Owners of Europe’s commercial real estate stock face two key questions in the near-term: first, are their assets correctly positioned to cater for changing occupier needs in their given sector and location? Second, are they of the quality to meet ever-more stringent investor and tenant expectations around environmental and social sustainability?
For many, the answer to both questions will be no. It means there is a huge need in the coming years for renovation and capital expenditure across European markets. For lenders, this represents an opportunity to deploy capital against assets that are more likely to attract new financing, or an eager buyer, at the end of their loan terms.
In an April research paper, CBRE Investment Management attempted to put numbers on the scale of the opportunity for lenders. The manager’s research team estimated that should, either legally or through occupier choice, an Energy Performance Certificate B standard become a minimum requirement by 2030, as much as 75 percent of Europe’s standing stock could require refurbishment to meet the standard. CBREIM went on to estimate that between €720 billion and €900 billion of debt is held against these assets.
Its calculations led it to the estimate that, when that debt is refinanced, between €252 billion and €315 billion of debt will need to be ringfenced purely for capital expenditure.
Not all lenders’ funding models or capital costs make value-add lending appropriate for them. However, there is a growing cohort of debt providers keen to take the risk of backing sponsors that have plans for significant capex or refurbishment in a bid to grow the value of their properties.
For those lenders, financing revamp projects makes sense. In a market in which prime yields in core asset classes are tight, an element of value-add risk can enable them to seek higher returns, while writing loans against collateral that will improve in quality during the loan term.
In an inflationary environment, there is greater risk around financing any business plan in which construction and material costs are baked into the budget. However, in many cases, the risk to the lender of being exposed to rising costs will be offset by the benefit they gain through the sponsor improving their loan security. Indeed, as inflation drives investors and lenders towards quality assets that are likely to sustain rental growth, properties in line for refurbishments are likely to become more attractive.
The sustainability argument for backing significant capex and refurbishment projects is also compelling. There is a growing awareness within the real estate industry that demolishing old buildings and replacing them with shiny, energy-efficient assets is not always the best route to net-zero carbon. Embodied carbon, the CO2 emitted during the production of materials, can be high in ground-up development projects.
In a paper published last October, industry body the British Property Federation cited the Royal Institute of Chartered Surveyors’ estimate that 35 percent of the typical lifecycle carbon of an office development, and 51 percent for a residential building, is emitted before the building is opened. The BPF concluded there will always be good reasons for demolishing older buildings, perhaps with deep rooted structural problems, but consideration must be given to the environmental effects of new builds.
Borrowers are increasingly willing to sign up to loan agreements in which sustainability improvements are measured during the life of the loan, with margins falling, or rising, depending on their performance. As sponsors’ focus on improving the quality of the stock they already own increases, lenders have an opportunity to contribute to the environmental upgrade of Europe’s real estate – as well as its appeal to modern occupiers – by financing them.
Daniel Cunningham is editor of Real Estate Capital Europe