ZNE’s Story and What it Means for the Burgeoning Asset Class of Environmental Real Estate
Disclaimer: Nothing in this article is to be construed as a recommendation of a particular investment product or strategy. Align has not conducted full due diligence on any of the below strategies, products, or managers, and has not recommended any of the below strategies, products, or managers to clients.
Affordable housing is a shining example of impact investing in real estate; however, the success of the asset class has left the industry complacent. Real estate is the largest asset class on the planet, representing over $3.6tn in value.[1] Yet opportunities for impact investing have been slim outside of affordable housing. For impact investing to serve as a whole portfolio solution for clients, it needs to diversify out of multifamily affordable housing and into other areas of the real estate industry, both from a financial and impact perspective.
Align is sourcing the next generation of impact investments in real estate. This three-part series will explore emerging impact investing opportunities in real estate by highlighting different managers present at the 2022 SOCAP conference. We start with ZNE Capital (“ZNE”), who did not attend SOCAP but, at the request of Align, met with Align and other industry leaders at the conference to discuss ZNE’s strategy and ZNE’s upcoming Regulation A offering.
ZNE is at the forefront of a new asset class, “environmental real estate.” Despite the desperate need to decarbonize the built environment, which accounts for approximately 40% of global GHG emissions, the real estate industry has been one of the slowest to adapt to the needs of a changing climate.[2] A recent article on a 73-year-old man who has committed to reduce his drinking by 2050 (when he is 101) is analogous to the wholly inadequate state of environmental considerations in the real estate industry.[3] The current targets and offerings Align is seeing labeled as “environmental real estate” are not based on the most recent science-based targets and will fall short of what is needed to keep warming below 2*C. Despite the abundant opportunity in this space, even many basic energy efficiency improvements are not being adopted by mainstream asset owners. Why is this the case?
Until the creation of green leases (also an innovation from the impact investing community) which fix utility costs for tenants and allow tenants and landlords to negotiate a split on the savings and benefits of energy efficiency upgrades, landlords had no financial incentive to improve the environmental performance of their buildings. But fixing the split incentive problem is just one piece of the puzzle. Real estate investors have been short-sighted in recognizing the value of sustainable improvements in real estate outside of just cost savings. For example, when the partners at ZNE tried to market a sustainable apartment building deal on a popular crowdfunding platform for real estate, the property received little interest and in fact, backlash from anti-environmental investors. Yet, when the partners advertised the same deal without any mention of “green” or “environmental” and simply presented the financial case for the investment, it received funding. This is an example of a market failure in recognizing the value of sustainable improvements. In fact, studies have proven that environmental real estate drives value, with studies suggesting rental premiums of 6% and sales premiums of almost 8% to comparable non-green buildings.[4] Objective investors should realize that not only do sustainability improvements create an asset, they can also avoid some future liabilities that can impact cashflow.
Areas, such as my hometown of Denver, through laws such as the “Energize Denver” ordinance, are already requiring building owners to implement sustainable retrofits and remodels, significantly increasing the cost of ownership and impacting the cashflows and thus net internal rate of returns (IRRs) to investors. Meanwhile programs such as the 179D and the 45L tax incentive programs that allow investors to monetize sustainability improvements were just extended for another 10 years under the Inflation Reduction Act.
Yet traditional asset managers are reticent to look past a seven-year proforma, despite claims of being long-term investors. As with green leases, it falls once again to impact investors to lead the way and prove the business case for deep decarbonization of the built environment outside of what the industry believes is possible right now. For example, ZNE’s previous real estate fund provided 50% reduction in GHG and water usage in year one while offering a highly attractive return and utilizing zero offsetting. For context, the comparable investments Align reviewed only provided 50% reduction over 10 years. Yet ZNE is aiming to do even better with its upcoming Regulation A offering in which it hopes to prove that not only can net zero real estate be built, but it can also be profitable. ZNE can provide net zero real estate in year one, largely by saturating properties with onsite renewables, but investors are projected to realize a 3% lower net IRR over a seven-year hold period, something traditional real estate investors have been unwilling to do. As a result of this and being a first-time fund manager, ZNE has struggled to raise capital. In fact, ZNE has had such trouble with raising institutional money it is now focusing on the retail market through a Regulation A offering. It remains to be seen if retail investors will step up where institutional investors have fallen down.
The lack of institutional capital flowing to this asset class is particularly disheartening given the dire need for net zero real estate. As the IEA’s most recent (produced in 2021) scenario analysis illustrate, to stay in line with the Paris Accord, more than 85% of buildings will need to be net zero ready as of 2050.[5]
IEA Scenario Analysis:
Align aims to play a catalytic role in this space, helping institutional investors to understand the more technical aspects of the underlying investment thesis behind net zero and “net zero ready” real estate and the potential benefits of being an early investor in the space. As the effects of climate change continue to amplify and government regulations increasingly require capital expenditure to bring buildings in line with SBTs, real estate investors may face a rude awakening as they try to catch up to leaders in the sustainability space. The longer investors wait to align their portfolios with the realities of climate change, the more expensive it will likely be to quickly adapt their portfolios.
The next wave of environmental real estate will take simple measures such as green leases for granted, and focus on deep decarbonization, and do so quickly.
[1] Grandview Research: https://www.grandviewresearch.com/industry-analysis/real-estate-market
[2] https://www.worldgbc.org/embodied-carbon
[3] https://mronline.org/2021/11/09/man-announces-he-will-quit-drinking-by-2050/#:~:text=A%20Sydney%20man%20has%20set,2049%20when%20he%20turns%20101.
[4] https://www.forbes.com/sites/markzettl/2022/03/01/the-green-lease-is-the-next-phase-of-built-environment-sustainability/?sh=6edcffed5e56
[5] https://www.iea.org/reports/net-zero-by-2050