10 Jun 2019
How do we balance effective residential investing with being sensitive to tenants’ needs and to climate change? With the right approach, they can be far more harmonious that you might think. In fact, we would argue that they are intrinsically linked.
Using change as a lens
We have identified four global forces for change that we believe will shape the future. In turn, they will also shape our long-term approach to how we prioritise environmental, social and governance (ESG) factors. The four forces are:
If we look at residential assets using these forces as a lens, we not only see the form and function of the asset, but also how it fits within its wider environment. We can see what social value a property brings to the community. And, most importantly, how the occupier uses and engages with the space.
Happy tenants make business sense
A key insight from our recent “happy tenant = happy landlord” research showed that tenant turnover matters. Understanding and providing what our tenants want and ultimately seeking to retain tenants makes sound financial sense. The reason is fairly obvious, yet often overlooked: losing a tenant brings a whole host of costs. These costs can be for small refurbishments, fit-outs and repairs, or for outlays such as broker fees and advertising. On top of this, there’s the lost rent between tenancies. These costs can amount to several months of rent, thus making a real dent in investors’ income and, by extension, asset-level returns. Of the many factors that influence tenant turnover, increasing rental and occupational costs are right up there. Clearly, keeping tenant turnover low makes sense, which in turn suggests that chasing every opportunity for higher rental growth might not.
Tenant satisfaction is, of course, a function of the quality of the accommodation, including adequate maintenance and good services. However, it is also a function of the amenities that are available, such as concierge services, fitness facilities and parcel pick-ups – all of which are becoming increasingly important in supporting tenant contentment. We are also finding that more intangible aspects are also coming into play, such as health and wellbeing considerations in the design and operation of the asset. For example, providing more natural light and good air quality are important. And ensuring that we use low-volatile-emitting materials in the fit out, makes a difference in the let-ability and attractiveness to occupiers.
But a building is more than just bricks and mortar. It also serves a social purpose, especially in a multi-family residential building. Our industry needs to move away from thinking of itself as a remote landlord and move towards acting as a steward of the community. Health, inclusivity and mental wellbeing are not words normally associated with residential landlords. But they should be, as they are key to promoting tenant contentment and satisfaction.
The link to investment performance
While this all makes sense, demonstrating a clear link to investment performance is more difficult. For example, would a building with higher ESG credentials achieve higher rental growth or income? There is very limited research and literature available on the financial effects of green multi-family residential buildings from a landlord´s perspective. But research from the US market (Hopkins, 2018) suggests that multi-family properties with green certification have a significant rental premium to properties without such certification. The research also suggests, perhaps counterintuitively, that these certified buildings have higher operating costs. However, the level of rent collected is substantially greater than the higher costs. While this research is interesting and might make sense for some investment strategies, it runs counter to our view as a long-term investor. Developing higher ESG standards should not be seen as a chance to chase higher rents, but rather as an opportunity to reduce tenant turnover and to keep those hard-won tenants for longer.
If operating costs go down, income can go up
In fact, our own experience, particularly in our extensive residential portfolio across Germany, tells a more nuanced story than the US research. All the assets in our German residential portfolio are modern and less than 10 years old. They are built to a high ESG standard, particularly in terms of energy efficiency standards. But they often have green certification, too, such as Leadership in Energy and Environmental Design (LEED).
Our experience hasn’t shown clear evidence of a rental premium on these assets. But we have found anecdotal evidence that tenants do value energy efficient buildings, which can improve the asset’s attractiveness and implies that residents will stay for longer. Put simply, if we can provide a home with lower utility costs through better efficiency, then this should lead to greater affordability and attractiveness for the tenant. The total cost of occupation for the tenant normally equates to rent plus operating costs. If we can reduce the operating costs, then there is more scope to maximise rental income without increasing the total cost of occupation for the tenant. This is particularly the case where we provide an all-encompassing rent that includes utility costs, as any benefit from improved efficiencies flows directly to the landlord.
Keep turnover low to maximise income
Furthermore, our research into the relationship between tenant turnover and rents points in a direction that may be counterintuitive for some investors. But the arithmetic is clear, particularly when viewed as a long-term investment. The benefit of a higher gross rent can be negated if it brings increased tenant dissatisfaction. All else being equal, investments in low-turnover markets, such as Germany, will generate much better net income than high-turnover markets, such as the UK. Again, there are structural reasons for this, but we believe the general principle holds across markets. Rather than blindly trying to maximise rents, long-term investors should focus instead on keeping tenants happy in order to keep them in the buildings longer.
If we take a broader view of ESG and take into account longer-term ESG risks like climate resilience and climate transition risks, then there is a strong argument that we are ensuring a more resilient and durable income stream from our assets. It no longer seems altruistic to have a portfolio of residential assets that are designed to meet long-term climate targets and to manage the wellbeing of its occupiers. It actually makes commercial business sense to do so. If done correctly, investing in residential assets can create a virtuous circle with a happy tenant, landlord and planet.