The case for sustainable real estate credit

UBS Asset Management’s David Hirst (pictured), chairman of the sustainability workgroup within Real Estate & Private Markets, comments on sustainability in real estate debt.

The notion of sustainability in the context of real estate is not new, but it is only starting to permeate among debt providers.

With institutional investors asking how investments measure up across all asset classes and tenants expecting more from the buildings they occupy, a growing number of credit fund managers –particularly those with real estate roots – are taking into consideration sustainability practices around the assets they back. A trend not driven by regulation, the benefits of downside protection and potential value enhancement – besides upholding fiduciary responsibility – are nonetheless compelling reasons to conduct what is essentially advanced due diligence.

UBS Asset Management’s David Hirst, chairman of the sustainability workgroup within Real Estate & Private Markets, discusses how real estate debt fund managers can incorporate environmental, social and governance principles into their strategies just as those managers focused on making equity investments.

How ingrained is the topic of sustainability among real estate debt fund managers?

David Hirst: Sustainability as a topic was picked up by institutional investors of real estate equity early on, five to 10 years ago; now lenders are pushing in the same direction. We were one of the first to complete the GRESB Real Estate Debt Assessment, the global real estate debt sustainability benchmark; 10 funds responded when it launched in 2015. Last year appetite grew to 18. Our UK and US debt funds ranked top in the survey’s inaugural year, first and second in 2015 and first and third in 2016.

The experience we had in direct real estate informed what we’ve done on debt investing, which means debt funds like ours, bred out of a real estate group, have got a massive head start on understanding the topic.

I remember five years ago, sitting in a conference room of lenders that didn’t understand the topic at all. Their main criteria was: “What’s the value impact?” rather than the way we’ve come at it: there may be value impact, but the chief aim is to protect value. In the UK, for example, in April next year, an underlying asset with an ‘F’ or ‘G’ EPC (energy performance certificate) rating can’t be leased or sold until the building’s standard is improved.

How do real estate debt funds adhere to GRESB principals?

DH: GRESB measures funds’ overall sustainability programme across portfolios – 88 percent of UBS Asset Management’s AUM is submitted to GRESB – through a series of questions against which you’re scored.

Do you have an underwriting process and lending checklist? What sustainability features are on that checklist – things such as contamination, energy, water, waste, certifications? We want to know there has been adequate environmental cleanup in the event an asset is constructed on the site of a former factory, for example.

How do you look at business plans with an eye to improving value? A suggestion we might make is that environmental certifications are obtained on refurbishments. Do you have a committee or responsible people, or is your lending committee at least seeing the topic? Are you reporting back to investors?

If commitment to sustainability is not mandatory, why should debt fund managers comply?

DH: One factor is simply the downside perspective. There are regulatory obligations surrounding the underlying asset and occupier risks associated with poorly performing buildings. As a lender you’re taking security on a property so you need to know the security is worth what you think it is. If it’s a poorly rated building you have to factor in some capex or risk it becoming obsolete.

A few years ago, lenders hadn’t understood that. Now people are more cautious in their underwriting and there is lots of competition to lend against buildings that are fully leased to good covenants. Where traditional lenders have stepped back is from more interesting deals where you have to make an effort to understand the property.

In an up market, there is potential to improve a building’s desirability and market rent, as well as reducing occupancy costs through features such as voltage optimisation and LED lighting.

Whole loan lenders like UBS think of it as more of a partnership therefore may share in any capital appreciation. Real estate debt fund managers also have a fiduciary responsibility to their investors to be doing the right thing. The work we do doesn’t cost our investors any more; it pays for itself. It’s really a case of enhanced due diligence.

How can debt fund managers incorporate sustainable principles into their strategies?

DH: The first step is to understand the topic, potentially engaging a third-party specialist to support your work. Then it’s a matter of creating a policy on sustainability, perhaps setting up a working group and putting it into your underwriting processes – you may want to include loan covenants that dictate EPC ratings are at set levels, for example.

To an extent, certain features of sustainability, like the presence of asbestos, are already taken into account as part of environmental surveys that are carried out upon purchase of a property. There are other things managers can do to be proactive and think about things in a bigger way, however, from bike racks and car charging points to waste management and air quality.

We don’t have set criteria, but work with borrowers to understand what improvements can be made on the sustainability front, encouraging them to carry out initiatives by granting a ‘green discount’ of 15 basis points.

Are there any limiting factors?

DH: There is a sliding scale of possible intervention. If you’re talking about a standing investment, with one tenant occupying the whole building, there’s nothing you can do to improve sustainability on site without the tenant’s agreement. When developing from scratch, a lender can insist on a certain standard as part of the loan agreement.

The targets we’ve set are focused on what we can impact and where it makes financial sense. There’s a balance to be struck; we’re not going to insist on BREEAM certifications for the sake of it; only if it saves costs.

How do you see the trend unfolding?

DH: If you’re a fund with an institutional investor base like we are, no matter what the asset class, you’re starting to get questions about how you do it sustainably. We’re building a culture of sustainability around all second line investments, including infrastructure debt.

UBS Asset Management is taking it seriously across the piece, creating a chain effect by asking our suppliers and advisors to comply, also. Specifically with regard to debt we’re ahead of the market, but other people are now talking about it which is encouraging.

Lending to smaller borrowers that aren’t necessarily thinking about sustainability means debt fund managers have the potential to make a real impact. Debt funds are only a small proportion of the overall lending market though; the banks have the potential to make a massive difference, likely over the next five years.

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