Environmental, Social and Governance (ESG) investing has become more popular over the past decade as businesses that consider the impact of their policies on all stakeholders are positively rewarded in society. In ESG investing, also known as sustainable investing, investors analyze and assess how companies compare to others in terms of performance, while also considering environmental, social and governance factors in conjunction with financial factors. ESG considerations are particularly relevant to investing in real estate.
Investors and companies usually fear that ESG investing does not generate expected returns and that it is limited in diversification. Despite these concerns, recent research suggests that ESG investing, in fact, does help investors and companies achieve better overall performance. Investors and companies can benefit in many ways, such as receiving tax credits, while also supporting ESG values.
Market and outlook
According to recent research, U.S. companies on the S&P index that are ranked among the top five in ESG investing performed better than their counterparts in the bottom five by at least three percentage points each year for the past five years. ESG investing has grown to a $40.5 trillion dollar market as of mid-2020, according to a Pensions & Investments report. ESG-mandated assets have almost doubled over the last four years and more than tripled over the last eight years. With significant increases in social and environmental awareness across the world, shares in ESG companies are likely to grow exponentially in the next decade. Experts are anticipating half of all professionally managed investments to be comprised of ESG-mandated assets in the U.S. by 2025. ESG-mandated assets are expected to grow almost three times as fast as non-ESG-mandated assets. As a result, there could be about 200 new ESG-mandated funds to launch over the next three years in the United States.
There has been a growing demand for Leadership in Energy and Environmental Design (LEED)-certified office space. LEED-certified buildings attract top tenants and help increase commercial real estate tenants’ bottom line. According to a CBRE report, about 4,700 buildings (41 percent of commercial space) across the 30 largest U.S. office markets have been certified as “green.” Recent research also shows that real estate properties across the U.S. that are exposed to sea-level rise are selling at a 7 percent discount compared to similar properties with less exposure. In addition, negative impacts of the COVID-19 pandemic on the real estate industry are pronounced. As a result, some companies are taking steps to reinvest their businesses and build sustainability into the core of their operations. Building a sustainable and safe environment is just as important to investors as it is to tenants and all stakeholders.
The benefits of tax credits
ESG investing can reduce the tax liability for companies/investors, while also improving the wellbeing of communities, the nation and the world. Federal and state governments provide tax credits to promote investment capital to flow to domestic programs that benefit communities and the nation. Below is a list of a few tax credit programs:
- New Markets Tax Credit Program (NMTC) as part of the Community Renewal Tax Relief Act of 2000: NMTC provides tax credits as an incentive to stimulate business and real estate investment in low income communities. NMTC investors provide capital to community development entities, and in exchange are awarded credits against their federal tax obligations. Investors can claim their allotted tax credits in seven years as 5 percent of the investment for each of the first three years and 6 percent of the investment for the remaining four years, for a total of 39 percent of the NMTC project.
- Renewable Electricity Production Tax Credit Program (PTC) and the Investment Tax Credit (ITC) under IRC Section 45: PTC is a per-kilowatt-hour tax credit for electricity generated by qualified energy resources and sold by the taxpayer to an unrelated person during the taxable year. PTC is available for the first 10 years of production at a qualified facility. The ITC allows investors to deduct 26 percent of the cost of installing a solar energy system from federal taxes. The ITC applies to both residential and commercial systems, and there is no cap on its value.
- Low Income Housing Tax Credit Program (LIHTC) under IRC Section 42. This is the most important federal resource available to support the development of affordable rental housing for low- and moderate-income households. Under this program, federal tax credits are allocated to state housing finance agencies by a formula based on population. State housing agencies then award the credits to private developers of affordable rental housing projects through a competitive process. The awarded tax credits are used to raise equity capital from investors in their developments. Investors can claim the tax credits over a 10-year period once the housing project is placed in service.
- Historic Rehabilitation Tax Credit Program (HTC) under IRC Section 47– HTC is an indirect federal subsidy to finance the rehabilitation of historic buildings. HTC provides for a tax credit of 20 percent of qualified rehabilitation expenditures for rehabilitating certified historic structures. The tax credit provides for a dollar-for-dollar reduction of federal income tax liability taken ratably over five years, beginning in the tax year in which the building is placed in service.
- Charitable deductions for easements. Companies/investors can take a charitable deduction for contributions of a qualified real property interest to a qualified organization exclusively for conservation purposes (IRC Section 170(h)(1)). The allowable deduction for conservation easements is up to 50 percent of the donor’s adjusted gross income less net operating loss carryback for the taxable year or 100 percent for certain ranchers and farmers.
The COVID-19 pandemic has acted as a great stimulator for the ESG investing trend. Many countries have experienced the unintended climate benefits of cleaner air and water during the COVID-19 shutdowns. The pandemic also highlighted inequalities within and across countries as wealth and income gaps widened. More specifically, the pandemic drew attention to the problem of health inequality due to varying quality of public health infrastructure, particularly the inequality of access to healthcare. There is growing momentum among policymakers to focus on matters that provide support to the environment, societies and communities. Issues like climate change, resource scarcity, greenhouse gas emissions, health and safety, diversity and effective board oversight all have significant effects on a company’s financial performance and on stakeholders throughout the world. ESG qualities can help companies develop a competitive advantage, drive performance and attract more investors. And, similarly, those companies that are behind in adopting policies around ESG will most probably be negatively impacted.
Katherine Zheng is a senior manager and Philip DeRosa is a partner at accounting firm Marks Paneth.