also assessing risk management strategies. Since buildings cannot be relocated from harmful environmental conditions, it is crucial to evaluate whether companies are reinforcing their structures against climate risks, such as implementing fire-resistant roofs and stormproof windows. Adams emphasized the need for a sustainable leader strategy to pinpoint REITs that are actively pursuing these opportunities and addressing potential risks.
Climate Risk Awareness Among Institutional Investors
Adams noted that more institutional investors are integrating environmental, social, and governance (ESG) factors into their decision-making processes, often without explicitly labeling themselves as sustainability-focused. They are compelled to address physical climate risks, with some REITs voluntarily reporting their climate-related vulnerabilities through Task Force on Climate-related Financial Disclosures (TCFD) reports. European REITs are reportedly more proactive in this regard than their American counterparts, while Australian firms also show heightened awareness.
Political Climate and Sustainability Initiatives
Norton raised concerns about the current US political climate, questioning whether companies are scaling back their sustainability efforts. Adams countered that they are not. His focus is on identifying companies that view sustainability initiatives as financially beneficial rather than merely for public relations. While some organizations may have reduced their public discourse around sustainability due to political pressures, many continue to pursue these initiatives because they are profitable. The loss of programs like Energy Star, which previously aided property owners in benchmarking energy efficiency, poses challenges, but the commitment to sustainability remains strong among many REITs.
Assessing the Green Premium in the Real Estate Market
When asked about the existence of a green premium in the current US market, Adams acknowledged its presence but with certain conditions. While some academic studies have overlooked factors such as location and the age of buildings, recent research indicates that these elements must be considered to accurately assess sustainability. The perceived green premium is often attributed to its ability to bolster leasing negotiations. Over time, properties that are more environmentally friendly tend to perform slightly better financially, though the difference is not substantial. However, as tenants become increasingly focused on renewable energy and reducing their carbon footprints, demand for sustainable features is expected to rise, even if they aren’t explicitly marketed as such.
Commitment to Reducing Greenhouse Gas Emissions
Norton inquired about the ongoing efforts to lower greenhouse gas emissions. Adams pointed out that a significant portion of the Fortune Global 500 has pledged to achieve net-zero emissions by 2050, many with science-based targets. While not all companies are equally committed, a substantial number are making progress towards this goal, with detailed investment strategies in place. Despite some discussions about abandoning these targets, most real estate firms maintain their commitments due to the positive business implications.
Metrics for Evaluating Sustainable REITs
Norton asked how Adams ensures that REITs are genuinely pursuing sustainability. He shared that his approach involves evaluating nine specific metrics, one of which includes green building certifications. With data on around 420 REITs, they are ranked based on the proportion of their green-certified buildings, and only the top 10% are selected for their portfolio. Achieving this status requires a company-wide commitment to sustainability that goes beyond marketing efforts.
Key Metrics for Sustainable Performance
Adams detailed additional metrics that his team considers crucial, including reductions in carbon emissions over the past three years, water usage decreases, decarbonization commitments, and climate risk policies. Companies excelling in one or more of these areas may qualify for the portfolio. He also noted that not all buildings face the same risks, and engagement with companies is a vital part of the process. His wife, Sarah, reaches out to REITs annually to encourage improvements in critical areas, receiving feedback from over 60% of them this year, along with follow-up discussions.
AI, Data Centers, and Sustainable Investing
Norton discussed the implications of AI and data centers, known for their high carbon emissions. Adams emphasized that his investment approach varies by sector, as data centers can consume significantly more energy than traditional office buildings. Instead of excluding these assets to lower their carbon footprint, Adams seeks out data center REITs committed to sustainability, specifically those aiming for 100% renewable energy targets. Companies like Iron Mountain, Digital Realty, and Equinix exemplify this commitment by sourcing a majority of their energy from renewable resources.
Investment Opportunities in Manhattan Office Space
Norton asked about attractive investment opportunities in real estate. Adams identified healthcare and data centers as the only two sub-sectors not trading at a discount to net asset value (NAV). The growing demand for senior housing aligns with the aging Baby Boomer population, benefiting companies like Ventas, Welltower, and Healthpeak Properties. In the data center sector, the ongoing rise of AI is expected to continue driving demand for companies such as Digital Realty and Iron Mountain. Manhattan office space, despite previous investor hesitance, is showing signs of recovery, with office visits returning to pre-pandemic levels. The market for Class B office space is oversaturated, while premium Class A spaces are in demand for corporate headquarters and client meetings. Noteworthy companies in this niche include JBG Smith Properties, SL Green Realty, and Empire State Realty.
Identifying Undervalued Stocks
Norton asked if Adams sees any specific undervalued stocks. He mentioned Mid America Apartment Communities as a promising opportunity, especially in light of the US housing crisis, which is exacerbated by inflation and tariffs impacting housing development. The growing demand for multi-family apartments aligns with demographic shifts towards the Sunbelt region. Mid America has effectively utilized local utility rebate programs to implement water-efficient fixtures, achieving a 40% reduction in water usage, which translates to lower costs for tenants and mitigates future drought risks. Additionally, Digital Realty stands to benefit from the expanding demand for AI computing and data services, with a commitment to 100% renewable energy helping attract firms focused on decarbonization. Lastly, British Land is positioned well in major cities like London, supported by its environmental retrofit initiatives that decrease carbon emissions while meeting rising energy efficiency regulations in the EU and UK.
