Motivated by their investors, their borrowers and the need to ensure that loan collateral meets market standards, alternative lenders are pushing more into environmental, social and governance-focused real estate lending in Europe.
In the last 12 months, alternative lenders have been increasingly active in green and sustainable lending, says Craig Wilson, a London-based partner on consultant Knight Frank’s capital advisory team. “It certainly seems to be at the forefront of their minds when they make decisions as to which deals to take forward,” he says. “All the debt funds are really busy at the moment, and if they have 10 deals on their desk and two or three of them are ones that really tick the boxes in terms of ESG credentials, then they typically will go to the top of the pile.”
By now, borrowers are well aware of the need to emphasise any ESG bona fides that they can. Lenders ask them first about ESG, then about other details of the deal, says Wilson. “That ESG credentials slide is no longer towards the back [of the pitch deck],” he says. “It’s probably page two or three.”
Banks with public ownership generally have a different motivation for impact investing than debt funds: corporate social responsibility, says Andrew Antoniades, who runs the lending platform within the capital advisory group at consultant CBRE, which involves managing several impact funds in the UK. “[Banks] feel the need to be doing something ethically aside from return,” he says.
Meanwhile, alternative lenders really do not have a choice.
“They have to. Investors are demanding this; that’s the number one driver for why the alternative lenders are getting in there,” Antoniades says. “I do not think you can effectively raise capital now unless you can offer ESG – to show a track record, to show you believe in it, to show you understand it.”
Alternative lenders might also differentiate themselves from bank lenders by having more direct experience investing in the types of real estate projects they finance, says Kristina Arsenievich, who leads ESG strategy for real estate at Barings Real Estate. “It is the ability to offer practical insights on ESG integration, which stems from being closer to this asset class, and to be more engaging and supportive that makes a difference.”
Motivated by investors
Not all alternative lenders are seeking deals with ESG factors, but those that source capital from investors with net-zero carbon targets are particularly motivated, Wilson notes. A pension fund, for example, may have a net-zero target and require that any new deals help move it towards that target. BT Pension Scheme, the largest private pension in the UK, has set a 2035 goal of having net-zero greenhouse gas emissions for its investment portfolio. A group of 71 institutional investors – the UN-convened Net-Zero Asset Owner Alliance, which includes BT Pension Scheme and the California Public Employees’ Retirement System – has pledged to reach net-zero targets for portfolios by 2050.
Part of the reason for the recent surge in sustainable non-bank financing deals is a rebound following the pandemic downturn. Moreover, the market is starting to understand the economic value of ESG credentials: a premium on the price paid for ESG real estate relative to real estate without the credentials, which may become obsolescent, Wilson says.
“[Investors] are preserving value and sometimes enhancing value rather than losing it”
“Obviously, that is a key factor,” he says. “Not only can investors start accessing potentially cheaper finance because it has the right ESG credentials, but also they are preserving value and sometimes enhancing value rather than losing it.”
This applies not only to new buildings, but also to retrofits where owners are significantly modernising their properties to create sustainability, Wilson says. In the UK, Energy Performance Certificates assign an A-to-G rating – A is best – to any property before it is built, rented or sold. The government will penalise commercial buildings with ratings lower than C, so owners are scrambling to make upgrades to their properties as needed.
While for now there is a benefit – for instance, margin discounts for meeting predefined key performance indicators on sustainability-linked loans – in the future that will flip, and for most loans there will be a penalty for not meeting those KPIs, Wilson says.
“The availability of debt for those assets will start to dry up for the applicants that do not meet them,” he points out. Lenders would not want “to fund or provide finance for an asset which may be losing value over the next three to five years”.
Just as purchasers worry about stranded assets, alternative lenders can worry about stranded debt, for example for a loan on a building without the right ESG pathway, Antoniades says.
“Who is going to refinance the asset if it is not energy efficient, or that is not contributing to the local economy?” Antoniades says. “You have to think about this as an alternative lender because a good loan today may have challenges later on.”
Concerns about stranded debt due to ESG factors could significantly change the underwrite of an asset for alternative lenders, beyond the usual factors like the tenant makeup, loan-to-value ratios, and the location of the property, Antoniades says.
Borrower demand is also pushing alternative lenders to adopt ESG strategies. “I personally have seen a massive change in the last 12 months where borrowers are saying, ‘No, give me a green loan; put strings attached to it. I want my feet held to the fire to perform to the green credentials, to the sustainability credentials’,” Antoniades says. That is because the borrowers are backed by investors that have their own ESG agendas: winning an ESG-linked loan can help a borrower earn ESG cachet with investors.
Carrot and stick
One area where alternative lenders may try to distinguish themselves from the banks and each other is in incentivisation structures for their borrowers – a carrot-and-stick approach, Antoniades says. Banks tend to offer token incentives, he says.
Lenders will probably explore whether offering five- or 10-basis-point savings as incentives will be worthwhile, he says, but probably not the punishment alternative. In the early days, ESG lenders generally offered slight rewards – a lower interest rate – on their real estate loans. According to Loan Market Association guidance, lenders should offer both a reward for borrowers that meet their ESG targets and a penalty of the same amount for the borrows that do not, Arsenievich reports.
“[ESG claims are] going to get tougher to demonstrate and to justify, in particular as alignment with EU Taxonomy regulation progresses”
Barings Real Estate
“LMA’s view is that it needs to go both ways,” she says. “The incentive that you are offering needs to be backed up by recognising that not meeting a target constitutes a ‘sustainability’ breach. So it is an attempt to keep borrowers in check and to make sure targets are taken seriously.”
Borrowers, of course, push back on the penalty concept, and there is flexibility for negotiation. The margin difference is not large enough to penalise a borrower significantly, Arsenievich notes.
ESG lending in Europe has the potential to help make the continent’s real estate stock greener. This is true for new development and retrofits, which are almost always motivated by the need to boost energy efficiency, Wilson says.
For both the alternative lenders and bank lenders to European real estate, the main focus has been on the environmental aspect of ESG, but recently more lenders have started to move into the social aspect, Wilson observes. For example, Knight Frank recently worked on a purpose-built student accommodation development facility where initiatives to promote positive mental health and well-being for students featured among the green loan’s KPIs.
“That is something you would not have seen on loans three or four years ago,” he says. “It is moving on from being just the environmental piece. We are starting to see more and more of the ‘S’ and the ‘G’.”
That said, the ‘E’ will always be the dominant piece of ESG, Wilson says. He personally has not seen a ‘G’ KPI, which probably would be tied to diversity of backgrounds represented on the boards of directors of the companies that are borrowing.
ESG-specific real estate debt funds and non-bank lending strategies will eventually become mainstream, Wilson says. ESG loans will become dominant versus non-ESG loans, similar to how electric cars will eventually take over as gasoline-powered cars are phased out, he suggests. “Once it becomes fully mainstream, it will be more about talking about exceptions rather than those that do meet ESG criteria.”
It is too early to say how the competition between alternative lenders and banks will play out in this space, Wilson says. “Most clearing banks have got quite strong offerings in the ESG space and debt funds – some of them are only just really rolling out those types of products now and they have a little bit of catching up to do.”
The volume of loans classified as sustainable for European real estate is growing, but the ESG benefits claimed for certain properties have probably been overstated.
More stringent regulations, such as the European Commission’s Sustainable Finance Disclosure Regulation, could slow the momentum in sustainable funding and development, because those regulations will force ESG disclosures to become more transparent, Kristina Arsenievich of Barings Real Estate says. The growth will not come to a halt, but ESG claims are “going to get tougher to demonstrate and to justify, in particular as alignment with EU Taxonomy regulation progresses”, she says.
At the same time, the more stringent reporting on ESG has done a better job of showing the value of social impact lending over the last few years, which should help boost that aspect of ESG lending, Arsenievich adds. “Increasing the scope of ESG reporting has two key benefits: it highlights opportunities for improvement and allows us to take account of broader impacts, including social value. And it is the impact part of the risk-return-impact equation that will continue to drive the momentum and to demonstrate that sustainability-linked lending is worthwhile.”
ESG reporting requirements will also give lenders and investors a better read on return on investment. Reporting and verification of ESG performance will provide better feedback on what works at generating ESG impact and what does not, and those results will help fine-tune subsequent lending and investment, Arsenievich says.