Returning to real estate

A growing number of investors are seeking to integrate environmental, social and governance (ESG) considerations into portfolios. Different asset classes provide different avenues of positive ESG implementation, writes Crispin Royle-Davies, senior research analyst in the Public Real Assets team at Nuveen, a global investment manager with over $1.1 trillion in AUM across public and private markets.¹

While real estate has fallen out of favour cyclically with some investors, the asset class can provide an effective foundation for setting, realising and measuring ESG targets, especially in carbon emissions.

The case for real estate

Following actions from central banks globally to tackle rising inflation, interest rates have surged and remained high for longer-than-expected. As a result, real estate investment trusts (REITs) have been negatively impacted. Transaction volumes and asset valuations have been hit, while increased interest rates have put pressure on earnings for REITs, to a greater or lesser extent dependent on hedging.

Data from Bloomberg shows that REITs typically underperform broader equity market indices during rate hiking cycles when the velocity of rate hikes exceeds market expectations as was the case between 2017 and 2019 (see charts above).

However, the same data shows that, before the end of a hiking cycle, REITs have previously outperformed broader equity market indices, as was the case in 2006 and 2018. These periods typically coincide with a broader economic slowdown where the longer duration cash flows provided by REITs become more appreciated by the market.

The chart above demonstrates that despite US interest rates rising between November 2018 and July 2019, US REITs delivered a strong bounce back against the S&P 500, as markets were confident that interest rate increases would soon end.

Consensus expectations are that we are nearing the end of the interest rate hiking cycle. Commentators are optimistic that regions may see rates begin to decline from 2024.

The positive historical traits of REITs remain strong for investors, potentially delivering steady income alongside effective diversification. Add to this significant market discounts to REIT net asset values (NAV) and the ingredients could be in place for REITs to rally, with short-term discounts being underpinned by historical benefits for portfolios.

If now is the time to reintroduce REITs back into portfolios, doing so with a carbon reduction focus has the potential to offer investors further diversification alongside other opportunities.   

Opportunities in carbon reduction

Realising net zero climate targets by 2050 is becoming a priority for investors, real estate companies, and tenants. Real estate counted for 40% of global carbon emissions in 2021², emissions reduction in the asset class is essential to realise material global environmental changes. REITs focused on carbon reduction have the potential to tap into these demands, by transforming inefficient existing buildings into more environmentally friendly properties, thereby reducing their carbon emissions.

Studies show companies that prioritise decarbonisation should have superior access to, and better pricing for, equity and debt capital relative to their peers. This is a key competitive advantage in a market with tight financial conditions. Transparency has been rewarded in this regard. Companies disclosing Scope 3 carbon emissions can enjoy a cost of capital 20 basis points lower than those that do not³. Real estate businesses focused on carbon reduction also have access to the green bond market —  a rapidly growing source of capital (see chart).

As global scrutiny of carbon emissions becomes a priority, regulators are increasingly imposing taxes or penalties on landlords who exceed global greenhouse gas thresholds or own buildings that do not conform to minimum energy efficiency standards. 

In Canada, for example, a carbon tax of CA$65/ton is set to increase to CA$170/ton by 2030, and in the UK, it is now illegal to let out commercial buildings with the two lowest EPC classifications. The latter demonstrates this is not an issue that can wait to be dealt with in several years; it is critical today for financial returns for real estate companies. 

By planning and implementing carbon emission reduction plans now, companies should be able to mitigate the expense of future penalties and as such will likely deliver superior long-term risk-adjusted returns compared with peers who ignore this structural trend.

Even without a regulatory push toward lower emissions, making assets more energy efficient can pay off for real estate companies. This is because many tenants have their own corporate emissions reduction or net zero targets. Operating from real estate, whether it be headquarters, shops or logistics facilities, with the lowest carbon footprint is key for reaching these goals. This should translate into better financial returns for more energy-efficient assets via rental and valuation premiums compared with inefficient assets.

REITs can provide opportunities, but selectivity is key

REITs have the ability to rally following an interest rate hiking cycle. This potential is made more attractive given the evergreen benefits of REITs, which can provide steady income alongside effective diversification to portfolios.

For investors, we believe current attractive valuations and income return, robust dividend growth and healthy fundamentals offered in many REIT sectors can make it a solid addition to a long-term, diversified portfolio. Investing in these companies helps them further their environmental goals of carbon reduction to generate tangible impact on climate change.

Investors seeking to set and meet sustainability-linked goals should consider partnering with a manager with proven experience in both real estate and responsible investing. This will help ensure that the investments are credibly aligned with both your financial and environmental goals. 

Nuveen

Nuveen, the investment manager of TIAA, offers a comprehensive range of outcome-focused investment solutions designed to secure the long-term financial goals of institutional and individual investors. Nuveen has $1.1 trillion in assets under management as of June 30, 2023, and operations in 27 countries. Its investment specialists offer deep expertise across a comprehensive range of traditional and alternative investments through a wide array of vehicles and customised strategies. For more information, please visit www.nuveen.com

1 As of 30 Jun 2023. Nuveen assets under management (AUM) is inclusive of underlying investment specialists.
2 Architecture 2030
3 Ahyan Panjwani, Lionel Melin, Benoit Mercereau, “Do Scope 3 Carbon Emissions Impact Firms’ Cost of Debt?” 17 Oct 2022

XAR-3149285CF-Y1023W
Real estate investments are subject to various risks associated with ownership of real estate-related assets, including fluctuations in property values, higher expenses or lower income than expected, potential environmental problems and liability, and risks related to leasing of properties. Nuveen, LLC provides investment solutions through its investment specialists.