Taking an alternative path to financing

When Cheyne Capital announced a £150 million (€171 million) senior loan to part-fund the acquisition of Deutsche Bank’s London headquarters in April, the alternative asset manager was not just backing one of the largest UK office deals so far this year. Cheyne was also underlining the importance of sustainability. 

An integral part of the financing deal revolved around a commitment by the new owners – UK-based property investor Castleforge and Malaysian construction firm Gamuda Berhad – to a high-specification upgrade of the 25-year-old Winchester House after the bank leaves in 2024.

The proposed ESG package includes smart building technology alongside improved airflow quality and energy efficiency. In addition, the owners are aiming high with their target benchmarks: BREEAM ‘Outstanding’, WELL Core Platinum and NABERS UK Five Star.

As Cheyne’s Andreas Dimitriou told Real Estate Capital Europe in April, the upgraded Winchester House will need to be acknowledged as “a top-tier ESG office building” if it is to attract blue-chip tenants upon completion in 2027. At present, just one in seven refurbishments in London achieve an ‘Outstanding’ BREEAM rating, according to Dimitriou.

Cheyne’s Winchester House deal embodies how, in their bid to grow market share, alternative lenders are increasingly keen to factor ESG risk into their underwriting and back schemes with clear sustainability objectives.

Edward Daubeney, co-head of debt and structured finance for EMEA at property consultant JLL, notes that with the current elevated interest rate environment and economic uncertainty keeping the lid on debt availability from some of the more traditional lenders, debt funds, in particular, are “very much stepping into the fray” this year with an ESG agenda.

“We are seeing traditional equity sources now working on credit programmes,” he says. 

“There are plenty of new entrants, and debt funds continue to raise capital. They all see the opportunity in credit because it’s lower leverage now, achieving greater risk-adjusted returns compared to direct investment into real estate.”

Strong ambitions

Yet nowhere is the pace of change more keenly felt than at Aviva Investors. In late 2020, the UK manager established its “sustainable transition loan framework” as a means of improving existing buildings and infrastructure that underperform when it comes to energy efficiency and their ongoing carbon emissions. By May 2022, the company had hit its target of providing £1 billion of sustainable transition loans – three years ahead of schedule.

Gregor Bamert, head of real estate debt at Aviva Investors, says around half of its lending during the past two years has been part of the sustainable framework. Bamert expects that proportion to increase in its lending in 2023. 

As he says, it makes “a lot of sense” for asset owners to align their investment and financing strategies. But he also believes alternative lenders with “a long-term orientation”, such as Aviva Investors, will have “a very significant role” in transitioning real estate to a low-carbon economy. 

“Many of our peer group who are focused on that sort of investment approach, whether it be through a framework or something like that, they have to feature ESG very strongly in their underwriting.”

Indeed, LaSalle Debt Investments, the European lending arm of the investment manager, followed suit earlier this year with a similar sustainability-focused lending framework, targeting at least €500 million of green loans across Europe in 2023.

Bamert stresses the importance of borrowers showing evidence of a sustainability plan. “It’s always a two-way conversation,” he says. “But we are big on additionality. If somebody comes to us with a specific plan, we would typically say, ‘Okay, you either need to do more or you need to do it faster, or indeed, both.’”

The full value of loans written under Aviva Investors’ framework are typically subject to sustainability-linked key performance indicators, with more favourable borrowing rates available upon the borrower achieving measurable environmental improvements in the assets being lent against.

As Bamert acknowledges, this “margin ratchet” incentive is the main lever Aviva Investors can pull here. “Certainly, for those of our borrowing clients who are listed or have other public disclosure requirements, for them to be able to say that they’ve met the KPIs has a value in its own right in terms of positioning them with all of their stakeholders.”

The flip side is that if the borrower fails to meet the promised KPIs, “the margin starts going up, and potentially quite meaningfully”, or in extreme circumstances the loan is subject to a cash-trap – surplus rent after debt service is withheld. The harshest sanction is not doing the deal at all if the underwriting risk is too high. However, the framework’s stated objective is to invest and improve property generally rather than “screen out” underperforming assets.

Bamert suggests that the benefit of Aviva Investors’ “principles-based” framework should mean it is “more meaningful and ambitious” than a very strict lending formula because the whole ESG agenda is changing so quickly. 

“If you go back five years,” he adds, “for an office building to have an Energy Performance Certificate of ‘A’, you would have said that’s pretty ambitious. But now… is that really all you are aiming for?”

ESG pressure on office demand

The refinancing spotlight is firmly on the office sector 

In the office sector, the risk of obsolescence invariably links the ESG challenge to the ongoing debate over hybrid working. A measure of the uncertainty around offices is seen in JLL research showing global vacancy rates hitting record highs in 2022. There appears to be little respite for the sector so far this year.

In the UK, for instance, JLL’s Edward Daubeney notes that the emphasis on ESG has become more pronounced in the past few months, especially on offices, whether in London or in the regions.

“Lenders are super-focused on the borrower delivering a plan to bring the building up to current standards and standards going forward,” he says. “Lenders want to know, what are the current ESG credentials? Where can the borrower get them to? How much is it going to cost to do that, and how long is it going to take? If you want to maintain rents and occupation in these office buildings, you must ensure your building is going to be compliant.”