Lending in the property sector is increasingly focusing on environmental factors, write Wojciech Herchel, Sam Taylor, Clarence Er and David Devlin
The commercial and residential real estate, or property, sectors are colossal emitters of carbon. In the UK, buildings are responsible for almost a quarter of all carbon emissions. While there have been major advances on reporting of energy performance certificate (EPC) ratings and carbon emissions, there remains a clear need for the sector to proactively and materially reduce building emissions.
Real estate lending generally concentrates on the building itself and by its nature is suited to green, social and sustainable lending, where use-of-proceeds is strictly defined and ring-fenced. The loan market is private in nature. As such, standardisation to embed sustainability has lagged behind listed equity and bonds. While their private nature makes it more difficult to fully evaluate environmental, social and governance (ESG) criteria (as data is typically less available than for public debt), lenders can benefit from having more scope to directly engage with borrowers.
A number of real estate companies have also employed sustainability-linked lending. This category uses sustainability performance targets, and allows proceeds to be used for general corporate purposes.
Old as well as new?
The real estate industry is increasingly looking at a building’s ESG-efficiency not only when it is up and running, but also throughout its lifecycle. This approach considers the processes and materials used not only in construction, but also when the building is being retired or rebuilt. That said, in the UK, 60%–80% of the buildings estimated to be required by 2050 are already in existence, and their construction footprint has already been crystallised. A gleaming trophy building built with cutting-edge sustainable technology might be appealing, but repurposing existing stock is likely to have a lower carbon footprint than demolishing and rebuilding.
The World Green Building Council has set out its vision, which acknowledges that a co-ordinated effort on new and existing buildings is required to achieve the target set out in the Paris Agreement on climate change:
- All new buildings to be operationally net zero and with 40% less embodied carbon (carbon emitted when creating building materials) by 2030
- All new buildings to have zero embodied carbon, and all buildings to be operationally net zero by 2050.
What gets measured gets done
As in the broader ESG investment market, reporting for the real estate sector has improved. The market has typically focused on energy labels rather than sustainability targets, with lenders including these labels in their ESG frameworks. However, energy labels are not consistent across countries (even within Europe), so loan documentation increasingly includes carbon footprint and energy consumption, which are both approaching standardisation. This allows lenders to compare across their portfolio, although the idiosyncratic nature of buildings does create challenges when it comes to consistency – for example, a retail mall will have very different efficiency targets than an office building.
Since 2009, the Global Real Estate Standards Board has become a leading investor initiative focusing on real assets and infrastructure. It looks at commercial and residential real estate and provides ESG indices and scores for both portfolios and individual assets, aiming to solve the problem of validating and standardising data across complex and idiosyncratic assets.
Are incentives aligning?
Stakeholders such as lenders, owners and tenants often have competing economic incentives, but they are beginning to align on ESG topics. Real estate lenders are increasingly viewing ESG compliance as more than just a component of corporate ESG targets and instead as a risk factor, especially with regulatory requirements constantly evolving. In England and Wales, commercial and residential properties are required to have an EPC rating of E if they are to be rented out. For residential properties, this will increase to C rating from 2025, while rented commercial properties will be required to have a B rating from 2030. Lenders are therefore demanding increased reporting and compliance with ESG metrics, with some going further by offering reduced margins for those achieving ESG-related targets.
Tenants also have multiple incentives to lease green buildings. Corporations increasingly report on ESG targets, so will seek to reduce the carbon footprint of their offices. Energy prices are volatile and have been increasing, again making energy-efficient buildings more attractive. Buildings without robust green footprints may be seen as future refinancing problems for owners and lenders.
Going forward, green leases may also start to form part of the eligibility criteria for green loans. These leases require management and improvement of a building’s environmental performance through, for example, getting energy from renewable sources, reducing carbon emissions, or decreasing waste and water use. Importantly, these leases may put an obligation on both the landlord and the tenant.
The same incentives can be seen in the retail space, with mortgage borrowers receiving favourable loan-to-value (LTV) or margin terms for improved energy labels, low-energy new-builds, or additional LTV headroom for investment in ESG-positive modifications, such as solar panels. All these factors contribute to a lower carbon footprint for the lender’s portfolio of real-estate loans (Table 1).
Not just the ‘E’
As seen in the Alliance Homes example, social factors are also a subject of increased focus. Lenders can engage directly with borrowers, sometimes with consultants’ help, to improve the impact of the building on the wider community. Terms can be enshrined in the loan documentation for provision of affordable housing and green spaces within developments, employment of disabled local residents, tenants paying a living wage, or improved green transport.
Retail mortgage lenders are also embracing the UN’s sustainable development goals (SDGs), such as SDG 1 (‘End poverty in all its forms everywhere’) and SDG 7 (‘Ensure access to affordable, reliable, sustainable and modern energy for all’). Some lenders offer social support, such as helping elderly people to relocate, providing budgeting or job coaching in the event of unemployment, and arranging tie-ups with green energy providers to provide cheaper energy. Additionally, some lenders offer beneficial terms for entrepreneurs or self-employed people (including medical students in training) to support those who are naturally disadvantaged by traditional bank lending terms.
Where do we go from here?
Real estate offers more than just financial return – it provides a home, workplace or place of leisure. This makes it an important sector for all of us, as well as one that could make a major difference in tackling ESG issues. As we have seen, real estate development can also offer significant social benefits for local communities.
To build on positive developments, stakeholders must continue to strive for transparent reporting of real estate’s real sustainability impact, to better measure how we meet the goals of the Paris Agreement and provide a roadmap for further improvements.
Wojciech Herchel is head of insurance advisory EMEA at Schroders
Sam Taylor is head of the Investment Solutions team at NN Investment Partners
Clarence Er is director in the Life and Alternative Credit team at Leadenhall Capital Partners
David Devlin is annuity investment lead at Scottish Widows
All authors are members of the IFoA Private Credit Further Developments Working Party