An investor perspective on sustainability and commercial buildings

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This article discusses the role of sustainability performance in investor appraisals of company value, and explains why sustainable commercial buildings can enhance valuations.

Summary

As at 30 June 2007, investment in the property sector — predominantly through listed property trusts and major construction and development companies — makes up approximately 8% of the total Australian equities (or share) market. Increasingly, the values assigned to these investment vehicles rely on intangible, as distinct from tangible, assets. A company's approach to sustainability can have significant influence over the perceived and real value of its intangible assets, and therefore can affect its market value. This article discusses the role of sustainability performance in investor appraisals of company value, and explains why sustainable commercial buildings can contribute to long-term valuations.

Definitions

Over the past two decades, as the economies of developed countries (including Australia) have continued to migrate from manufacturing to knowledge-based services, intangible assets have increasingly displaced tangible assets as drivers of market value (see left figure).

Tangible assets include things like cash, buildings, plant and equipment, contracts with customers, and finished goods. Intangible assets are more nebulous, but are generally considered to include quality of earnings, customer loyalty, brand strength, reputation, tacit knowledge, the quality of leadership, and the skills, relationships, experience and behaviours of the company's employees.

Intangible assets are not recognised as traditional accounting assets, and therefore remain largely unaccounted for, to the extent that 'the top 100 Australian organisations "wrote off" their financial accounts $7.5bn in intangible assets in 2005' (Society for Knowledge Economics, 2005).

However, the Society for Knowledge Economics (2005) notes that 'investors want information about the drivers of business value and how such drivers are managed, not merely the bottom line results of past performance'. This information is increasingly provided in the form of alternative accounts, such as triple bottom line (i.e. economic, social and environmental) and corporate social responsibility (CSR) reports, which 'provide a broader, more balanced, perspective on organisational wealth and shed light on the capacity an organisation has to create value in the future'. These perceptions, or proxy measures of future value, are critical to investors and their decision-making processes.

Sustainability, which in a corporate setting is interpreted as corporate social responsibility (see Aligning mission, vision and strategy for sustainable commercial buildings for more information), and is concerned with performance across the triple bottom line of social, environmental and economics factors, therefore provides an important lens for expectations of future value. In the property sector, the attitude adopted by property trusts and development, construction and design companies towards sustainable commercial buildings can therefore be considered as one indicator of rounded performance. This is explored in more detail in the next section.

How investors assess sustainability

Investors assessing sustainability use a range of techniques to understand the environmental, social and governance risks and opportunities that contribute to company value. AMP Capital's Sustainable Alpha team use a particular approach to invest in share market-listed companies that have corporate, workplace, stakeholder and environmental systems in place and a record of performance that is appropriate to the set of sustainability risks and opportunities facing them.

Each company is assessed according to two distinct, though complementary, dimensions:

• Corporate social responsibility (CSR): CSR is a bottom-up evaluation of how each rated company balances the needs of different stakeholders in its business. This encompasses an assessment of how a firm fulfils its financial and legal responsibilities to its stakeholders in the market place (e.g. shareholders, suppliers and customers), as well as how it manages its workplace and environmental supply chain issues, and its reputation in the communities in which it operates.
• Industry sustainability (IS): Industry sustainability is a macro-level framework for assessing broader social, economic and technological trends that are deemed likely to have a tangible impact on a company's future strategic and financial position. As its starting point, IS recognises that there are long-term global pressures on industries to adopt practices and sustain growth rates that do not substantially detract from the living standards of future generations.
  

Does using a sustainable investment approach relate to long-term financial performance?

A recent statistical study by AMP Capital Investors (2005) demonstrated that companies with higher corporate social responsibility ratings (based on AMP Capital's internal ratings) outperformed lower rated companies at a statistically significant level over the four and ten year periods to 31 December 2004 (see left figure).

With such out-performance, it is no surprise that sustainable investing is catching on. A benchmarking study by the Ethical Investment Association (2006) illustrated the rapid growth in sustainable investing. The study showed that the Australian-managed socially responsible investment portfolios grew 56% in the 2005/06 financial year from $7.67 billion to $11.98 billion, in comparison to mainstream-managed portfolios, which grew 15.5%.

Why sustainability is important for the commercial building sector

From an investor's perspective, sustainability in the commercial building sector is important because:

• it is significant in determining the intangible and future value of the business
• it impacts on material risks and opportunities of the business.

Both of these factors are essential for making better informed investment decisions.

Determining future value

Twenty years ago, the financial value of a business was mostly about tangible assets — buildings, equipment and investments. Today about 77% of the value of a typical Australian company is made up of intangible assets (AMP Capital Investors, 2006), while Ballow, Thomas and Roos (2004) claim that nearly 60% of the aggregate value of the US stock market is based on investor expectations of future growth.

This means that in the case of the average Australian property developer, the value of the company is based on more than just its stock of machinery, tools and equipment, and the valuation of its buildings. In other words, if the company was sold and split-up, the proceeds from the sale of tangible assets may not cover the company's debt.

So where is this extra value?

Much of the financial value of a company is in its brand and reputation, which emanate, for example, from being known as a company that delivers high-quality commercial buildings to its clients. It is that reputation and other intangible assets that ultimately make an investor think the company is going to have cash flow in the future; this decision has little to do with the company's tangibles assets (see left figure).

Similarly, by providing safety on the construction site and competitive working conditions, the company may have a competitive advantage in attracting and retaining talented staff. It may also have created value — particularly with the growth in green leases — by providing the latest energy-saving designs, thus opening up a competitive advantage when attracting tenants. In addition, the company may have value in its engagement processes with the community, which ensures that it develops sites in keeping with the local environment and community needs.

Overall, the vision and values that drive a company on a path to sustainability are likely to ensure that the company is ahead of the curve in terms of regulatory risks and costs. It is these intangible values (being those values not directly or easily financially quantifiable) that contribute to company value.

New models for a new world

So what has changed for investors? When valuing companies, investors traditionally assess the quality of the business by examining factors such as:

• firm strategy
• operational capability
• competitive analysis
• risk assessment
• management quality.

However, new company models to analyse a sustainable business must consider issues such as:

• human capital management, culture and leadership
• staff alignment to OH&S and company values
• community and consumer support
• risk management of the supply chain
• good governance
• stakeholder consideration to limit brand risk
• voter values, which drive government policy
• material risks of climate change
• environmental requirements along the value chain (e.g. green leases).

How do these issues impact on company valuation?

Traditional financial analysis suggests that the price of a company is based on its cash flow, grown over time and discounted. Discounted cash flow analysis (and most methods for assessing company value) relies on understanding current and future risks and growth opportunities confronting future cash flows. Therefore, any assessment that fails to address intangible issues will be incomplete.

The figure (titled 'Discounted cash flow model') above shows two important issues for investors to consider:

• the risks associated with the company (if possible, these risks should be quantified)
• the nature of the growth rate of the cash flows.

For example, investors may ask whether cash flows are 'high growth, low risk' cash flows or vice-versa. It is the sustainability issues that intrinsically impact on risk and growth and hence company value. In other words, it is the analysis of intangibles that improves line of sight on growth and risk issues.

Sustainability risk

Using climate change as an example, sustainability issues can impact on the material risk of the commercial building sector in both direct terms (i.e. sea level rises or increased storm events and damage to property) and in indirect terms (i.e. regulatory costs to develop buildings that are more energy efficient). Some of the material risks that investors may consider are included in the table below.

These risks need to be fully explored and analysed, both for specific companies and to understand broader industry trends. For example, understanding voter values that drive government policy on sustainability can enable a company to remain ahead of the curve and to identify growth opportunities that may otherwise be regulatory risks. Australia now has government policies in many jurisdictions that require minimum environmental standards, and similar trends are being driven by client demands and changing work practices. Both the NSW and Victorian state governments require that all their new office leases are in buildings rated with a 4-star or higher Green Star rating. Those property owners who have identified the trend towards green leases and now have a stock of available green buildings are in a position to achieve growth from this policy. Similar behaviour by anchor tenants illustrates how innovators who push beyond mere compliance will continue to gain benefits from operating this way.

Similarly, those developers of commercial buildings with poor safety performance risk both higher worker's compensation premiums and difficulty in maintaining and recruiting labour. From an investor's perspective, poor OH&S performance represents an avoidable cost to a company, and reflects on the quality of company management, which in turn reduces the company's ability to compete in an increasingly competitive labour market.

Sector analysis shows that costs of work-related injuries and illnesses for a sector can be the same or more than the sector's total operating profit (EBITDA) (e.g. for the construction sector, the OH&S costs are 98% of profit - these figures were calculated using the total cost of work-related injury and illness to the Australian economy and each industry's operating profit (EBITDA) from Australian Bureau of Statistics. Percentages for other sectors are detailed in the full report 'The Investment Reasons for OH&S'). In addition, the construction industry's proportion of national OH&S costs is 11%, while for property and businesses sector, it is 8% or a combined total of $6.1 billion annually (NOHSC, 2004). In 2005, worker's compensation costs as a percentage of labour costs were higher for the construction sector than any other sector in Australia (ABS, 2005). These statistics illustrate the materiality of the cost of safety in this sector and the opportunities for having a more sustainable workplace by cutting costs and reducing injuries. They also illustrate to investors that companies in this sector start with higher costs to simply get their people in the workplace, compared with other sectors.

Investor lessons

From an investor's perspective, there are many sustainability lessons for the property sector to learn. Some of these are discussed below.

Regulation

Those businesses that simply react to new sustainability regulations are exposed to regulatory risks. Businesses operating at a beyond compliance position often reap first mover advantages.

The environment

Growing environmental concern by relevant stakeholders provides business opportunities for ecologically sensitive design (to reduce impacts on water, energy and waste), and for implementing decentralised, eco-efficient solutions. In residential construction, state government land releases for new residential areas increasingly require developers to be proficient in ESD, and this is becoming more important in commercial development as green leases become more prevalent.

Split incentives

In some instances, a disconnect remains for incentives for eco-efficiency. Companies at the construction stage of commercial buildings are often not the owner, manager or occupier of the completed development. This often reduces the incentive for investment in eco-efficiency, which does return benefits over time, but has a higher upfront cost.

Blurring of home and office

Changing demography in Australia provides opportunities for adaptable residential design. Current trends indicate that by 2020 there will be a blurring of the home and office. Residential design that offers flexibility in needs and services can have competitive advantages.

Affordable housing

The contemporary property boom has altered the shape and speed of urban renewal. With generous negative gearing and taxation provisions in Australia, many property investors have received a windfall and prices have increased rapidly, isolating many lower income and younger people from the residential ownership market. With growing demand for housing located close to working centres, affordable housing is in short supply and will continue to pressure the industry and provide opportunities for residential and mixed-use developers. Over time, affordable housing may more frequently become a necessary condition of development approval.

Community relations

Poor community engagement processes can lead to community backlash. With greater environmental focus, environmental NGOs, indigenous groups, and community interests can potentially generate negative publicity, representing a risk for companies without legitimate sustainability approaches to development. The most significant issues relate to the ability to integrate developments into an existing community (both socially and environmentally), and the recognition of future social trends in development, including affordable housing and aged care. The desire for public consultation will drive opportunities in the sector to incorporate stakeholder participation processes into planning and development, in order to ease reaction against developments and to ensure a smooth transition into existing communities.

Safety

Safety represents a significant risk in the workplace for the property sector. Construction has the highest rate of worker's compensation costs as a proportion of labour costs in the economy. A safe workplace is a regulatory requirement that is governed by states, opening up significant risks to developers not savvy to jurisdictional differences. Costs from accidents and fatalities can significantly affect the cost of a business, the company's reputation, and their ability to retain workers. Investing in safety provides companies with the opportunity for better relations with stakeholders (including unions and the supply chain), better staff retention, and higher productivity. Ethically, safety in the workplace is a human right in the developed world.

Political influence

The high level of political influence by the property sector can impact on company reputation and attract ethical concerns. Public disclosure of political donations can ease concerns in a sector that is the second highest donator to government. Also, best practice corporate governance can reduce concerns about the quality of high-level, independent decision making on behalf of shareholders.

Building momentum by investors

Material impacts on company value from sustainability are increasingly being recognised throughout the investment community as being critical for determining sustainable value. The growth of specific investment networks illustrates the mainstreaming of sustainability for investors. Moreover, in some cases, these networks are using their combined shareholder power to engage with other sectors and industries.

The UN principles for responsible investment (PRI)

The UN principles for responsible investment (PRI) were signed by over 190 leading financial institutions with greater than USD 8 trillion assets under management. The PRI was formed in 2006 by the UNEP Finance Initiative and the UN Global Compact, along with key financial stakeholders. Signatories commit to acting in the best long-term interests of their beneficiaries, and acknowledge, in their fiduciary role, that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios. The rapidly growing list of major investors and fiduciaries indicates that companies will increasingly be assessed by their ESG performance, and that investors will be active owners in the ESG space.

The carbon disclosure project, 5th edition (CDP5)

Investors with $41 trillion of assets under management requested that the world's 2,400 largest companies disclose their material risks of climate change. This indicates recognition from the investment community of the financial implications of sustainability, such as climate change, and suggests that realignment towards sustainability is now required by companies. This represents more than one-third of the world's invested assets. In 2006, CDP4 revealed that 94% of ASX100 respondents recognise the potential for climate change-related issues to impacts on future earnings, liabilities or the company's general risk profile. However, of the same respondent group, only 9% have established formal GHG emission reduction targets with clearly articulated time lines, and only 9% provided total energy costs and demonstrated a clear understanding of the potential impact on profitability of changes in energy pricing.

The enhanced analytics initiative (EAI)

Investors with $2.4 trillion in assets under management have indicated the importance of identifying intangible value through the level of expenditure that asset managers are willing to spend. EAI members allocate a minimum of 5% of their respective brokerage commissions to research houses that are effective at analysing material extra-financial issues (EFI) and intangibles. According to the EAI, 'EFIs are best described as fundamentals that have the potential to impact companies' financial performance or reputation in a material way, yet are generally not part of traditional fundamental analysis. For example, future political or regulatory risks, the alignment of management and board with long-term company value, the quality of human resources management, risks associated with governance structure, the environment, branding, corporate ethics and stakeholder relations' (http://www.enhancedanalytics.com).

UN environment program finance initiative property working group (PWG)

The PWG includes property asset managers and experts who are working to increase awareness of the importance of responsible property investment. They will also be working with the UNEP's sustainable building and construction initiative.

References

AMP Capital Investors (2005), Financial payback from environmental and social factors, Accessed from AMP Capital Investors website.

AMP Capital Investors (2006), ASX top 100 companies.

Australian Bureau of Statistics (2005), Labour costs: Australia, Canberra: ABS.

Ballow, J.J., Thomas, R.J. & Roos, G. (2004), Future value: the $7 trillion challenge, Outlook No 1, New York: Accenture.

Daum, J.H. (2002), Intangible assets and value creation, Brisbane: John Wiley & Sons.

Ethical Investment Association (2006), EIA SRI benchmarking survey, Accessed from EIA website.

National Occupational Health and Safety Commission (2004), The cost of work-related injury and illness for Australian employers, workers and the community, Canberra: NOHSC.

Society for Knowledge Economics (2005), Australian guiding principles on extended performance management: a guide to better managing, measuring and reporting knowledge intensive organisational resources (final draft), Paper presented to GAP Congress on Knowledge Capital, November 3-4, Melbourne.