This article is sponsored by Schroders Capital.
Delivering on challenging sustainability objectives is already business-as-usual for many major real estate investors. But while equity managers have led the way in developing sustainabilty and impact-focused strategies, credit providers are playing catch-up. Loans designed to deliver on such goals are not yet a standard feature of the mid-market.
There is a huge opportunity here as demand from institutional investors for products with sustainable and impact attributes continues to grow, predicts Kristina Foster, fund manager, real estate debt, at Schroders Capital.
Where do you see demand for credit in the mid-market?
We define the mid-market as loans of £15 million to £100 million (€17 million to €116 million). Demand for real estate credit in that space is strong across all borrower types, assets and geographies. That’s unsurprising given that lending volumes in Q1 2023 were 30 percent less than Q1 2022, which was already below the pre-pandemic peak. Around 40 percent of the current finance market is accounted for by banks, compared with 58 percent previously. The decline in lending appetite from the banks, who were once dominant lenders in this space, makes financing even more challenging for borrowers.
In addition, the amount of credit provided by alternative lenders has halved, given the difficulty in getting higher-yielding deals over the line in a market where rates have increased sharply and values are falling, which has put the serviceability of loan covenants under pressure.
With fewer acquisitions taking place, a much higher proportion of demand for loans within the mid-market segment is being generated by owners seeking to refinance.
How would you describe the progress towards sustainability across the mid-market real estate sector in Europe?
An element of sustainability has become embedded as business-as-usual. Most real estate investors have focused on energy performance certificates (EPCs), which work as a starting point and are a standard that everyone recognises, albeit there are significant differences in how energy performance is rated across geographies.
In my view, the rise in focus on sustainability and impact in the mid-market has been driven by increased regulation and larger real estate investors becoming active in the mid-market space.
The obvious key sectors these investors have focused on have been logistics and BTR residential, but many are also investing in alternative sectors related to ‘living’ themes, such as affordable and social housing. Those assets tend to have smaller lot sizes but can be acquired as part of a larger portfolio strategy.
These are long-hold strategies and so mid-market owners are thinking about S&I factors in order to ensure their assets remain attractive to the market and larger, active players.
Is the concept of impact investing being adopted in the real estate industry?
Impact investing is an ever-growing part of investors’ portfolios in much of the world, but certainly in Europe and the UK. Within real estate it is a newer but growing theme, and we have seen products launched with strategies that target regeneration, as well as social housing and supported living.
This is a new space for real estate lenders to operate in. If alternative lenders, such as ourselves, want to manage impact lending funds then they will need to build processes and frameworks to measure impact to operate in this space. Lenders and borrowers will need to work together to be able to make this both viable and scalable.
How are you approaching mid-market lending from an S&I viewpoint?
Across all our loans we promote environmental and social characteristics with good governance practices. There are some circumstances under which we will not lend at all, such as on fossil fuel assets, assets with an EPC rating below a certain level, or to a borrower with poor internal and external governance.
We use a proprietary scorecard, through which we assess and score the environmental, social and governance credentials of both the asset and borrower, with a minimum threshold for investment.
For an impact strategy, in addition we use a bespoke impact assessment including a scorecard which we have built in conjunction with BlueOrchard, which is Schroders Capital’s impact manager, with more than 20 years of experience in delivering impact strategies and with significant expertise in private debt.
The fundamental difference is a very deliberate and defined impact objective. We really focus on the impact intent of the investment, on our contribution as a lender – including type of financing and covenants – and on the measurement of the outcomes we are driving through the loan.
Using best practice in terms of processes and reporting, we measure clear predefined sustainable performance targets, to drive positive change through the terms of the loan agreement. Timing is also key as we typically lend for an investment horizon that can deliver impact.
How could a lender make loans which would be classified as ‘impact’?
As mentioned above, the impact intent is very important in setting the impact objective at the outset.
To take an example, we could be financing a value-add business plan which would increase the provision of social supported housing. We use geospatial data provided by our in-house data science unit, which identifies areas which are underserved and where there is a demonstrable social need, which this investment can address. In other words, there is an additionality given the specific area context and we have a baseline to measure progress of the built environment and improvement of ratios and social well-being in covering these needs.
Our clear and stated objective would be to increase the provision of social supported housing in the area, but also to drive additional positive outcomes, for example in the asset’s energy efficiency. We might look at using carbon risk tools to measure the pathway to net zero and include covenants which mandate specific mitigants or expenditure which would improve the asset, whilst making sure that the investment is not harmful to other sustainable factors.
In this case we may incentivise the borrower to deliver a higher proportion of social-supported living than in the original business plan through improving margin ratchets as well as holding the borrower accountable to the business plan by making the terms of the loan contingent on the delivery of the impact which we have underwritten. The impact-linked incentives, such as margin ratchets, also provide an opportunity to regularly monitor and track progress in achieving the set thresholds.
Impact loans sound more expensive and burdensome from a reporting perspective. Are mid-market borrowers going to want to do this?
It’s likely that while impact strategies are evolving, an impact lender will be working with a like-minded sponsor with in-house expertise and a well-developed ESG strategy. There’s no question that reporting will be more onerous, but in our view impact investing generates improvements in assets and communities which are attractive to our investors and to sponsors alike as it is diversifying risk.
Typically, impact strategies will include an element of value-add or development projects. The financing here is clearly more expensive, and so the differential against non-impact loans in the current market is nominal. Again, sponsors can benefit through margin ratchet reductions within an impact loan structure, which align our impact objectives with the financial motives of the borrower.
We would also note that S&I is becoming a major factor in the liquidity of assets. Working closely with a lender in this space is beneficial for sponsors who want to ensure they do not end up with stranded assets, and here there is a common ground between the asset owner and impact-focused debt manager.
The other challenge is for real estate lenders, such as ourselves, to develop a meaningful impact framework which clearly defines which impact is intended to be delivered with the credit strategy.
We have benefited from the experience and frameworks of BlueOrchard, alongside Schroders’ Sustainable and Impact teams. This has allowed us to take best practice across asset management and design a workable framework which addresses the nuances of real estate and the needs of borrowers together with wider regulation and reporting requirements.
It is clear impact investing will continue to grow as a proportion of investors’ allocations, and real estate debt products will therefore need to provide investors with investments that align with their objectives. As we see this trend continue, we think there’s a great opportunity to improve assets, the communities in which they sit and ensure the viability of assets well into the future.
What are the ongoing requirements to measure and monitor impact loans?
We want our impact investments to contribute to more sustainable societies and therefore focus on the UN Sustainable Development Goals (SDGs) which are most relevant to real estate. Our philosophy is therefore to make a positive social impact, as well as making a positive contribution towards climate goals. In our view, societal progress and addressing the climate challenge are two sides of the same coin and can be addressed simultaneously.
In terms of reporting, we use Sustainable Performance Targets (SPTs) which are specifically tied to the outcome we are looking to achieve. These can be very granular and based specifically on the asset we are financing. We expect our borrowers to report progress against these SPT’s on a quarterly basis. For us they form the core of our rationale for providing financing and are therefore essential to achieving the stated impact objectives.
We also set SPT’s at the fund level which addresses the core themes of the strategy. We can therefore report to our investors at asset and fund levels and provide the reporting analysis required to satisfy their respective S&I requirements.