This article is sponsored by Schroders.
At the beginning of September 2021, London-headquartered asset manager Schroders launched its European debt platform. It features euro and sterling-denominated investment grade and senior loan strategies, and a high-yield euro strategy. After a successful capital-raising process, with some €450 million committed so far, the platform is now starting to deploy, and Schroders has committed to making ESG an essential element of that process.
“When you are starting off a new platform it is a great time to incorporate ESG. Trying to retrofit it would be far tougher,” says fund manager Kristina Foster.
She explains how the firm has integrated environmental and social considerations within its loan selection and monitoring processes, and the processes by which real estate lenders can promote positive change at both the borrower and asset level.
Why does it make sense for lenders to incorporate ESG considerations into their loans?
For a lender, one of the key risk considerations is refinance. A number of traditional risk factors are increasingly influenced by ESG, from changing governance requirements such as minimum energy performance ratings, to tenant occupational requirements; a building might have a net-zero carbon footprint, but may fail to provide the right facilities or engagement for tenants.
As such, ESG is becoming a tenant requirement that will drive value, and the refinancing risk for higher ESG-rated buildings will reduce as they will find it easier to attract tenants, generate higher rents, improving yields and liquidity, and enhancing returns. ESG has therefore become a key component of risk management, and it is important that you are able to capture ESG data, analyse it, compare it across the wider the loan book, and monitor on an ongoing basis.
Over the last 12 months there has also been a sharp shift from investors approaching ESG as a tick-box exercise, to the expectation that it will be integrated into loan underwriting and then monitored on an ongoing basis. Borrowers are still getting to grips with how ESG can be integrated into lending structures and loan monitoring, so we need to help them by providing a framework that is clearly measurable and reportable.
How did you tackle the integration of ESG within your lending platform?
An advantage of being part of Schroders is that sustainability is such a driving force across the whole business that there are already plenty of experts within the real estate group to provide us with support. We drew on the experience of the direct real estate team, marrying that up with regulation guidance and considering what is acceptable to borrowers. We also brought in a third-party specialist to help us shape the ESG framework which we use to analyse all of our potential loans.
In introducing an ESG framework, the intention is to reduce your investment universe for the right reasons, while making sure that you are moving in sync with the market. You need to harness the subjectivity and foresight of the people who are sustainability experts, and then combine that with input from product specialists to make sure the framework works in practice. It must be reportable and measurable, as well as being clear and understandable, not only for our team and the wider business, but also for borrowers.
We also needed a framework that was flexible enough to cover three different strategies, from investment grade through to high yield.
How can a real estate lender have an impact on ESG?
For the debt side it has taken longer to really embrace ESG than for direct real estate equity, mainly because the perception has been that you’ve needed equity control to make an impact. We view things differently, and promote ESG through the borrower by directing them through the terms of the loan, and those points of direction will get stronger as time goes on. Our strategies are aligned to Article 8 of the Sustainable Finance Disclosure Regulation (SFDR), which means that we promote social and environmental characteristics within all our loans.
Our ESG framework uses an impact measurement tool to gauge ESG performance at the borrower level as well as at the real estate level. The criteria on which we score borrowers relate to their sustainability policies, their engagement with their employees and their supply chains. We work with the borrower, talking to them about what they can do to improve the aspects of their business that we review and supporting them in developing their business from an ESG perspective.
On the property side we make an assessment of the building fabric, services and energy performance, but also think through features that can make the building more attractive from a tenants perspective, particularly to enhance the social characteristics. Often it is possible to educate borrowers about the things they can do and help them take what they are already doing to the next level. As more lenders integrate ESG into the underwriting and monitoring process, their influence on borrowers will grow. Of course, sophisticated institutional owners of direct real estate are often already doing more in ESG than we require.
Some smaller borrowers have a passion for it and have made great strides. Others are making small steps, but lack awareness of what can be achieved, in which case we can introduce them to specialists who can help them deliver the improvements needed to meet our threshold. We have an open book policy with potential borrowers when it comes to our ESG framework, and sharing our experiences with other borrowers has been helpful in driving forward the ESG agenda in the market.
Our ESG framework process involves rating each loan from zero to five. For standing investments the ESG score needs to meet a minimum threshold of three and above and for the senior loan and high-yield strategies, where we are providing development or transitional loans, the ESG score must meet the minimum threshold as the property improves over the term of the loan.
How is Schroders thinking about the social side of ESG when it comes to lending?
At the borrower level it is about their behaviours and how they interact with their employees and tenants. At the property level we look at factors like walkability, transport links, amenity space, engagement with tenants – whether that is through a website or a formal landlord-tenant feedback process – and on-site safety and security. Provision of each of those elements contributes to the overall ESG score. There is definitely more to be done on the social side, and this aspect is evolving. An interesting way to take the social impact further could be to look at how the borrower enacts an enhanced social policy within the building, for example by letting an area to a charity at a discounted rent.
How can lenders take ESG to the next level?
There is clearly investor appetite for impact funds with the objective to deliver ESG performance. Lenders can think about including key performance indicators in their loan terms which are linked to delivering an ESG measure; this could be things like improved energy performance, recycling, better tenant management – if those measures, which are agreed with the borrower, are delivered one of the metrics of the loan could change. The mechanism must be something that is palatable for borrowers, and also works for lenders and their end investors. This is where lenders have a greater opportunity to be part of the climate change movement which is a very exciting and positive move for the industry.