Special Feature: Saving the planet, one default at a time

CRE sustainability initiatives can protect lenders against risk while helping to reduce the environmental impacts of commercial buildings. Al Barbarino reports

Programs like ENERGY STAR and LEED, guidelines from the Global Reporting Initiative, and organisations like GRESB (Global Real Estate Debt Assessment) have led the way in encouraging Environmental, Social and Governance (ESG) practices.

Real estate owners, tenants and investors have come to realise that the benefits serve a purpose beyond ‘saving the planet.’ As highlighted in GRESB’s latest Debt Survey, debt funds are also more active than ever in following ESG principles.

Dan Winters from GRESB
Dan Winters from GRESB

“Lending to borrowers that positively engage ESG principles can go a long way in helping lenders to protect against risk,” says Dan Winters, head of North America with GRESB.

“High performance buildings have attributes that go beyond basic code compliance on energy, water and waste efficiencies at the asset level, while also signaling a higher degree of owner sophistication,” he says. “Financing these types of properties can help lenders protect against loan defaults and collateral degradation, leading to a better portfolio risk profile over time.”

For GRESB’s 2015 Debt Assessment, its first focused solely on debt fund managers, the organisation was able to engage just 10 debt funds, reflecting what at the time represented just 7 percent of the real estate debt fund universe.

“Sustainability risk assessment and management is not yet standard practice in real estate lending,” the report stated.

But the release of the 2016 results last month showed that 18 debt funds participated, and according to the organisation’s ranking system the average GRESB Debt Score increased by 6 percent to 48.

Key findings, per GRESB’s report on the survey, included: (a) Participants demonstrate strong year-on-year improvement by incorporating ESG policies into ongoing operations; (b) More lenders are implementing ongoing monitoring of annual energy, water and waste metrics within the loan portfolio; (c) Leading participants demonstrate deeper ESG integration via senior leadership accountability coupled with targeted lending programmes [energy efficiency, etc.]

Yet results were mixed, with leaders reporting “systematic underwriting, lending and monitoring programmes in various stages of maturity,” but with “quite some lenders still display[ing] ad hoc ESG-based risk management with minimal infrastructure required for effective portfolio monitoring.”

The research

If debt funds and other lenders need convincing, they can look to their counterparts on the equity side – and some shining stars in CRE lending – to see that following ESG makes good financial sense.

A 2015 University of Cambridge analysis of GRESB data showed that “investing comprehensively in sustainability as measured by the GRESB rating pays off for REITs by enhancing operational performance and lowering risk exposure and volatility.”

While strides had been made in terms of asset level certifications at the individual building level, the study’s authors noted “an increasing awareness that crucial decisions about the ownership and operation of buildings are frequently made at a higher level, for example in the context of managing a real estate investment portfolio.”

“The corollary of this realisation is that an effective strategy of reducing emissions in the building sector needs to simultaneously target the individual building as well as the portfolio, investment fund or company level,” they wrote. “The results of this global study suggest that investing in sustainability pays off for REITs both in terms of enhancing operational performance and lowering risk exposure and volatility.”

In the debt sphere, the advantages for borrowers are relatively clear cut in that certain lenders are able to provide cheaper debt financing to borrowers who, in the long-term, should be able to benefit from cost-savings tied to building efficiencies. Fannie Mae for instance offers slightly discounted loans for multifamily properties seeking to make energy- and water-saving property improvements.

For lenders, the clearest advantages boil down to risk prevention. A study conducted by Xudong An of San Diego State University and Gary Pivo from the University of Arizona examined 22,813 loans from a large CMBS pool and found that ENERGY STAR and LEED assets had 20 and 30 percent lower likelihoods of default, respectively.

Two types of sustainability features were considered: “smart growth locations” that are walkable, transit-oriented, near green infrastructure, or avoid traffic-related air pollution; and “green buildings,” including LEED and Energy Star properties.

“We have demonstrated that certain sustainability features including building energy efficiency, walkability, and proximity to fixed rail transit significantly reduce default risk in CMBS loans,” the authors found. “Our explanation for these results is that certain sustainability features can affect mortgage default risk through their impact on income and value and that those benefits may not be fully reflected in the conventional variables used in default risk models.”

Organisations paving the way for other lenders, which GRESB has highlighted in its reports, include UBS Asset Management, whose Global Real Estate business shoots for a 20 percent reduction of greenhouse gas emissions and a 10 percent reduction of energy consumption at the portfolio level, every five years, on a rolling basis, for both its debt and equity funds.

Colony Capital noted in a statement that it “utilizes a comprehensive borrower ESG risk assessment that informs and monitors adherence to our sustainability standards for property improvements for loans exceeding $10 million.

“Colony uses these tools to ensure borrower adherence, evaluate impacts on our loan portfolio and identify management opportunities for future process adjustments.”

And ABN Amro became the first commercial bank in the Netherlands to issue a euro green bond last year, with proceeds tied to mortgages of highly-efficient homes, solar panel loans, and CRE loans for the construction of energy efficient buildings. GRESB members, which account for 90 percent of REITs issuing a green bond, have now issued $7.2 billion worth of such bonds.

A new capital market product, social bonds, emerged this year, with several major issues, including a €1 billion offering from BNG Bank, a AAA-rated Dutch financial institution that will fund affordable housing projects.

Impact

According to the U.S. Department of Energy, commercial buildings account for 18.7 percent of energy usage, 40 percent of carbon dioxide (CO2) emissions, and 88 percent of potable water consumption in the US.

“Considering that utility costs (as they relate to energy, water, and waste) impact CRE company profits, it makes business sense to adopt green buildings, which are estimated to consume 29 to 50 percent less energy than ‘non-green,’” according to a 2014 report from Deloitte, which urged more firms to incorporate ESG practices.

“There is increasingly clear evidence that buildings (re)designed with green features will depreciate less quickly than others and will be more likely to meet the growing demand of a more discerning occupier and investor market.”

Lenders considering implementing ESG policies may stand to protect against financial risk while reducing the environmental footprint of commercial buildings.

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