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NATIONAL ASSOCIATION OF REAL ESTATE INVESTMENT MANAGERS 14 NAREIM While sustainability leaders are relying on traditional acquisition due diligence tools, they are also taking advantage of new ways to look at the data in the data room. Sara Neff stresses the importance of the EPA's ENERGY STAR Portfolio Manager tool for energy and water data. "We always take data from the due diligence process and drop it into ENERGY STAR – this helps us make sense of the data through benchmarking it against other buildings in its class and geography, and determining how far it has to go to meet green building criteria (if it is not there already)." For Cavarly Garret, Executive Director of Global Real Assets at J.P. Morgan Asset Management, tools to measure walkability of buildings help round out the analysis of location "Walkscores and transit scores give us a better understanding of a property's competitive position." Laura Craft's team at Heitman leverages ULI Greenprint's environmental data management software "to further track, report, benchmark, and analyze energy, emissions, water, and waste performance." Benchmarking buildings using these sustainability tools helps to understand operational performance compared to peers in the market, and can help a buyer estimate what efficiency gains are possible for a building. Addressing social and governance issues in due diligence For many companies, evaluating sustainability in acquisitions is primarily focused on environmental risks and opportunities. But for companies looking to build long-term relationships with JV partners, LPs, or other investors, social and governance risks may be even more important to their due diligence process. Cavarly Garret from J.P. Morgan summed up this sentiment: "Governance issues are very important to J.P. Morgan. We have zero tolerance for corruption and bribery. These matters are very important when selecting JV partners." Management to prevent bribery and corruption is a top governance issue in most investors' screen, but for companies with a global reach, issues around child labor, forced labor, worker health and safety, and disaster preparedness are also becoming a part of partner screens in investment decisions. According to Karen Lutz from TRC "In companies operating in highly regulated industries or that have operations in high- risk countries, this due diligence needs to be expanded to include a wider range of social risks, as well as environmental risks." Labor risks are an especially important consideration for companies operating on a global scale, or who are employing especially vulnerable populations in their operations. One Private Equity company reported that they walked away from a long-term JV partnership after reviewing their labor policies and social impact controls of their potential partner – a year later this fund was implicated in a major international labor violation as part of a development project. Preparing for Disposition During the disposition process, it is important to make sure these improvements are highlighted to appraisers and the potential buyer to ensure their value is reflected in the sale price. This can be difficult, as most appraisers and buyers are looking at historical prices and market comps to determine a buildings value. Leading sustainability managers are active in ensuring value generated from sustainability improvements is captured in the disposition process. Bentall Kennedy commissioned their own study in 2015 to prove that their sustainable buildings had lower operating expenses and better renewal rates than their uncertified peers in the same markets 3 . Other leading REITs have worked with the Institute for Market Transformation and the Appraisal Institute to help appraisers learn how to value green building investments and certifications 4 . By educating all actors in a transaction about the value of sustainability investments, it is more likely that all of them will factor this into the sales price of an asset. While research and education help prove the value of sustainable investments, sometimes the easiest way to ensure a sustainability improvement is captured in a real estate disposition is to turn it into rent or net operating income. When pursuing their first major renewable energy contract, Kilroy ensured that the long-term agreement was structured so that the solar developer paid rent to Kilroy along with the contract to sell renewable energy to the building. According to Sara Neff "We had to find a way for our deal team to get comfortable with the increased asset value associated with on-site solar. We found that a 3rd party contract that paid us rent for on-site solar worked the best – by adding additional rent to the building over a 10 or 20-year term, this could be included in projected future cash flows, and increase value at sale." The concept of turning sustainability improvements into something that impacts the core financials of a real estate asset was a common theme among real estate investors. According to Laura Craft at Heitman, the need to call out sustainability improvements specifically in disposition may be redundant. "Implementing sustainability improvements can increase cash flows of a property and thus generate increased valuations. Energy and water improvements tend to have the highest return on investment. Once the property has upgraded to more efficient energy and water systems, the property's cash flow will begin to reflect actual savings. The property's value will increase based on the improved NOI." In a competitive market where good deals are difficult to find and even harder to execute, sustainability can be a crucial tool to find new opportunity in your acquisitions. The deal teams should take full advantage of sustainability experts at their companies – they can bring a new lens to identify hidden risks and unlock potential value in the acquisition process. 1 For the purposes of this article, "sustainability", "ESG" and "corporate responsibility" will sometimes be used interchangeably, and will refer to efforts to reduce risk and generate value through improving social, environmental, and governance policies, programs, and performance. 2 "Are We Nearly There Yet? Private Equity and the Responsible Investment Journey", PwC, 2016. 3 Avid Devine and Nils Kok, Green Certification and Building Performance: Implications for Tangibles and Intangibles, Journal of Portfolio Management, fall 2015 http://www.iijournals. com/toc/jpm/41/6 4 http://www.imt.org/real-estate-and-finance/ lenders-and-appraisers