Fred Lee, Senior Associate at Farrer & Co, outlines some pioneering approaches to ESG-led property investment.
Trustees of non-exempt charities in the UK have long been required to consider the management of their property holdings and investment strategies in accordance with the best interests of their given charity. This duty derives from the charitable objectives – which in many cases will be environmental or social in nature – and the reputational and fiduciary pitfalls of not meeting the stringent requirements placed on trustees who hold real estate assets. By virtue of the Charities Act 1993 and later the Charities Act 2011, charity trustees have had to work very closely with qualified surveyors simply to be able to dispose of property held by the charity (pursuant to Section 119 of the Charities Act 2011). Well-advised charity trustees will already be aware that better buildings will drive up occupier demand and give rise to better rental and disposal values, thus benefitting the charity.
The statutory framework to be navigated by property-holding charities is fairly well charted, but attitudes to what constitute socially responsible and sustainable investment practices have changed dramatically in recent years. For many trustees (charitable or otherwise), it is no longer quite enough to secure income and capital growth in isolation without considering the wider, societal impact – both positive and negative. Where charities may have an advantage on this front, though, is that they will have for some time been on the receiving end of calls from their beneficiaries, and their boards of trustees, who are passionate about the stated charitable objectives being on message with what is now known as environmental, social and corporate governance (ESG). For legal and reputational reasons, charities do not want to drop the ball on this and, even more so, they want to be seen to be actively managing their environmental and social impact through good governance; if done well, this can only benefit the charity’s interests.
As a result, it has become increasingly incumbent on charity trustees to consider the long-term benefits of managing a sustainable property portfolio that produces steady income and the potential for decent capital return when it comes to disposing of that property. It makes complete sense, therefore, that the longer-term horizons of charity trustees may be well-aligned with the ESG aims envisaged by many institutional investors and property funds.
Focus on social factors
In March 2021, the Department for Work & Pensions called for evidence from trustees of pension schemes on their experiences of “the effectiveness of occupational pension scheme trustees’ current policies and practices in relation to social factors”.
The ministerial foreword of the accompanying consultation identifies concerns that “trustees are ill-equipped to deal with financially material social factors in their investments” and “pension schemes whose trustees do not consider other financially material ESG factors will risk seeing reduced returns in the future”. The social factors identified include supply chain practices, consumer protection, working conditions, remuneration, modern slavery, human rights and community engagement. Essentially, the ‘S’ of ESG has not to date been receiving the same levels of attention as the ‘E’ factors, according to the DWP.
Environmental factors are, of course, grabbing the headlines because they are of paramount importance but, as the DWP reminds us, “the law requires trustees to take account of financially material environmental, social and governance considerations”.
Misunderstanding among trustees
Now that ESG factors crop up more and more in the context of commercial real estate – both in investment management and with development – these drivers are set to have greater influence on decision making and, furthermore, are opening up alternative uses of land and shaping how that land is developed. This goes further than investors merely ‘greenwashing’ their portfolios, although many will be future-proofing against the inevitability of greater scrutiny over energy efficiency and the sharing of data relevant to that.
The DWP seems to have identified a level of misunderstanding as to what ESG compliance entails, as far as pension trustees are concerned. The danger is that investors in real estate across the board will miss out if they do not future proof their portfolios. This may involve accepting greater upfront cost on capital expenditure to improve buildings and taking on some tenants that make up for a lack of pure covenant strength with excellent ESG credentials. An ESG-compliant tenant is of course not immune from insolvency but there is a noticeable trend towards the notion that a ‘good tenant’ is more than one that simply pays its rent on time and in full, but also one with the right profile. The screening of tenants with negative reputations has troubled trustees for years, but now they will go the extra mile to secure tenants with a positive public image. This trend is being borne out not only in the drafting of new leases, but also in the mix of tenants preferred by landlords and how those tenants are using the land for more sustainable and more varied purposes. So, despite the very apparent concerns of the DWP, the tendency towards the ESG-conscious model suggests that investors are accepting the need to shift to a longer-term view when managing social risks.
Common concerns
It would seem then that charity trustees and trustees of pension schemes have, at a fiduciary level and because the statutory requirements placed on them, plenty in common when it comes to considering ESG factors. There is much for these categories of investors to learn from each other in terms of what ESG-savvy investors have been looking for when acquiring or developing property, as well as what they have been requiring in their leases for some time now and the mix of tenants they choose to contract with.
The institutional lease is evolving constantly and is being used to harness the reputations of charity landlords and tenants alike through the inclusion of provisions dealing with things such as energy efficiency, working conditions, anti-bribery and anti-corruption concerns. It is possible and often desirable for landlords and tenants to cover the ‘E’, the ‘S’ and the ‘G’ in their leases – they are, after all, often publicly accessible documents – meaning that the so-called ‘green lease’ is just part of the trend. The move towards addressing these wider concerns has only been accelerated in the wake of the combined effects of pandemic, climate change, recession and social injustice – all very much on the radar of those active in the third sector. In short, ESG objectives are very often analogous to charitable ones, especially those in the ‘S’ category where, it seems, charities have stolen a march on the pension schemes.
Striking a balance
As ESG now very much forms part of the investment landscape, the challenge for those in a position of fiduciary duty – such as trustees of a charity or a pension scheme – will be to balance their investment decisions not only to generate returns but also to optimise social gains and minimise environmental impact, all the while with a firm grip on the legislative and regulatory framework. It is becoming increasingly apparent that pursuing one does not necessarily have to be at the expense of the other and the concept of ESG is likely to become a cornerstone of portfolio management for years to come.
Fred Lee, Senior Associate at Farrer & Co, outlines some pioneering approaches to ESG-led property investment.
Trustees of non-exempt charities in the UK have long been required to consider the management of their property holdings and investment strategies in accordance with the best interests of their given charity. This duty derives from the charitable objectives – which in many cases will be environmental or social in nature – and the reputational and fiduciary pitfalls of not meeting the stringent requirements placed on trustees who hold real estate assets. By virtue of the Charities Act 1993 and later the Charities Act 2011, charity trustees have had to work very closely with qualified surveyors simply to be able to dispose of property held by the charity (pursuant to Section 119 of the Charities Act 2011). Well-advised charity trustees will already be aware that better buildings will drive up occupier demand and give rise to better rental and disposal values, thus benefitting the charity.
The statutory framework to be navigated by property-holding charities is fairly well charted, but attitudes to what constitute socially responsible and sustainable investment practices have changed dramatically in recent years. For many trustees (charitable or otherwise), it is no longer quite enough to secure income and capital growth in isolation without considering the wider, societal impact – both positive and negative. Where charities may have an advantage on this front, though, is that they will have for some time been on the receiving end of calls from their beneficiaries, and their boards of trustees, who are passionate about the stated charitable objectives being on message with what is now known as environmental, social and corporate governance (ESG). For legal and reputational reasons, charities do not want to drop the ball on this and, even more so, they want to be seen to be actively managing their environmental and social impact through good governance; if done well, this can only benefit the charity’s interests.
As a result, it has become increasingly incumbent on charity trustees to consider the long-term benefits of managing a sustainable property portfolio that produces steady income and the potential for decent capital return when it comes to disposing of that property. It makes complete sense, therefore, that the longer-term horizons of charity trustees may be well-aligned with the ESG aims envisaged by many institutional investors and property funds.
Focus on social factors
In March 2021, the Department for Work & Pensions called for evidence from trustees of pension schemes on their experiences of “the effectiveness of occupational pension scheme trustees’ current policies and practices in relation to social factors”.
The ministerial foreword of the accompanying consultation identifies concerns that “trustees are ill-equipped to deal with financially material social factors in their investments” and “pension schemes whose trustees do not consider other financially material ESG factors will risk seeing reduced returns in the future”. The social factors identified include supply chain practices, consumer protection, working conditions, remuneration, modern slavery, human rights and community engagement. Essentially, the ‘S’ of ESG has not to date been receiving the same levels of attention as the ‘E’ factors, according to the DWP.
Environmental factors are, of course, grabbing the headlines because they are of paramount importance but, as the DWP reminds us, “the law requires trustees to take account of financially material environmental, social and governance considerations”.
Misunderstanding among trustees
Now that ESG factors crop up more and more in the context of commercial real estate – both in investment management and with development – these drivers are set to have greater influence on decision making and, furthermore, are opening up alternative uses of land and shaping how that land is developed. This goes further than investors merely ‘greenwashing’ their portfolios, although many will be future-proofing against the inevitability of greater scrutiny over energy efficiency and the sharing of data relevant to that.
The DWP seems to have identified a level of misunderstanding as to what ESG compliance entails, as far as pension trustees are concerned. The danger is that investors in real estate across the board will miss out if they do not future proof their portfolios. This may involve accepting greater upfront cost on capital expenditure to improve buildings and taking on some tenants that make up for a lack of pure covenant strength with excellent ESG credentials. An ESG-compliant tenant is of course not immune from insolvency but there is a noticeable trend towards the notion that a ‘good tenant’ is more than one that simply pays its rent on time and in full, but also one with the right profile. The screening of tenants with negative reputations has troubled trustees for years, but now they will go the extra mile to secure tenants with a positive public image. This trend is being borne out not only in the drafting of new leases, but also in the mix of tenants preferred by landlords and how those tenants are using the land for more sustainable and more varied purposes. So, despite the very apparent concerns of the DWP, the tendency towards the ESG-conscious model suggests that investors are accepting the need to shift to a longer-term view when managing social risks.
Common concerns
It would seem then that charity trustees and trustees of pension schemes have, at a fiduciary level and because the statutory requirements placed on them, plenty in common when it comes to considering ESG factors. There is much for these categories of investors to learn from each other in terms of what ESG-savvy investors have been looking for when acquiring or developing property, as well as what they have been requiring in their leases for some time now and the mix of tenants they choose to contract with.
The institutional lease is evolving constantly and is being used to harness the reputations of charity landlords and tenants alike through the inclusion of provisions dealing with things such as energy efficiency, working conditions, anti-bribery and anti-corruption concerns. It is possible and often desirable for landlords and tenants to cover the ‘E’, the ‘S’ and the ‘G’ in their leases – they are, after all, often publicly accessible documents – meaning that the so-called ‘green lease’ is just part of the trend. The move towards addressing these wider concerns has only been accelerated in the wake of the combined effects of pandemic, climate change, recession and social injustice – all very much on the radar of those active in the third sector. In short, ESG objectives are very often analogous to charitable ones, especially those in the ‘S’ category where, it seems, charities have stolen a march on the pension schemes.
Striking a balance
As ESG now very much forms part of the investment landscape, the challenge for those in a position of fiduciary duty – such as trustees of a charity or a pension scheme – will be to balance their investment decisions not only to generate returns but also to optimise social gains and minimise environmental impact, all the while with a firm grip on the legislative and regulatory framework. It is becoming increasingly apparent that pursuing one does not necessarily have to be at the expense of the other and the concept of ESG is likely to become a cornerstone of portfolio management for years to come.
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