Property debt market participants acknowledge the importance of environmental, social and governance risk to real estate investment. Managing the pace of change is nonetheless turning into one of their biggest challenges.
Far from obscuring real estate’s sustainability objectives, the economic and health consequences of covid have provided renewed impetus, not least around the rapidly evolving frameworks for ESG-linked finance. It falls to debt advisers to help clients navigate a complex set of principles for green and sustainability-linked loans, which loan industry body the Loan Market Association has established in phases since 2018.
But if market participants are to ‘future proof’ their businesses, Steve Williamson, chairman of CBRE’s debt and structured finance business, says they must heed the new Sustainable Finance Disclosure Regulation. SFDR, part of wider EU taxonomy reforms, puts in place rules for financial market participants and financial advisers on transparency about sustainability risks and the provision of sustainability-related information in financial products. The taxonomy’s scope is expected to expand to include social objectives when it becomes fully effective in December.
As co-author of a CBRE discussion paper, Sustainability & ESG – why it matters to the real estate finance market, Williamson highlights plans by the UK for a similar green taxonomy. Though there are no details yet, he says the information so far from the Bank of England suggests the UK might well go “further and faster than what is currently set out in EU taxonomy”.
Chris Holmes, partner in consultancy Deloitte’s UK-based debt and capital advisory business, points out that “the more proactive lenders” are creating their own sustainable lending frameworks, often with an incentive pricing structure for prospective borrowers. He says pricing incentives on senior debt include reductions of 5-20 basis points on the baseline loan margin if the borrower is deemed to be meeting all the lender’s ESG criteria and key performance indicators.
“Our job is to help navigate the drivers and incentives available from the lending community, and find out whether they are going to fit with the borrower’s requirements and what the borrower is trying to do,” says Holmes.
“I don’t see a world where ESG or green lending disappears – or the incentives. You have to keep that sort of incentive mechanism because otherwise the onerous level of conditions or criteria on their own may not necessarily keep borrowers on the right track here”
“My sense is that this is really driven by the top institutional groups, both from the investor side and from the lender side. And the mid-market will probably move more slowly towards this area because they perhaps do not have the same profile or drivers from their stakeholders. I don’t see a world where ESG or green lending disappears – or the incentives. You have to keep that sort of incentive mechanism because otherwise the onerous level of conditions or criteria on their own may not necessarily keep borrowers on the right track here.”
Michael Kavanau, JLL’s head of debt and structured finance for EMEA, has a different take on the outlook for incentives. “We are going to continue to talk about how important ESG is,” he says. “But that is what I call the price of admission – that all deals are going to have to have some ESG KPIs. To get a well-priced loan on a good asset from a good lender, you are going to need to tick those boxes, and there will not be a significant pricing benefit.”
Kavanau expects ESG-linked finance to become the norm in the next 12-24 months, “given how exponentially fast we have moved from three years ago, when we hardly talked about it, to now when we talk about it in every discussion. There are certainly places that have got to the goal line a little bit faster than others. But it’s equally discussed and of equal interest pan-Europe”.
A survey of EMEA investors published in JLL’s report Responsible Real Estate – Decarbonizing the Built Environment found that 23 percent had already made a commitment to follow SFDR and 40 percent expect to do so in the coming year. “The way that SFDR works is that there are disclosures that one has to make when raising money, whether it is debt or equity,” says Kavanau. “Both sides, in order to continue to raise capital, are sensitive to it. Both sides need to have a strategy. And those strategies are converging.”
Yet 22 percent of respondents admitted they had no plan to comply with SFDR, and 5 percent did not know what they would do. Such ESG hesitancy betrays a blind spot among a significant minority of institutional players, and possibly signals the emergence of a two-tier financing market.
Two types of deal
“There will be assets that might not hit certain KPIs, and for a while there will be liquidity in that market,” says Kavanau. “It will just be higher priced. The world just starts to fall into two buckets: the ESG-sensitive deals that get better execution and the non-ESG deals that get less good execution. Much of the real estate market falls into the ‘long tail’ category of small/medium-sized participants, and their engagement is likely to lag major institutional movement.”
The financing conundrum reflects how ESG is underpinning the broader repurposing of property – partly to allay fears over asset obsolescence but also as a means of aligning investors’ and occupiers’ interests.
As Williamson suggests, there may soon come a point when it is harder to raise finance on secondary buildings that fail to meet green or sustainability criteria: “There are going to be yield and value differentials when you compare buildings that are ESG-compliant versus buildings that do not address ESG criteria. I think as more banks develop their green lending programmes, many will be less willing in the coming years to lend on buildings not meeting their ESG/sustainability criteria.
“Potentially non-compliant properties will be harder to finance and will be less attractive to tenants, which will impact values. The good news here is that I think ultimately it will result in the acceleration in the redevelopment or the retrofitting of those properties.”
“Time needs to be dedicated to getting it right,” says Deloitte’s Holmes of the ESG agenda. “Has it made our life more difficult? No, it has made it more interesting, and I think it has given better optionality for the borrower community. Those that are driven by ESG will want to get it right, will want to be best in class or be top of their [real estate index provider] MSCI sector, and they want to optimise their chance of the best possible exit. They will do anything they can anyway to make their building sustainable.”