This article is sponsored by BNP Paribas Asset Management.
Europe’s real estate debt fund managers are under increasing scrutiny when it comes to environmental, social and governance performance. Regulation, including the European Union’s Sustainable Finance Disclosure Regulation and the EU Taxonomy, requires them to be clear about how sustainable their investments are. Meanwhile, investors, with their own green objectives, are demanding managers deploy their capital appropriately.
But returns targets and sustainability goals can coexist in real estate debt strategies, argue two professionals with differing responsibilities at BNP Paribas Asset Management: Christophe Montcerisier, head of real estate debt, and Nicolas Toupin, ESG analyst specialising in real estate and private assets within the firm’s Sustainability Centre.
In the current environment, why does it make sense for debt fund managers to consider ESG?
Christophe Montcerisier: Economic volatility creates real estate market dislocation, but also opportunities. There is a price resetting going on, and a growing divergence between quality assets and the rest. Buyers can acquire quality property at replacement cost.
However, they need to remain cognisant of ESG risks as it may affect the future value of the underlying property. The same applies to lenders, as there is a strong alignment of interests between lending strategies and ESG. We are focused on preserving capital and seeking stable income, so that means financing high-quality assets which carry lower ESG risk.
We strongly believe that by investing in environmentally friendly properties, sponsors maximise the potential for value creation. As a lender, financing such properties means there is less refinancing risk at maturity.
How is sustainability regulation impacting debt fund managers?
The European Union’s SFDR [which came into effect in 2021] is geared towards improving transparency for financial and investment market participants. It applies at both the management company level and at the financial product level. So it has strongly impacted the way we work towards sustainability, including in our real estate debt business.
It means we need to disclose more information to our investors. We need to demonstrate how this is accounted for in our investment process. I would say SFDR was welcomed by financial markets, as it helps investors understand the difference between funds which are classified as, say, Article 6, 8, or 9 under SFDR, and the extent to which they integrate ESG.
What role does the EU Taxonomy play?
NT: It is a framework that classifies environmentally sustainable economic activities. It was also welcomed by the market. The fact is, in Europe, the real estate sector is not on track to meet climate objectives, which will require it to reduce carbon emissions by 60 percent by 2050. The industry will need to double the annual renovation rate of existing buildings in the coming 10 years if it is to improve energy efficiency to meet EU climate ambitions.
The EU Taxonomy brings clarity and transparency to issues such as energy performance, so the hope is it will help to drive capital allocations where they are needed – including to energy-focused renovation projects.
It also reinforces the credibility of Energy Performance Certificates as the standard for energy efficiency in real estate markets. This is an important point. Building owners, lenders, and investors now know that being aligned with the EU Taxonomy requires complying with the highest energy performance standards, certified with EPCs.
What are the challenges of complying?
NT: There are complexities to the regulation. For example, it can be difficult to know how to align with the ‘do no significant harm’ principle of the EU Taxonomy, which means that for an activity to qualify as sustainable it must not negatively impact any of the Taxonomy’s six stated objectives.
Also, while the taxonomy has made the EPC the standard for the market, the EPC itself and the calculation methodology are not uniform across European countries. So we are hoping for more clarity on that from the revised version of the Energy Performance Building Directive, which is due later this year.
Is data collection a challenge?
NT: It is not always easy for lenders to gain access to information from sponsors. But it is easier today to get hold of information on buildings than in recent years. We always engage the sponsor in the conversation about data for any investment we are making.
However, it is fair to say data collection remains one of the most significant challenges we face.
How does all this influence how you operate as a debt fund manager?
CM: Unlike equity investors, which can directly influence the buildings they own, lenders are not in the driving seat. So you need to be active on ESG and ensure the property you finance is consistent with the strategy you have defined from a sustainability standpoint.
For our lending strategy, we start with a broad view on the type of assets we will target, in which sectors, and in which countries. Then, we look at specific transactions and apply a disciplined selection process. As a significant alternative lender, we see a lot of transactions in the market as banks seek to distribute their loans.
First, we analyse the risk and return profile of the deal to ensure it fits our strategy. We favour transitional assets with a capital expenditure plan which will improve performance over time. We also look for portfolios, to provide granularity to our investors.
Next, we examine ESG performance. This is where Nicolas works closely with us, in advance of taking the deal to investment committee. Once we have decided to pursue a transaction, the ESG team will undertake much of the analysis.
How much influence does the ESG team have on a deal?
CM: Our Sustainability Centre, of which Nicolas is a member, has a right of veto. At the end of the process, we receive a rating for the deal from the team. If it produces a rating for the transaction that does not fit the company’s ESG policy, we cannot make the investment.
As a recent example, we were financing a logistics portfolio in Italy, but one of the assets was to be built on an ecological corridor, so that was not possible. However, we were able to remove that asset from the portfolio and were able to finalise the financing.
How does the ESG team analyse potential transactions?
NT: The Sustainability Centre provides investment teams with research, analysis, and data at company and sectoral levels. It supports teams’ efforts to integrate sustainability-related risks and opportunities into investment strategies.
Overall, the real estate-focused ESG team members work with the investment teams to educate them on the most relevant issues to look for. For instance, on logistics, we help them engage with sponsors on issues such as additional road traffic, noise pollution and construction concerns.
For specific loan deals, we conduct a preliminary ESG assessment, where we analyse the building’s characteristics and the sponsor’s ESG policies. We then do in-depth analysis of the asset to examine energy consumption and any sensitivities to the surrounding area. We also obtain an external assessment from a consultancy, which is responsible for calculating key performance indicators by which we continuously monitor the ESG performance.
How important is a third-party opinion?
NT: It is interesting to discuss transactions with other experts in the industry. We will talk about the available documentation and discuss policies to consider when looking at the energy performance of individual buildings. It is an additional strength to have a third-party opinion. This reassures clients that KPIs are calculated by external parties.
Are ESG requirements for managers becoming more clearly defined?
CM: Each year there is more clarity. The regulators see what is happening in the markets and aim to provide clarification for market players. It will take time, but we have the tools available to the market. We need to ensure ESG databases grow, and market participants are crunching the numbers, to allow market participants to make accurate comparisons about ESG performance between assets.
NT: There are still situations where it is difficult to find the correct documentation for buildings, and there are some inconsistencies like the differing energy performance standards between countries. But the situation is evolving over time. There is more information to hand for managers today, and regulators are focused on ensuring this continues to improve.
Do you expect ESG analysis to become more standardised in the debt space?
CM: We hope so. For example, as part of our KPIs, we set quantitative goals for sponsors to meet a certain threshold on NEC [net environmental contributions] performance. NEC indicators are open source, so it would be great to see them become standard at the market level, because it would enable investors to better compare managers’ products.
We could not imagine doing business without the ESG analysis we undertake. My hope is that sustainability analysis and KPIs become more broadly used across the lending market.
How can managers avoid being accused of greenwashing?
CM: Regulation dictates the rules, but the rules are not very precise in some areas. So the market reacts to them and interprets them. We have always taken the view that we should stay on the safe side and, for instance, not claim a fund complies with Article 9 until we are 120 percent sure. We take the view that we should not overstate our performance, but always be working on improving it.
NT: Classifying funds as Article 6, 8 and 9 was a good move by the EU, and we have seen funds overstate their ESG process and have funds subsequently declassified. We have taken a careful approach because we see that as a risk.