Why sustainability matters for REIT stocks
Norton: What’s your thesis for incorporating sustainability considerations?
Adams: It’s more obvious in real estate than other sectors. If you said Coca-Cola was more sustainable than Pepsi, the lay investor might look at you quizzically. But if you said this building’s more sustainable than that one, you’d think it’s probably more energy-efficient, uses less water, creates less waste. A consistent stream of industry and academic research confirms that. One compares structures with green building certifications to regular buildings and finds the green buildings do better financially. They are more attractive to tenants because they have more natural light, better indoor air quality, access to outdoor spaces. They do better on revenues and costs, they get better financing, they have low insurance costs.
Norton: So how do you practice this?
Adams: On the opportunity side, we lean into companies that have figured out how to make buildings more profitable through sustainability initiatives. On the risk side, because we can’t move buildings out of harm’s way if there’s a storm or heat stress or floods, we ask if the companies are making buildings more resilient, putting in defenses such as fire-resistant roofs and stormproof windows. We’re building a sustainable leader strategy that tries to identify the REITs that are leaning into these opportunities and taking care of these risks.
In real estate, more institutional investors are quietly integrating environmental, social, and governance factors. They’re not saying they’re sustainably minded, they just must deal with physical climate risk. A set of REITs is voluntarily issuing Task Force for Climate-Related Financial Disclosures reports about which buildings are at risk and which aren’t. More European REITs are paying attention than some US REITS, and almost all the Australian guys are also paying attention.
Norton: Is there still a green premium to capture in the United States today?
Adams: I think there is, with a couple of caveats. Some academic studies didn’t account for location and building age, and some newer studies say you need to account for it to identify the greenness. So, you won’t always see a LEED-certified building commanding a higher rent, because it’s not actually the certification that does it, but the features within.
The way REITs describe the green premium is that it helps their leasing team win the deal. Over the long term, those with more green buildings do better by a couple of basis points. It’s not massive but I think that will change. A couple of years ago, REITs said, ‘Listen, the tenants don’t care, but we do it because it saves us money.’ Now they say tenants need renewable energy at their data center because they set a science-based target two years ago and they don’t want to rent a building that won’t help them lower their carbon footprint. When you have disruptions like working from home, the demalling of America, or a retailer or office guy who needs less space but wants it to be better to encourage people to come in, it will drive demand for those sustainability features, even if they’re not called sustainable. It’s just a nicer, higher-quality building.
Norton: Are people still trying to lower their greenhouse gas emissions?
Adams: There’s a spectrum. Two-thirds of the Fortune Global 500 have made a commitment to get to net zero emissions by 2050. They have science-based targets or net zero targets. Are all two-thirds serious about it? Some aren’t really committed. Others have spent years trying to get buildings on a pathway to net zero. They have the investment schedule, the asset-level plan. I’m sure a bunch of companies are talking about abandoning those targets. But from our perspective, the majority of the real estate guys are keeping them because it’s good for business.
How to find sustainable REIT stocks
Norton: How do you ensure they’re doing that?
Adams: I can’t look into a CEO’s eyes and check his soul for his commitment to sustainability. We have nine qualifying metrics. One is green building certifications. We have data on about 420 REITs about what percentage of their buildings are green-certified. We rank them from top to bottom and then cut off at the top decile. So, 42 REITs qualify into our portfolio, based on the fact that they are leaders in green building certifications. If you’re in the top decile, over 80% of your buildings are green-building-certified. You didn’t get there by accident. The board agreed it’s better for business and pays money, and that it isn’t a marketing exercise.
Norton: What are some other metrics?
Adams: We’ve narrowed them to the ones that are material: Things like lowering carbon emissions over the last three years, lowering water use, having a decarbonization commitment, having a biodiversity policy, a climate risk policy, climate resiliency efforts. If you’re a leader in one or more of these areas, you can potentially qualify for the portfolio. Some buildings aren’t exposed to the same risks and opportunities as others. For example, the LEED energy certification started with office, moved to more commercial properties, then to retail, then to residential.
We also engage with companies. Every year, my wife and co-founder Sarah Adams writes every REIT in the portfolio, asking them to make an improvement in a systemically important area. This year, we asked them to share what projects in their decarbonization strategy are working financially and which aren’t. We got responses from over 60% of them this year and have had 45 follow-up calls.
Data centers, AI and sustainable investing
Norton: What’s your approach to AI and data centers, which are big carbon emitters?
Adams: This is a good example of how we don’t apply the same metrics to every sector. Data centers use 20-50 times the energy of an office building of the same size. Other investors might kick them out to lower the portfolio’s carbon footprint. But we’re trying to invest in leaders who are lowering their carbon footprint. We want to own the data centers that are growing the fastest but doing so sustainably. So, it’s a requirement that the data center REITs we invest in have a 100% renewable energy target. Iron Mountain, Digital and Equinix all do, and all three are getting the majority of their energy from renewable sources today.
If you’re doing that and you’re taking care — if you’re using closed-loop systems for water and cognizant of communities and noise and those types of things — we don’t have a problem with data center growth. But if you’re dropping a data center into a suburban area and powering it with natural gas generators and leaking methane all over the place, we don’t want to invest in that.
Read their full interview here, including questions on how the current administration is impacting companies, investing in Manhattan office space, and if Sam see any specific stocks that look undervalued.
Article by Leslie Norton, Editorial Director for Sustainability at Morningstar.