Evaluating ESG Investing with a Critical Eye

The principles can help commercial real estate firms make responsible investing a priority.

Environmental, social and corporate governance (ESG) has become shorthand for principled decision-making in the professional world. Most people agree that keeping the planet clean, prioritizing social good and promoting ethical business practices are net positives.

According to an article published in November 2021 by NASDAQ, institutional and retail investing in ESG strategies grew 42% from 2018 to 2020. It’s important to remember that ESG investing is a strategic mindset. There are no assets that are inherently ESG by nature. Investors can scrutinize their options to determine which financial decisions meet the criteria of ESG for their portfolio.

An ESG Primer

Investors should be mindful of the three components that make up ESG:

Environmental. Enhancing an asset’s environmental performance will positively impact its long-term investment performance. For a real estate portfolio, this is a simple input-output equation: focusing on renewable energy implementation, energy consumption reduction, waste reduction, water usage reduction, hazardous materials removal and carbon emission reduction all improve the physical environment where the property is located.

Social. Investors should strive to cultivate a healthy work environment for employees, tenants and the communities that are involved. According to a 2019 survey by BuiltIn, an online community for startups and tech companies, this is not just anecdotal; their findings revealed that 88% of employees believe that a strong, supportive company culture was vital to their company’s success. On top of that, software developer TeamStage found that businesses that embrace a socially responsible mindset could see a four-fold increase in revenue, suggesting that there is no tradeoff between social considerations and profitability.

Governance. Governance simply refers to a company holding itself to a higher ethical standard and establishing a framework of transparency, benevolent policies and fair procedures. These governance principles are best outlined in the United Nations-supported Principles of Responsible Investment (PRI), a pledge for organizations striving to uphold ethical business practices and moral financial decision making. The number of signatories is in the thousands and spans more than 130 countries. This includes big organizations such as Blackstone, Prudential PLC and the Harvard University Endowment, as well as smaller companies such as Graceada Partners, which all pledge to follow responsible principles for investing.

These principles can provide an excellent starting point for commercial real estate firms that want to prioritize responsible investing. For example, when a firm buys a new property, it would evaluate making water conservation and energy efficiency a required and central part of its investment process instead of something that’s ancillary. And when a new office or apartment building is acquired, the firm would specifically evaluate social and community aspects of the property and their management practices.

Putting ESG Values into Practice

When planning for the fiscal year or even the next quarter, an ESG-conscious real estate investor can run an investment analysis of a property or an asset that promotes itself as incorporating ESG. By scrutinizing the three main factors that go into investment analysis — risk, cash flow and resale value — while having an ESG overlay to those components, investors can make ESG-conscious investment decisions that can simultaneously maximize these three categories.

It’s one thing to seek out ESG investments, but it’s another to live by them. Companies that integrate ESG values into their own business model have the potential to stand out from those that don’t. For a commercial real estate investor, locating properties that make efforts toward renewable energy implementation, energy-consumption reduction, waste reduction, water-usage reduction, removal of hazardous materials and carbon-emission reduction helps create ESG-positive, long-term investments.

To maintain the highest level of ethical business practices, it’s important to establish an organization-wide framework of expected policies and procedures. Having these guidelines in place will provide transparency and create control measures to ensure adherence to social investment principles. This framework includes — but is not limited to — a code of ethics, sexual harassment policies and a regularly updated compliance manual. Encouraging employees to lead ethical lifestyles within office hours has been shown to translate to better productivity and company satisfaction.

According to the Forum for Sustainable and Responsible Investment’s 2020 trends report, in 2010, the 10 largest investment firms held more than 70% of all sustainable assets under management. By 2020, the 10 largest firms held under 40%. This indicates that more organizations are actively seeking ESG investments. And while ESG-focused investments in gateway cities and primary markets have led the charge, there has also been growth in ESG considerations in secondary and tertiary markets across the U.S. These markets have considerable room for improvement and therefore represent a significant opportunity for major ESG impacts in the future.

Promoting and Committing to ESG

There are two ways to promote ESG investment values: directly or indirectly. A direct initiative to promote ESG within the commercial real estate space would involve a firm joining organizations that raise awareness about ESG, such as PRI and the U.S. Green Building Council's LEED certification, and working alongside other like-minded corporations. This not only helps each business, but also the environmental and social spheres involved. An indirect approach could be described as “leading by example,” which can encourage other firms and investors to follow suit.

Both tactics are helping to create a new foundation for investing. In late 2021, The Wall Street Journal predicted that within the next five years, 100% of investments will be classified as either an ESG risk or ESG opportunity. If this becomes the case, the discussion that investors will be having at the end of this decade will not be about ESG vs. non-ESG but weighing the merits between two ESG-oriented investments and determining which one edges out the other.

It’s important for investors to be aware of ESG and its impact on the industry. Taking a stance and pledging to adhere to a set of core values can be beneficial; it’s something many firms have done with the UN PRI pledge. Enshrining values is ultimately an opportunity to signal to key stakeholders a desire to incorporate ESG efforts into every investment decision. And if The Wall Street Journal’s prediction indeed holds true, organizations will want to ultimately be on the side of opportunity, not risk.

Ryan Swehla is co-CEO and co-founder of Graceada Partners, an investment firm in Modesto, California.