Real estate debt: Banking on ESG

The next three to five years will pose several challenges in terms of sustainable real estate financing, especially for banks with large legacy loan books. That is clear from even the most cursory discussion on the topic with industry specialists. 

On the one hand, the move to decarbonisation and other methods of protecting the climate and planet from the human race will gather force and pace. 

On the other hand, the phrase ‘stranded assets’ will become a growing element of everyday conversation in international institutional financial markets. 

“We have seen huge changes in the past year or so as environmental, social and governance (ESG) considerations in general, and sustainability in particular, have risen up the agenda,” says Neil Odom-Haslett, head of commercial real estate lending at Abrdn. 

While Abrdn has set up a new green debt fund, this is not, he stresses, an entirely new phenomenon. “We’ve lived and breathed ESG for years and it is hardwired into our investment process.” 

In the here and now, sustainability is firmly in the spotlight and there is an almost tangible eagerness for informed market participants to discuss it. 

Peter Cosmetatos, CEO of CREFC Europe, goes to some lengths to contextualise it. Most firms with a strong interest remain in exploratory mode, figuring out what they can do and how they should do it. “It’s almost the only thing most lenders want to talk about, and there is a great thirst for knowledge, advice and market standards,” he says.

Several real estate developers and investors are market leaders in this area, he continues, supporting the work of specialist organisations like the Green Building Council, and Better Building Partnership, and reporting to GRESB and adopting methodologies like Carbon Risk Real Estate Monitor. All are playing a key role in helping their lenders learn about the subject.

And this is where a keen, disinterested observer might detect a glimpse of what could prove to be the industry’s Achilles heel. 

Lenders are not, by and large, experts in sustainability. They have short attention spans, are remote from the asset and its users, depend on others for data about its performance and characteristics, and have limited influence over how the asset is used. 

And, as Cosmetatos points out, sustainability is a complex area where not only climate but social considerations need to be weighed and weighted against each other as well as against traditional credit and commercial considerations. 

There is no single, simple, obvious metric to use, Cosmetatos says. “It isn’t even obvious what data you need, as a lender, and what questions you should ask – at the due-diligence stage as well as once a loan has been made – in order to assess the collateral – and the sponsor’s strategy – and its progress from a sustainability perspective.”

Cosmetatos says: “How do we define green/sustainable in terms of real estate debt financing? I think the right way to think about it at the asset level is not to define green/sustainable but rather to aim to improve the resilience, impact and sustainability of each asset, having regard to its own performance and its own potential.

“For financiers, it’s a question of enabling that kind of improvement. I think trying to define green or sustainable buildings is a red herring, likely to complicate the decarbonisation that the large majority of existing buildings need to undergo. Some will not need any improvement, and some will need to be demolished, but the large majority must be improved. After all, we can’t just demolish sub-performing buildings and replace them – the carbon cost would be immense, even if you ignore other considerations.

“Transitional investing and lending strikes me as a better risk-adjusted strategy, as well as a more policy-useful one, at a time of accelerating activity and expertise in making the built environment more sustainable,” he continues. 

“Would you rather lend against today’s greenest building in the certain knowledge that when your loan matures in five years’ time, say, it won’t be the greenest building in town anymore? Or would you prefer to finance improvements to brown buildings which will, by definition, be more sustainable when you have finished with them than they were when you started?” 

This ‘long brown tail’, formed by owners who gradually realise the benefits of upgrading rather than demolishing and replacing, is where he believes the bulk of sustainable financing activity will take place over the coming decades.

Greenworks Lending, which was acquired by investment manager Nuveen last year, provides finance to clean up buildings via the Property Asset Clean Energy (PACE) finance provisions that have been adopted by some states in the US. 

Jessica Bailey, CEO and president of Greenworks Lending, says: “Everything we finance has to reduce a building’s energy consumption, by improving the efficiency of, for example, heating and ventilation and lighting systems.” 

Making funds available over 20 to 30 years helps make the upgrading of buildings commercially viable. “We also work in the new construction sector, offering to finance developers to install cleaner infrastructure from the outset,” Bailey says.

Odom-Haslett agrees that there is more to sustainability than investing in brand new shiny offices with a top EPC rating. “Some lenders will want new green buildings, of course, but they will represent only 5% of the total loan book,” he says. 

“What do you do for the other 95%? Retrofitting and occupying old buildings will have much more of an impact. To help drive the process, we are rolling out incentives to borrowers, encouraging them to meet pre-agreed environmental standards and so qualify for a reduction of several basis points in their margin.”

There is no cast-iron definition of what constitutes a green loan, says Odom-Haslett. “But we can state with some certainty that a sub-standard, badly designed building with recently installed cycle racks is not a green building.”

Against this backdrop, regulatory incentives for lenders might, however, be misaligned, Cosmetatos suggests. Unless financial regulators quickly become much more sophisticated, their climate stress tests and climate-related disclosure requirements are likely to drive capital away from, instead of towards, the enormous need for retrofit financing, he argues. 

He also raises the question of whether financial regulators appreciate that it is better for banks to provide capex facilities to help make buildings more sustainable than to provide finance for the handful of new, top-rated, best-in-class buildings constructed each year, which are easily financed in any event. 

Cosmetatos is concerned that there is not enough “effective collaboration and communication” between the design/construction and the finance/investment industries. 

He gives two examples that indicated this to him. “One is the fact that I learned of the RIBA 2030 Climate Challenge by chance in December, when one might have expected it to be well known among developers and their backers. The other is from a TED talk in which I heard a clear, intuitively sensible articulation of how new-build housing can best be sustainable.”

Climate-transition loans
In 2020, Aviva Investors launched a Sustainable Transition Loans Framework and committed to originate significant volumes of sustainable real estate debt over the subsequent four years.

Gregor Bamert, head of real estate debt at Aviva Investors, reports that the project is going well. “We made a public commitment in December 2020 to extend £1bn (€1.2bn) of sustainable transition loans, targeting 2025 to align with other Aviva Investors initiatives as part of our pathway to net zero. We have had a very positive response from borrowers and investors and have found far more opportunities than we anticipated. Within a year, we had made just over £740m of loans, putting us well ahead of target.

“As we consider reviewing the original targets, we find that we could either make more loans or revise upwards the underlying qualifying criteria, which are already more demanding than standard regulatory requirements.”

Aviva Investors emphasises lending to facilitate improvements to existing buildings that are clear candidates for an upgrade and the investor expects maximum bang for each lent pound. 

Bamert cites Big Yellow as a good example; Aviva Investors made a £50m seven-year loan to the storage company in October 2021, having provided a £35m loan with sustainability features in March 2020 and a £100m facility in 2012. 

Big Yellow’s buildings have a large physical footprint but consume little energy as they are mostly unheated. In such a situation, installing solar panels on the roof has a broader positive impact in relation to energy consumption than taking similar action elsewhere. “Doing the same in a heavily occupied office block in London would make virtually no difference,” he states.

Among other sustainable activity, in April 2021, Aviva Investors announced the completion of a £72.9m, seven-year sustainable-transition-loan agreement with Commercial Estates Group, the property investment management and development company. In November, it announced that it had agreed a £200m, 15-year facility with Primary Health Properties, a listed real estate investment trust.

The £1bn committed to sustainably-linked building upgrades is part of Aviva Investors’s £8.5bn or so total current loan book, but loans under the framework account for over 40% of the company’s new total lending for 2021, indicating that borrowers are keen to align their financing strategy with their sustainability strategy. 

As with Abrdn, the lending conditions offer margin reductions as buildings are improved, and, as Bamert notes, it is very rare for would-be borrowers to make a loan request for a building that needs improvement unless they already have a plan in place to carry out the improvement.

Some managers and investors are, of course, more active in the field than others, notes Cosmetatos. All find themselves at different points in their journey, both in understanding the physical and transitional risks and the opportunities in a rapidly evolving area, and in developing responses to them.

“The commercial real estate investing and financing industry has probably not done enough to link up with the growing expertise on the design and construction side of the sector, where there is probably less insight into how the investment industry and financiers approach things. We all need to get better at working together,” he says.

“The importance of a connected ecosystem that spans the whole sector should be obvious. If I want to do a climate-conscious renovation of my home, I want (a) advice from someone suitably knowledgeable and ideally accredited, linking up with (b) contractors with the right expertise and ideally an accreditation I can trust, linking up with (c) access to finance (whether from an existing mortgage provider or someone else) that understands and values the other links in the chain and rewards me for taking steps to future-proof my home. Something along similar lines will be needed for the large majority of commercial real estate owners that aren’t sustainability experts.”