3 steps for bullet-proof ESG due diligence

Investing in a development with high ESG value can skyrocket the long-term value of the asset. But, with the possibility of more stringent ESG regulations in the future (especially in the environmental realm), a development with poor ESG infrastructure has the potential to turn the asset into a ticking time bomb.

The challenge for investors is understanding the real or potential ESG value of an asset, with many developers making lofty, unsubstantiated claims about their projects and new regulations being passed globally every year.

To navigate this complex terrain, there are several steps you can take during your due diligence. Let’s dive in.

The risks of missing ESG red flags

First, a quick word on the potential damage of investing in a development with low environmental standards.

Shifting tides

Regulatory bodies are beginning to tighten the noose around ESG compliance.

In the U.S., which is behind Europe in terms of ESG regulation, Building Performance Standards have been rolled out in order to cut down greenhouse gas emissions in real estate. These laws ensure large commercial buildings abide by carbon and energy consumption targets.

Before 2022, two states, a county, and 31 cities implemented BPS; another eight states are set to join by the end of 2023. New York City’s version of this law, dubbed Local Law 97, is scheduled for 2024. For guides on meeting Building Performance Standards, check out IMT’s blog resources.

More regulation is likely to follow. For instance, industry associations such as NAREIM, REALPAC and ULI are discussing how to apply the EU-funded research project, Carbon Risk Real Estate Monitor, to the U.S market.

To stay ahead of the curve, thorough due diligence on environmental factors must be prioritized before investing in development.

Low environmental standards equal higher investment risk

Buildings that fall short of environmental and social standards could be hit by fines, exorbitant utility bills, and retrofitting expenses. This not only results in direct financial losses but also raises legal and operational risks that can erode a project’s profitability.

In the worst-case scenario, falling on the wrong side of regulations can lead to stranded assets, which have to either be sold at a loss or receive significant investment to turn them around.

Moreover, the market demand for environmentally conscious spaces is on the rise, and properties with poor ESG performance are likely to face challenges in attracting tenants and maintaining occupancy rates.

Your property could also lose significant value when the time comes to sell if it is below the market’s ESG standards.

Strategies for thorough ESG due diligence

With that said, it’s critical for every investor to get their ESG due diligence right. Here’s my advice:

Hire professional advice

There are numerous components of a building’s environmental standard, and deep knowledge across the spectrum is required. Depending on the development, you will likely need expertise in energy, heating, cooling, glass, steel, and local regulations.

The most efficient and effective way to do this is by hiring professionals. For instance, you could hire an attorney that specializes in compliance with ESG guidelines and a systems engineer to analyze if the building adheres to sustainability best practices and assess the project’s readiness to adapt to evolving environmental and social requirements.

If they raise concerns, take them to the developers and see what they have to say. Use your judgment to assess whether the developers can be trusted to uphold their promises.

Drill down into the developers’ propositions

Some developers are looking for shortcuts to bypass time and resource-inducing regulations, as well as providing grand promises with little substance (because that’s what us investors want to hear, right?). It’s your job as a shrewd investor to take nothing at face value and ensure their claims stand up under scrutiny.

To avoid falling for false promises, look for third-party certifications and ratings that validate the property’s ESG credentials. Certifications like LEED (Leadership in Energy and Environmental Design), BREEAM (Building Research Establishment Environmental Assessment Method), or ENERGY STAR are indicators of a building’s sustainability and energy efficiency.

Similarly, check for ESG ratings by specialized agencies that assess companies’ environmental, social, and governance performance. Relying on independent assessments reduces the risk of being misled by greenwashing tactics.

Equally important is reviewing the developer’s credentials: do they have a strong track record in the realm of ESG? I’d naturally be cautious of investing in a development that’s making big promises about ESG value if they don’t have any past cases to back up their reputation,

Leverage your network to run a ‘sanity check’

I’ve spoken before about the power of your personal network when it comes to due diligence. I want to reiterate what I’ve personally learned: that using your connections and asking for advice as part of your due diligence is an important yet often overlooked tactic.

Before signing off on an investment, I’d reach out to a handful of relevant contacts to run a ‘sanity check’. They could be real estate investors operating in the city you’re investing in, ESG experts, or anyone else who could shed some light on the investment.

Look for a reason to say “no”: if you do this and find no red flags about the development’s ESG standards, you’ll be in a much more confident position to close the deal.

Final takeaways

With a dynamic regulatory landscape and a wide-ranging array of factors that comprise a building’s environmental standards, doing ESG due diligence right is a complex process.

My biggest piece of advice is to go that extra mile – invest in professional opinions, reach out to as many contacts as possible, and adopt the mindset of finding reasons to say no.

Doing this will help you avoid confirmation bias, invest in developments that’ll stay on the right side of ESG regulations and standards over the long run, and ultimately ensure a healthy return on your investment.

Modified Date & Time : 02 Oct 2023, 12:50 pm

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Author

Paul Thompson

Paul Thompson is a real estate fund manager, consultant, and coach based in Arkansas. He has vast experience in wholesaling, land deals, fix and flip, buy and hold, mid-term rentals, and fund management. For more information, visit his website.

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