A focus on the S of ESG also makes financial sense for lenders

Just as property debt providers have made progress incorporating environmental targets into loan deals, socially focused measures can also be part of their financings.

As we contemplate a world beyond the pandemic, it is clear environmental, social and governance factors will be a major focus for real estate industry decision-makers.

In the cover story of our spring edition, to be serialised on recapitalnews.com from 3 March, we break ESG down into its component parts and examine how real estate debt providers are incorporating each into their activities.

They are making steady progress on loans that reward environmental performance. However, they are making less progress on incorporating social considerations into lending deals. Several sources argue that the G relates to ensuring delivery of the E and S, rather than baking good governance targets into the terms of financing agreements.

It is in the S where the industry will be playing catch-up over the coming years. Covid-19 has sparked debate about how economic activity can better serve society. In real estate, impact investment is gaining momentum and building owners are thinking more about how their space serves the needs of their end users.

Lenders can play a key role in supporting the industry’s drive to be a positive contributor to society. They have already demonstrated that it is possible to make environmental sustainability a meaningful concern when structuring a real estate loan. Several lenders have provided loans based on finance industry body the Loan Market Association’s frameworks set out in its Green Loan Principles and Sustainability Linked Loan Principles. An increasing number of loans in the European market feature mechanisms whereby the margin rises or falls within a range, depending on how the borrower measures up against a set of pre-agreed green key performance indicators.

Although there is plenty of scope for the real estate lending community to do more to promote environmental sustainability through its activities, some in the industry have demonstrated that debt facilities can be structured to reward or encourage green activities, and that those with capital to lend can exert an influence in this area.

The societal impact of a real estate asset is arguably more difficult to measure than its environmental impact. Yet as the S of ESG comes into the spotlight, lenders have a role to play in setting standards.

That might mean more lending in sectors with demonstrable social benefits, such as healthcare and affordable housing, or only financing schemes designed with local communities in mind. It might also mean going further and pegging loan pricing to borrowers’ social impact targets.

There have already been examples of such loans. For our cover story, we spoke to the UK-listed Catalyst Housing Association, which sourced a £50 million (€58 million) ‘socially linked’ loan from Japan’s Sumitomo Mitsui Banking Corporation in March 2020. As part of the loan structure, Catalyst receives a margin reduction if it meets set targets to assist its customers with maximising their income.

The challenge ahead is for lenders and borrowers to work out how best to measure the social impact of various types of underlying real estate, and incorporate targets associated with positive social impact into their loan agreements.

There is a financial imperative here. End users of property have a growing focus on the wellbeing of their employees, meaning they will favour properties designed to incorporate social factors. Institutional investors are also increasingly focused on deploying their capital sustainably. In a 2020 survey by Natixis Investment Managers, 70 percent of investors said they expect investing in line with ESG factors to become standard practice across the industry within the next five years.

A lender writing a five-year loan today should consider whether the underlying asset will be attractive to a buyer or a new lender from an ESG perspective by the end of the loan term. Just as lending against buildings with green credentials makes financial sense, so too does backing those assets that will meet society’s changing expectations of the real estate industry.