If ESG factors were previously considered reasonably significant for where to domicile real estate assets, they are now absolutely critical. Partly, this reflects the growing importance of sustainability in financial markets more generally.
A 2021 survey by BNP Paribas found that 21 percent of institutional investors believe ESG is central to their business, compared with just 10 percent in 2019. To some extent, this shift in attitudes simply represents good investment logic. ESG-focused funds offer low levels of volatility, good returns and longevity. Over three-quarters (77 percent) of ESG funds existing 10 years ago have persisted, compared with 46 percent of conventional funds.
But incorporating ESG requirements into the decision-making process around real estate fund domiciliation also reflects the hard realities of a changing regulatory climate. The European Commission recently launched its Sustainable Finance Disclosure Regulation as part of its broader Action Plan on Sustainable Growth. The SFDR, alongside overlapping regulation, will increase transparency demands around ESG for all financial market participants, including real estate asset managers looking to domicile funds to maximise returns.
“Regulators are adopting different approaches when it comes to ESG, which presents difficulties for the investor community,” Kiran Patel, chief investment officer at Savills Investment Management, a global real estate investment manager, explains. “It’s early days. We’re all learning, and I’m sure the regulator is learning as well.”
Not only do real estate fund managers have fresh ESG regulations to deal with in the EU; there are also challenges around ESG reporting to contend with. It may be early days for many of the sustainability regulations around real estate fund domiciliation, but investment managers will want clarity as quickly as possible so they can come to a decision on which jurisdiction is right for their fund.
Whichever regulations real estate fund managers are following when deciding on their fund domicile, being able to accurately and transparently assess and report on their asset’s sustainability credentials is essential. “Real estate fund managers should align their carbon data collection, analysis and reporting with established industry standards,” says Alex Edds, head of sustainability for Europe at LaSalle Investment Management.
The specific metrics that are collected and shared, however, are likely to depend on a domicile’s particular jurisdiction. In Germany, for instance, the Federal Financial Supervisory Authority, or BaFin, has extremely stringent standards, with its draft guidelines stipulating that sustainable funds must have a minimum of 75 percent of their investments in sustainable assets to prevent greenwashing. Assets must also cause no significant harm to the environmental or social objectives of the SFDR. Other markets do not have such mandates.
“If you look at Luxembourg – one of the most popular domicile markets in Europe – it doesn’t have a minimum asset threshold for funds to be considered sustainable, investors don’t have to follow an exclusions policy and regulators don’t mandate a particular scoring methodology,” says Patel. “Germany is going down the route of gold plating, requiring very high ESG standards.”
Before factoring in these different ESG regulations, fund managers will also have to grapple with broader challenges around sustainability in the real estate space. The building and construction industries account for roughly 40 percent of annual global carbon emissions, with the manufacture of concrete and steel accounting for an extra 5 percent each. If ESG is genuinely a priority for real estate fund managers, these issues must be dealt with first before they start to assess how regulations might impact where the fund is domiciled.
SFDR is the major ESG regulatory consideration for asset managers considering an EU market as a domicile for their real estate fund. The effective start date for the SFDR was 10 March 2021, but there are also the European Commission’s Regulatory Technical Standards, which were adopted in April 2022, and the EU Taxonomy Regulations to consider. Altogether, this represents a sizeable regulatory minefield to navigate when deciding on a real estate domicile.
“The journey to net zero and more sustainable real estate is challenging, and will require significant investment”
LaSalle Investment Management
“Investors will no doubt like the simplicity of [the SFDR], but the reality is that real estate is complex, the journey to net zero and more sustainable real estate is challenging, and will require significant investment,” Edds admits. “There will be winners and losers as we transition, and investors will require expert guidance to navigate this to ensure they end up on the winning side.”
As well as the SFDR itself, there is also the impact that the standard may have on regulators in other markets, such as the UK, which is launching its own Sustainability Disclosure Requirements. While there will undoubtedly be some overlap with the SFDR, the addition of another regulatory standard to weigh up in the real estate domicile decision-making process adds further complexity.
According to Sam Carson, head of sustainability, valuations and advisory services at CBRE UK, the prospect of other jurisdictions developing their own regulatory frameworks around ESG “cannot be avoided, as the evolution of ESG is happening quickly.”
The fact that, in Carson’s words, “much of the regulations are designed for equities, with real estate being included as an afterthought” also doesn’t help matters. It is hardly surprising, therefore, that Edds calls “dealing with the mountain of regulatory and client disclosure requirements” the single biggest challenge for real estate ESG teams right now.
Plenty to consider
Complicating matters further is the fact that ESG regulations are not the only consideration influencing the domiciliation of real estate funds. “Since capital is mobile and global, with pan-European funds to consider and investors coming from all over the world, tax leakage remains critical,” Patel notes. “It is still important to find a domicile that has the best tax efficiency; not just from the investor perspective, but also in terms of where you’re investing.”
Longstanding financial principles will remain important in any domicile decision, but ESG factors are likely to be front of mind for real estate investors going forward. The fact that compliance standards are only set to tighten further means that they simply cannot be ignored.
From 2025, a new international standard, the Task Force on Climate-related Financial Disclosures, will be mandatory for all fund managers. Other climate agreements, whether government or industry-led, are also in development.
In a survey by IFI Global conducted last year, only 39 percent of respondents didn’t think ESG factors would impact domiciliation patterns in the future. With the imposition of SFDR and other regulatory changes, this figure will likely have fallen. Real estate asset managers have plenty to consider. As do fund domiciles.