As the debate about ESG’s impact on returns rages on, real estate managers are more wary of the cost than their private equity counterparts
As the debate about ESG’s impact on returns rages on, real estate managers are more wary of the cost than their private equity counterparts
Private capital managers are still asking whether environmental, social, and governance (ESG) investing negatively affects fund performance. Among those recently surveyed by Preqin, nearly a fifth believe that ESG constraints will cost them yield and, ultimately, clients. In the same survey, respondents pointed to performance and performance track record as the key differentiating factors among managers in the industry.
Breaking down managers’ responses by asset class, however, reveals a distinct variation in views – particularly where real estate managers are concerned.
In our survey, real estate managers were the most skeptical about ESG’s impact on performance. Close to a third (30%), and by far the largest proportion of any asset class, said ESG was a major challenge to outperformance (Fig. 1). This group of managers also ranked highly when asked whether an ESG policy inhibited the number of quality investment options. Among all respondents combined, 12% said that ESG narrowed the opportunity set, but this rose to 18% among real estate GPs.
Does the data back up this skeptical view? Fig. 2 shows that private real estate managers without an ESG policy have outperformed the ESG-committed cohort over the past decade. While returns from the most recent vintages have reversed the trend, absolute-return-minded clients defer to longer track records.
However, further analysis reveals there is no statistical significance in average IRRs between ESG- and non-ESG-committed groups. Additionally, return variance from the ESG-committed group was about half that of the non-committed group.
Real Estate vs. Private Equity
Looking again at our survey, private equity managers were more optimistic. Only 19% said they were concerned about the effects of ESG on performance. And in contrast with the real estate trend, ESG-committed private equity funds proved more competitive than their uncommitted counterparts. Compared with real estate, Fig. 3 shows fewer instances of underperforming returns and much lower variance between the two cohorts.
At a total size of $5.54tn (as of June 2020), the private equity asset class has a 66% share of total private capital assets, compared with real estate’s 13.4%. This provides a deeper data pool for analysis: 1,567 funds in total, 700 of which are managed by ESG-committed managers.
A key driver in this divide may be the opportunity set. The real estate industry is smaller and therefore offers fewer available investment options, while private equity managers have a bit more room to maneuver. In some cases, a real estate manager may not be able to afford to forgo a property in lieu of leaving LP cash on the sidelines.
These differences highlight the balancing act GPs need to perform, generating returns while simultaneously investing responsibly. All managers need to put client capital to work or they risk losing it to a competitor; some are able to do so just as easily with an ESG policy, as there’s always another asset to buy, while others lack the luxury of choice.
It’s difficult to say if real estate managers will change their views on ESG, but stricter environmental regulation and tax incentives could alter how properties are managed. Residential and industrial properties are by far the most commonly owned, and are also the most likely to be affected by the two key drivers of ESG commitment: consumer demand and regulation. As homeowners and renters increasingly prefer energy-efficient homes, the needle is likely to move in ESG’s favor. And for industrial properties, deeper government involvement in areas such as carbon reduction and employee rights may force more managers’ hands.
Although it remains a sticking point for many managers, investors are more confident in ESG and its return merits. The majority (89%) of those we surveyed believe that investments with ESG considerations will, at the very least, perform as well as those without.
If you’re interested in learning more about ESG, take a look at our ESG homepage. Alternatively, if you’d like to receive regular updates on our ESG activity, you can sign up here. Finally, if you’re looking to learn more about our ESG methodology, you can download an overview.