Investing in sustainable cities

The world’s urban population is growing and the rural population has peaked, according to UN estimates. In developed countries typically around 80% of the population already live in urban areas. The UN expects growth will come from the developing world with India, China and Nigeria in the next two decades, accounting for more than a third of the expected growth up to 2050. Urbanization is closely correlated with economic development, meaning this isn’t necessarily a negative trend for the world economy, but it does present challenges given efforts to mitigate, slow or halt climate change.

Cities cover just 3% of the Earth’s land surface, but currently account for 75% of carbon emissions¹.
Making our cities both livable and sustainable will require capital, planning and innovation on an unprecedented scale, representing a huge opportunity for long-term investors. Frameworks regulating property development are also becoming increasingly important as regional, national and local governments try to meet net-zero commitments. In the past the climate was always a given – a predictable background factor – but that era is over.

Trends expected across all geographies in the coming decades range from upgrading the existing building stock including heating and ventilation, optimizing energy use, and employing better insulation or heat mitigation techniques (depending on geography), and potentially adapting existing commercial property to residential or mixed use. The International Energy Agency estimates total global floor area will have increased by 15% between 2022 and 2030 – equivalent to the existing floor area of North America².

In the EU, where data on the age and energy classifications of both residential and commercial property is readily available, about one-third of all EU buildings are over 50 years old. Nearly 75% of the building stock is not energy efficient, with only about 1% undergoing renovation each year. However, the European Environment Agency said greenhouse gas emissions from EU buildings decreased by 31% between 2005 and 2021³. This progress has been driven by higher energy efficiency standards for new buildings, energy efficiency improvements in existing buildings, decarbonization of the electricity and heating sectors, and warmer temperatures. The latter point has been complicated by increasing adoption of air conditioning in Europe to counter soaring summer temperatures⁴.

The direct impacts of climate are also impacting relative property valuations. Both in the residential and commercial sectors, occupiers will choose the most energy efficient properties lowering long-term energy costs and limiting exposure to restrictions on use. Legacy buildings that are difficult to upgrade, or are located in less attractive geographies, have the potential to become stranded assets, which is already having an immediate impact on relative valuations⁵. For example, in Florida, increasingly prone to hurricanes and flooding, home insurance markets in some areas have all but collapsed, with premiums becoming unaffordable and some insurers refusing to write new business and withdrawing from the market altogether⁶. In many cases the property impacted is in areas of high demand like Miami Beach and Palm Beach, making due diligence and assessment of climate mitigation potential very important for long-term investors.

The key takeaway for investors is that while densification, household growth and household purchasing power remain as important as ever and are reason to invest in prime locations, the distinction between residential, retail and office is becoming more blurred.

Across the globe, and particularly in Asia, real estate companies increasingly operate integrated commercial assets, driven by urban densification and regulatory pressure for reduced energy intensity and water use. In the US, mixed-use development is also becoming the standard as office floors are added to malls and shopping centers, while in other cases lower floors in office buildings are converted to retail. As companies continuously exploit best use of their urban assets and landbank, the differences between different commercial segments and asset types will melt further.

The Robeco Sustainable Property Equities strategy looks for companies that continue to be best positioned to monetize one of the three trends; Sustainable Cities (urbanization and earth preservation), PropTech (technology), and Lifestyle (socio-demographic). We believe that the best way to capture alpha from the transition to sustainable cities is to remain focused on REITs that operate and develop high-grade real estate assets in prime locations and those who are at the forefront of greening their buildings. It is our conviction that the transition to sustainable cities will have a significant impact on future fundamentals – including rents and profitability – and we are adapting the portfolio to this new reality.