How ESG Trends Are Shaping Real Estate Valuation and Investment Decisions

Environmental, social, and corporate governance (ESG) and sustainability initiatives are increasingly influencing investor decisions and impacting the market value of real estate. ESG factors should have a greater significance in property valuation due to heightened regulatory requirements, evolving stakeholder expectations and the need for effective risk management. 

This article highlights some of the ESG and sustainability trends within the real estate industry, discusses approaches to integrating ESG in real estate valuation, recapitulates real estate investors' reliance on ESG performance, and summarizes the future of ESG and sustainability in real estate. 

What Are ESG and Sustainability Trends in Real Estate?  

Real estate companies can integrate ESG and sustainability by using eco-friendly materials, implementing renewable energy, focusing on Corporate Social Responsibility (CSR), workplace wellness, Diversity Equity and Inclusion (DEI), and ensuring transparency in reporting their ESG progress and strategies. 

ESG and sustainability trends can be considered and factored in during any stage of a project life cycle.  

Investing and financing 

• Use green, sustainability-linked, or Property Assessed Clean Energy (PACE) financing.  
• Issue green and sustainability bonds for environmental projects. 
• Tokenize real estate to increase access to sustainable investments. 

Planning and design 

• Perform a sustainability risk assessment when evaluating a property.  
• Implement smart building technology, also known as PropTech, including building sensors, 3D technology and modeling, and health and wellness features such as air ventilation and filtration systems to improve and refine sustainable design.  
• Consider the overall community, taking into job opportunities, quality of life, and function in the design.  

Construction and sourcing materials 

• Reduce, reuse, and recycle materials to decrease waste and conserve natural resources. Alternative building options include circular, repurposed materials from decommissioned buildings, low-carbon materials like calcined clay, solar panels, and modular or prefabricated structures.  

Property operations and maintenance 

• Implement active energy management, cooling technology, water treatment, and recycling programs to limit pollution and waste. 
• Integrate PropTech to gather data for proper governance and reporting transparency. 
• Purchase renewable energy credits (RECs) and/or emission offsets to further reduce the property’s environmental impact.  

How ESG and Sustainability Initiatives Impact Real Estate Valuation 

The implementation of ESG initiatives is not formally considered during real estate valuations currently within the industry. Nonetheless, ESG is rapidly evolving and is expected to become increasingly prevalent and evident in the built market. There are currently three acceptable approaches to consider the valuation of real estate, including: 

• Cost approach 
• Sale comparison approach 
• Income approach 

However, climate change poses physical and transitional risks that could impact a real estate property’s value. Appraisers often refer to historical data and comparatives to determine value, but unfortunately, there’s currently a lack of reliable historical ESG data, and there aren’t a lot of true ESG comparable properties available. However, due to investor interest in ESG factors and forthcoming laws and regulations that could impact property value, real estate owners may want to consider alternative approaches to assessing ESG’s impact on real estate valuation. As such, there are three additional methods that can also be factored in while calculating fair value through the accepted existing approaches (cost, sales comparison, and income), including: 

Additive approach 

• Identify relevant ESG factors for the property, such as energy consumption, water usage, greenhouse gas emissions, etc. 
• Quantify the investment in the upgrades and the impact of the ESG factors, such as savings in energy and water charges, waste reduction savings, etc., within the property’s cash flow. 
• This establishes a baseline measurement of current usage, evaluates the initial investment cost of the upgrades against the projected savings, and then considers the market benefits of the ESG criteria. 

Integrative approach 

• Incorporate all the property’s features relevant to its valuation, including factors relevant to ESG (environmental risks, greenhouse gas emissions, impact on the surrounding community, etc.) and factors not relevant to ESG (property size, location, age, square footage, etc.).  
• Quantify the presence and/or absence of ESG factors and the cost of initial investment for upgrades, and then incorporate the quantified presence and/or absence of the ESG factors within the property’s cash flow. 
• This approach goes beyond the additive approach as it factors in all features relevant to the property's valuation, limiting the potential of double count ESG factors in the cash flow, and creates more accurate market impact by allowing real estate owners to also access changes in tenant demands, rental rates, and tenant retention. 

Scenario analysis 

• Identify the impacts within each of the three ESG pillars. Examples include: 
  • Environmental: Assess weather forecast projections to determine the frequency and intensity of weather-related events such as hurricanes, floods, rising sea levels, and rising temperatures. 
  • Social: Society’s responses to climate change. There can be significant shifts in demand for real estate, as towns or even entire metropolitan areas could become less appealing due to climate-change-related events. 
  • Governance: Implications for not complying with or reporting on laws and regulation changes surrounding ESG, environmental protection, and climate change. 

• This approach can help real estate owners and investors make better decisions by acting as an in-depth examination of various potential outcomes. Scenario analysis is crucial for decision-making, risk management, long-term planning, quantifying risks and rewards, and understanding drivers and dynamics, further improving negotiations and communication.  

As laws and regulations surrounding ESG and climate change, so can property value. Real estate owners can boost asset value by meeting carbon and energy reduction targets. Implementing ESG initiatives increases market value and mitigates risks from non-compliance. Incorporating ESG in valuations helps owners understand long-term value and mitigate risk. 

Real Estate Investors Reliance on ESG Performance 

Real estate investors now see ESG performance as a crucial tool for driving value. Many investors believe companies with ESG practices are less risky, better positioned long-term, and more prepared for uncertainty. As sustainability gains prominence, investors recognize the positive financial impact of ESG practices, noting benefits like reduced operating costs, increased property value from energy efficiency, and enhanced tenant retention from community engagement.  

Investors also see direct financial benefits from environmental sustainability, as improved real estate boosts the environment and generates long-term returns. Governance practices, such as transparent reporting, improve efficiency and mitigate risks. Companies focusing on ESG and sustainability show improved carbon emissions, progress towards net-zero goals, reduced climate risk, and enhanced financial returns. 

Additionally, some investors aim to “do better” with their money through ESG Investing, Socially Responsible Investing (SRI), and Impact Investing. ESG investing considers a company’s risks, opportunities, and financial metrics, while SRI uses ethical criteria to choose investments. Impact investing seeks to create positive social outcomes, often through clean energy and affordable housing projects. 

The Future of ESG and Sustainability in Real Estate 

Incorporating ESG practices has been proven to increase property value, investor confidence, financial returns, and decrease long-term risk.  

With net zero targets set for 2050, and increased concern about the long-term effects of climate change, there has been a rise of sustainable building ordinances, benchmarking, and building performance standards in cities and states across the U.S. Although there is backlash to the current SEC climate disclosure rules, effective March 6, 2024, which require all public companies to disclose climate-related information in their annual reports, there are additional local laws and regulations such as California’s climate risk reporting and NYC’s Local Law 97, that have been implemented causing building owners and operators to face increased pressure to implement and report on their ESG initiatives.  

Therefore, ESG and sustainability trends are here to stay, with benchmarking and reporting becoming essential. Creating ESG and sustainable practices while preparing for the implementation of future regulations will help real estate owners create an ethical and social platform to strengthen operational resilience, be environmentally conscious and socially responsible, and simultaneously mitigate risks associated with climate change. 

Regardless of where you are in your ESG journey, we can help fine-tune and streamline your ESG goals to create an actionable game plan, assess property value, and collect measurable and reportable data to meet reporting requirements and gain investor interest. Contact our team using the form below to get started.