Sustainability: Benchmarking the lenders
GRESB has extended its remit into real estate debt. Sara Anzinger explains why it is important to track the sustainability performance of lenders
The GRESB Debt assessment was introduced in 2015 to provide greater transparency to debt investors and to inform lenders interested in incorporating ESG factors in their lending decision-making.
An industry-driven organisation, GRESB has served public and private real estate equity investors since the launch of its benchmark in 2008. Since then, private alternative lenders have multiplied and real estate debt has emerged as a new asset class attracting institutional capital.
More than 50 institutional investors with $6.1trn in assets use GRESB as a common ESG reporting framework for their real estate investments. Increasingly, these same investors have expressed interest in seeing ESG further incorporated in real estate debt.
Although a rapidly growing source of commercial real estate finance, private debt funds are still a minority lender type – comprising 26% of the European-focused lending market – compared with banks.
So why develop an ESG assessment and benchmark for a niche market? In addition to investor demand, academic research is indicating that sustainability may be a driver of outperformance, not only for equity investors that benefit from upside related to higher rents, stronger occupancy rates and tenant preferences, but also for lenders vulnerable to downside risks resulting in loan defaults.
For example, recent research on both residential and commercial mortgages suggests substantially lower default rates associated with green-building certification. As lenders become more aware of such information, they may incorporate it to better understand and manage downside risk. In the future, lender demand for property-level and borrower-level ESG data may match that of equity investors.
Real estate contributes one-third of global carbon emissions, consumes 40% of global energy resources, 25% of water and 60% of electricity. Given the outsized role that lenders play in facilitating real estate investment, they are poised to lead market transformation. Debt funds, dependent on equity fundraising, might be more nimble than traditional lenders in incorporating new information and aligning loan portfolios with investor values.
While ESG considerations have become well established on the equity side of real estate investing, lenders have been slower to embrace this trend. Compared with real estate investors like REITs and private equity funds, lenders have less operational control over the buildings that serve as their collateral. This observation can result in the assumption that ESG considerations do not belong in the realm of debt.
When fund managers were approached to participate in the 2015 GRESB Debt assessment, sustainability professionals and real estate lenders within the same organisation were often found to not be in communication with one another. A structural shift in internal organisational communication may be necessary to further integrate ESG factors into lending. Further, because ESG risk assessment and management is not yet standardised, capture of such activity is challenging. Assessing, labelling and tracking climate-related risks, property sustainability features or the total number of ‘green’ loans provides the foundation for reporting financial and ESG outcomes to both internal and external stakeholders.
GRESB Debt provides data on two fundamental dimensions of ESG performance – management and policy (MP), and implementation and lender practice (IL). The MP dimension addresses the objectives, policies, and management controls that direct consistent ESG performance. The IL dimension addresses actions taken during due diligence and throughout the term of exposure, which culminate in loan book performance indicators.
Both dimensions are necessary, as ad hoc implementation provides inconsistent results and communicated objectives without eventual follow-through is often considered ‘greenwashing’. GRESB combines these dimensions into a single score with a weight of 45% for MP and 55% for IL.
It is notable that the average score for IL is considerably higher than that for MP. The opposite has been true on the real estate equity side, as reported by GRESB since 2009. However, because sustainability is a relatively new concept in lending, sustainability objectives and policies that directly relate to finance are relatively rare. Also, since credit risk management is a well-established function of lending, some ESG implementation already occurs as part of standard due diligence – for example, the practice of ordering an environmental site assessment. This surprising level of implementation should put the real estate sector at ease and spur lenders to embrace ESG assessment as part of standard underwriting practice and ongoing loan monitoring.
The 2015 GRESB Report documents industry-wide progress in the embedding of ESG policies and objectives among private equity real estate funds. However, the 2015 GRESB Debt results indicate a different story:
• Five out of 10 have sustainability objectives at the entity (debt fund) level and incorporate these into their overall business strategy.
• Three out of 10 include sustainability factors in annual performance targets of fund employees.
• Three out of 10 have a senior decision-maker dedicated to sustainability that is a member of the credit committee.
Managing downside risk is essential to delivering consistent risk-adjusted returns. Incorporating sustainability may support lenders in protecting and growing investor capital. By requesting and reviewing information pertaining to ESG factors during due diligence, lenders are able to more closely identify risks and may be better positioned to mitigate them. Among 2015 Debt Fund participants:
• All review one or more property level sustainability risk during due diligence: nine out of 10 review flood risk and building safety and materials; three out of 10 review water consumption/management; two out of 10 review climate change and GHG emissions/management; and one out of 10 review waste management.
• Three out of 10 consider the sustainability performance of borrowers/sponsors.
When sustainability assessment and labelling lie outside systematic processes and standard lending practice, corresponding risks and opportunities may remain hidden and go uncaptured. While certain ESG factors like contamination, flood risk, and proximity to transportation may be captured in widely used third-party reports, others are hidden and remain unrecognised.
Likewise, while none of the participating entities had dedicated financing for energy efficiency, financing for capital expenditures and property improvements resulting in higher building performance and positive environmental outcomes is routine. Among 2015 Debt Fund participants:
• Nine out of 10 require an appraisal/valuation.
• Nine out of 10 require an environmental site assessment.
• Eight out of 10 require a property condition assessment.
• One out of 10 require a borrower submitted sustainability-based asset plan.
• None of the 10 provide energy efficiency financing or specialized finance products for property improvements resulting in lower environmental impacts.
The 2015 GRESB Debt data reflect the fact that ESG in real estate finance is an emerging concept and practice. Sustainability has gradually been integrated in real estate (equity) investments over the past decade. Likewise, it will take time to engage and educate real estate. Laying the groundwork with 10 GRESB Debt participants in year one has already yielded successful results.
Sara Anzinger is manager real estate debt and fixed income at GRESB