Insights series / 19 November 2021
ESG applied to the real estate lending market
By Simon Todd, Director, Group Head of Real Estate Service
Real estate lenders have a key role to play in decarbonisation, social impact and good governance in the industry.
With investors, occupiers and regulators increasingly concerned about the environmental, societal and governance (ESG) implications of investment choices, real estate lenders have been adapting admirably. Applying ESG principles to portfolios can sometimes be difficult, but with the help of industry frameworks, managers have increasingly pinned this down.
Within real estate, it is the built environment that leads in the oncoming sea of change, and for good reason:
- Buildings are currently responsible for emitting large amounts of C02 each year, largely through energy use. In the USA, Europe and the United Kingdom, buildings are responsible for around 40% of all energy consumption and C02 emissions.
- Aside from having a physical impact on the environment, buildings also have a social impact, contributing to social well-being, providing access to basic amenities and essential services.
- In terms of governance, avoiding working with counterparties that are not presenting the correct ESG criteria and steering clear of practices that could lead to governance nightmares within their own organisations – such as greenwashing – are priorities.
Real estate lenders have a key role to play in ensuring the next generation of buildings not only decarbonise but provide a full suite of ESG related benefits, such as improved health, well-being, and safety. Buildings with good ESG credentials that incorporate such benefits will command enhanced resale value. Those buildings that do not, will be at a disadvantage in the market.
A word on greenwashing
Regulators have noted that “there is gold in being green” and that cutting green corners in pursuit of gold is a problem.
In Europe, the Sustainable Finance Disclosure Regulation (SFDR) came into force in March 2021 and is a measure entirely aimed at avoiding the greenwashing of financial products and advice. It obliges all financial participants based in or marketing in the EU to provide more sustainability related information and ensure investors have the disclosures they need to make investment choices in line with their sustainability goals.
In April 2021, the SEC issued an alert around greenwashing, reiterating those managers selling ESG to their investors needed to ensure that those investors are getting what they have been sold. It’s also worth noting that the following month, SEC chair Gary Gensler, confirmed that proposals for more environmental disclosure rules will be tabled by the end of the year.
New EU ESG Disclosure Rules – Key Dates for Asset Managers
|March 2021||The Sustainable Financial Disclosure Regulation (SFDR) came into force, requiring all market participants based in or raising capital from the EU, to define ESG policies and standardises their ESG disclosure obligations.|
|April 2021||The Corporate Sustainability Reporting Directive (CSRD) is proposed, aiming to bring - over time - sustainability reporting on a par with financial reporting. Companies will have to report on how sustainability issues affect their business and the impact of their activities on people and the environment.|
|July 2021||ESG Disclosure Rules apply to newly regulated ESG Funds.|
|Jan 2022||All asset managers must now make product-level ESG disclosures.|
|2022||Managers must disclose how they consider the sustainability of their investment decisions in line with the EU Taxonomy.|
How real estate debt managers are addressing ESG in their own businesses
First and foremost, lenders can lead by example within their own businesses. Examining their operational platform and supply chains and making more sustainable choices in those areas are key, but especially important is how and where they source their capital.
This is significant as there is a vast and expanding array of non-traditional lenders, who all must persuade their own investors that they have strong ESG credentials and abide by the UNPRI and other frameworks, to raise capital to make loans in the first place.
Real estate as an asset class has an especially hard time fulfilling the full range of ESG expectations as it is an investment class in its own right but also a critical part of social and business infrastructure, used by a vast array of parties, and always involves vast amounts of money and credit so it is directly and indirectly exposed to a greater range of risks than other pure investment groups (such as government bonds). Real estate is also, of itself, lightly regulated and has very few barriers to entry, anyone with cash can play – it is therefore disproportionately (by value as an investment product versus global equities for example) exposed to money laundering and other bad actors. On any extended test of ESG worthiness this is an unhelpful aspect to manage. Strong AML, KYC and governance is crucial.
Another historic challenge has been the lack of standardisation and multiple frameworks for ESG participants across asset classes.
Ensuring ESG methodology, policies and processes are embedded in every step of the value chain is key to standardisation of data. With the European disclosure and taxonomy directives, regulators are standardising the information managers and advisors should disclose.
While the industry gets more comfortable with standardisation, the more information around the ESG factors and methodologies applied will be a critical risk mitigant against any future claims of green washing.
Once the bar for ESG within an asset manager’s business has been raised, obtaining an ESG rating or score is also an option. Morningstar data suggests that asset managers with higher ESG ratings tend to deliver better returns to their investors. Given this, it is likely that such ratings will become a valuable way for investors to select managers and assess their ESG performance.
How real estate debt managers are addressing environmental impact in portfolios
When it comes to ESG within their portfolios, lenders can not only lead by example as we have seen but have at their disposal two major methods of incentivising borrowers to decarbonise buildings.
First, there’s the binary choice of whether to extend a loan to a borrower whose project is lacklustre on safeguarding the environment. This acts as both a major incentive for the borrower to reconsider their choices and as a matter of good governance for the lender, who would avoid potential reputational and other issues that may arise from being associated with that project.
Second, lenders can directly link long-term financial incentives to measurable improvements in the environmental performance of buildings that they lend against. In this way, borrowers reduce the cost of their finance when (for example) adhering to carbon reduction stipulations set by the lender.
In December 2020, Aviva became the latest in a series of lenders who have chosen this route, announcing US$1.4bn (£1bn) in loans for projects focusing on real estate carbon reduction. The capital will be deployed over the next four years, with the asset manager seeking out loan opportunities aligned with the United Nations’ Sustainable Development Goals (SDGs). Specific requirements for potential borrowers to adhere to will be set out, with the aim of reducing carbon emissions from their buildings.
Whilst Aviva is deploying capital using its own ESG framework, it has been tested against and is consistent with one of the popular industry frameworks available to real estate lenders.
The most popular of these frameworks were published by the various trade bodies for the syndicated loan markets in North America, EMEA and Asia-Pacific. The frameworks are the Green Loan Principles and Sustainability Linked Loan Principles. In a nutshell, they were created to promote the development and integrity of the respective loan products to facilitate and support environmentally sustainable economic activity and to promote transparency, disclosure, and reporting.
Managers seeking to use these frameworks will not only have to decide which framework is suitable, but how to go about the collection of new data sets and modify existing processes to facilitate.
Addressing societal impact in portfolios
In April 2021, the LMA published its Social Loan Principles (SLP), which works in conjunction with its other frameworks. The latest framework was published as a response to rapid growth in the lending space that has arisen because of the COVID-19 pandemic. The new principles aim to create a high-level framework of market standards and guidelines, providing a consistent methodology for use across the social loan market.
This framework has brought clarity to lenders and borrowers around what comprises societal impact and will encourage market participants to demonstrate the clear social benefits the funding relates to. Capital classified as having a societal impact includes projects providing affordable basic infrastructure (clean drinking water, transport, and energy) access to essential services (health and education) and affordable housing.
With the publication of these new guidelines, examples of real estate loans linked to social impact will no doubt increase. However, current examples do exist. One such example is found with UK-based social housing group Catalyst Housing, which secured its first loan linked to social performance in March 2020.
The US$70m (£50m) revolving credit facility was provided by Sumitomo Mitsui Banking Corporation (SMBC) and incorporates a margin reduction if Catalyst meet set targets to assist low-income customers, to maximise their income. Outcomes will be reported in Catalyst’s annual accounts, a move that promotes long-term thinking as it means the borrower is properly incentivised to ensure performance through the year.
The same reporting challenges exist in social loans as with the other frameworks. Once again, outsourced partners can help with the assessment, measuring and reporting around the data and helping to implement business processes that aid in its collection.
Addressing governance impact
It can be difficult to include governance into a loan agreement itself, in the same way we have seen it done for environmental and social factors, but it arguably doesn’t need to be.
Governance is fundamental to any aspect of sustainable environmental and social practice. It ensures the prospective borrower is presenting the right criteria in these areas before a loan is made. It ensures that they can deliver on any agreed “E” and “S” principles set out in a loan agreement on an ongoing basis.
It is also the mechanism which encourages the proper scrutiny of the borrower. Subject to scrutiny is any organisational or operational aspect of a borrower, their counterparties and supply chains. Risk to lenders can be considerable here – for example, the impact around improper materials used in a development or questions over entities in the borrower’s supply chain – are just some areas a sensible debt manager will want to ask about.
The answers provided to these questions could feed back into KPIs around sustainable practices in the other two areas of ESG, which are part of the loan agreement, or could prompt changes in procurement, or occupiers.
Asking these questions is also a check for the sake of the manager’s own reputation: not only do lenders want to control which borrowers they are associated with, but the answers borrowers provide to these questions determine whether managers themselves are complying with the ESG wishes of their own investors. In this way, ESG is a virtuous cycle.
ESG is only growing in momentum and commitment to it is not ideological, it is a fact of business. In the real estate sector, obsolescence is coming in the form of ESG obsolescence, and buildings without the right credentials will trail at a significant discount.
Similarly, managers that have sustainability at the heart of their lending frameworks will be more likely to thrive, whilst others will become obsolete or must play catch up. In the course of time, an enterprise value will consider more than just P&L on the balance sheet, it will also evaluate the qualitative factors contributing to business success. Factors like the quality of teams, strategy, management - and commitment to sustainability.
It may not be that long until there’s a multiple on it.