Catastrophic flooding in Europe, soaring temperatures around the world and widening disparities in wealth are intensifying the pressure on institutional investors to prioritise their capital allocations towards assets that offer the most far-reaching solutions to the two existential challenges of our age – climate change and social inequality.

The built environment, and overwhelmingly residential property, contributes 40 percent of global carbon emissions through heating/cooling and construction, and housing is the most basic manifestation of inequality in the grossly unequal access for many to affordable and decent homes. The real estate industry therefore clearly needs to be central to any solutions of sufficient scale and speed to address these twin global crises.

But European institutional investment models, focused on financial risk metrics of price volatility and diversification in the main fixed income and equities asset classes, have resulted in an average portfolio allocation to real estate of only around 10 percent. However, as the European Commission moves towards the concept of “dual materiality”, or ESG accounting, in pension fund financing, which proposes retirement schemes give equal consideration to climate and societal risks within their portfolios alongside traditional financial risks, a fundamental reassessment of real estate, and particularly residential property’s place in institutional holdings, could be under way.

Today we see some German institutional investors with a 35 percent allocation to real estate, but the market benchmark is more like 10 percent.

Institutional investors are re-evaluating their real estate exposure

“The EU’s emerging ESG institutional investing framework will accelerate trends that have been evolving over the past 20 years in real estate markets, with an increasing focus on energy efficiency, societal impact and the governance of entrusted capital in the investment process, as well as the management of properties over their lifecycle. Investors are demanding ESG solutions for both their existing and future investments,” Maximilian Brauers, head of sales for real estate key accounts in Union Investment’s institutional business, says.

“Low interest rates, post-Covid 19 recovery, the prospect of structurally higher inflation and outsized ESG impact constitute the perfect backdrop for real estate investments to shine in the years ahead. We expect institutional allocations to rise accordingly. Today we see some German institutional investors with a 35 percent allocation to real estate, but the market benchmark is more like 10 percent,” Brauers adds.

Dutch pension reform as the engine of a great capital rotation

The great laboratory test of whether investors will move from the financial model of asset allocation to a deeper concept of risk and returns targeting “breakthrough” climate and societal solutions may soon be bubbling in the EU’s largest institutional capital pool. The €1.7 trillion Dutch occupational pensions sector is set to transition from a DB regulatory system to collective DC schemes, where investment risks are borne by individual members, under radical reforms due to come into force in 2027. As a result, AXA IM estimates as much as €300 billion could flow out from ultra-low-yielding government bond holdings in Dutch institutional portfolios into mainly corporate bonds. But any new European pension financing framework for “moral money” would raise the intriguing prospect of whether a large proportion of this great capital rotation might also be directed towards real estate investments, helping to close the estimated supply shortfall of one million affordable homes in the Netherlands and to fund the sustainable refurbishment of existing stock.

No other European nation has such a deep-rooted understanding of the very real threat of climate change as the Dutch, with 40 percent of the population living on land below sea level. The dangers posed by rising floodwaters gave rise to the original “polder model” of social collaboration where communities came together to maintain the defensive dykes. A pension polder model to tackle climate change and social inequality, with the highest ESG dykes in residential investment, could also boost implementation of the EU’s Green Deal for a net carbon-neutral economy by 2050, led by the Dutch First Vice-President of the EC, Frans Timmermans.

By Steve Hays