Building a real estate ETF, bottom-up
Last week, the investment management behemoth BNP Paribas launched a “green” real estate ETF—a mutual fund that invests in listed property companies (aka REITs), passively, while taking environmental considerations into account. This real estate index, which is based on the FTSE EPRA Nareit Green Index, is special for two reasons.
First, it is one of the first passive real estate index products that integrates so-called environmental, social, and governance (“ESG”) considerations. Real estate plays an important role in ESG-related issues. The sector consumes 81% of electricity in the U.S., emits 40% of carbon, and provides shelter for 90% of our time (only 10% of time is typically spent outdoors). The FTSE EPRA Nareit Green Index (and thus the BNP Paribas’ green real estate ETF) applies a conduct-based exclusion based on the United Nations Global Compact principles, and constituent weights are adjusted (tilted) based on two sustainable investment considerations—green building certification and energy usage.
Second, and perhaps even more groundbreaking, the ETF is based on data that maps the individual holdings in portfolios of listed property companies/REITs. Drawing on a geolocation database of over 15 million buildings from GeoPhy, circa 73,000 individual buildings with over 10 billion square feet combined floor space are identified. These cover real estate holdings for 93% of the constituents of the FTSE EPRA Nareit Developed Index, the most widely used real estate index in the institutional real estate space.
Using a bottom-up approach, exploiting asset-level data, is important. It allows for matching each asset with green certification data, such as certification by LEED, Green Star, and BREEAM. And, it provides the basis for detailed, building-by-building energy use, and carbon modeling. The data is then aggregated to create portfolio-level metrics that provide a timely, consistent, and highly-granular assessment of the sustainability performance of each property company across three key indicators:
- Share of the total net leasable area covered by eligible green building certification
- Average estimated energy use per square meter
- Average estimated greenhouse gas emissions per square meter
These metrics are applied as “tilts” (or weights) to develop an innovative, sustainability-focused alternative to a “conventional” real estate index and ETF. The green index puts more weight on real estate portfolios demonstrating strong sustainability performance and reduces exposure to those portfolios with a less sustainable asset base. The graph below shows significant reductions in carbon emissions (-22 to -40% on a per-dollar basis) for the green real estate index.
Money talks when it comes to “green” financial products—including real estate ETFs. A simple backtest of two indices that focus on “greener” property companies shows excess returns of about 1% per year. While the results of the past are no guarantee for the future, the increasing regulatory and investor focus on the environmental performance of buildings may further reinforce the outperformance of REITs with a greener portfolio, with a high fraction of sustainable, low-carbon space.
A real estate portfolio reflects the aggregate performance of a collection of assets—information on each of those individual assets allows for the development of novel and innovative financial products. The BNP Paribas’ green real estate ETF is a leading example of a bottom-up approach to index construction—a similar approach in real estate can be taken for a “pure play” sector index, a climate resilience REIT index, etc. Each of these products will offer pension funds, insurance companies, endowments, and other investors the ability to make more targeted investments in real estate through a liquid product that is offered by REITs.
Stay tuned for these products to come to market, sooner rather than later! In the meantime, read more about the FTSE Green Index here.