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Navigating Sustainable Financing in Commercial Real Estate Debt
The Emergence of Sustainable Commercial Real Estate Debt
In recent years, the market for sustainability in commercial real estate debt has been on the upswing, mirroring the growing importance of sustainability in finance. This is further boosted by wider economic forces, which have expanded the appeal, and returns, of fixed income products. Investors, lenders, and borrowers are increasingly realising the financial, environmental, and social benefits that come with sustainable financing.
This burgeoning section of capital markets is reshaping the real estate sector as it aligns with climate policy objectives. The adoption of sustainability criteria in real estate debt is on the rise, and it’s a pre-requisite for accessing capital from prominent investors. In addition, sustainable debt instruments are now proving indispensable, serving as critical financial tools for low-carbon and climate-resilient assets and projects.
Equity vs Debt: Investment Comparison
Sustainability principles in real estate can differ significantly when it comes to equity and debt investments. Notably, the ownership structure and level of control play a crucial role in shaping how sustainability is approached.
In equity investments, you have influence over asset management and actively engage in sustainability decisions. As an equity investor, you’re responsible for asset performance and often driven by the direct benefits of improvements, including increased asset values and cost savings.
This approach involves balancing potential rewards and risks, as sustainability projects may require significant upfront costs. However, when integrated well into the asset’s business plan, they can yield positive returns by enhancing performance and boosting asset value.
In debt investments, you lack direct ownership and control over the underlying asset. As a debt investor, this restricts your ability to directly influence sustainability initiatives and performance. Furthermore, debt investment focuses on downside protection (i.e. avoidance of defaults) rather than the upside gain of equity investments.
Lenders often choose to inspire and collaborate with their borrowers on sustainability. In cases where direct asset-level control is limited, debt investors can exert their influence through financing decisions. They may opt to prioritise lending to borrowers who showcase robust sustainability commitments and a proven ability to effectively manage sustainable assets.
Driving Growth in Sustainability Real Estate Debt
Accounting for nearly 40% of global energy-related carbon emissions, and sometimes up to 70% in large cities, buildings are central to the low-carbon transition. With the scale of the sector’s emission footprint, substantial investment is required to transform the global real estate sector towards a low-carbon future.
Real estate organisations, including investors and investment managers, are increasingly formalising their commitments to decarbonisation. Meeting these ambitious targets requires significant action and financing. One essential financial component is the renovation of existing assets.
According to the European Commission (EC), an estimated €275 billion in additional investment for building renovation is needed annually to reach the EU’s 55% carbon reduction target by 2030. Alarming, however, is the fact that building renovation remains one of the sectors with the most significant investment financing gap.
Recent growth in the sustainable real estate lending market owes much to regulatory initiatives. The European Union (EU), through its Sustainable Finance Action Plan, has introduced a comprehensive set of regulations aimed at creating a framework that encourages financial market participants to integrate ESG (Environmental, Social, and Governance) factors into their decision-making processes.
The primary objective of the EU’s new regulations is to redirect capital flows toward sustainable investments. Notably, one regulation, the Sustainable Finance Disclosure Regulation (SFDR), has significantly impacted the development of the sustainable real estate lending market. Under SFDR, many lenders raising capital from EU-based investors for real estate debt funds are now required to disclose their sustainability commitments. This, in turn, has prompted the adoption of new sustainability strategies and tools to meet these commitments over time.
Real estate organisations are increasingly recognising the significance of a positive reputation linked to sustainability. Within the real estate debt market, some lenders and borrowers view sustainable practices as a means to elevate their standing and appeal to responsible investors and partners. The advantages of a favourable reputation are evident, but the potential damages from a negative one is equally apparent.
One rising concern is the risk of “greenwashing,” which refers to the deceptive practice of making false or misleading claims about an organisation’s or investment product’s sustainability practices or performance. Cases of greenwashing are on the rise, and major investment firms have been in the news for this. Many lenders are now taking steps to assess their borrowers’ sustainability practices to ensure they partner with trustworthy organisations that are not vulnerable to greenwashing allegations.
Ensuring that borrowers maintain a robust sustainability reputation can also contribute to reduced credit risk, as such borrowers are less likely to encounter regulatory, reputational, or operational issues during the loan term.
The typical commercial real estate loan period of three to five years can feel lengthy amid the fast-changing sustainability landscape. During this time, various risks, including climate change-related threats, shifts in market dynamics, and unexpected expenditures (such as increased insurance premiums and/or carbon taxes), may accumulate and create challenges for borrowers.
Lenders are now recognising the financial risks linked to sustainability, particularly climate change, within their debt portfolios. Sustainable debt practices are emerging as a way to manage and mitigate these risks by supporting borrowers and assets better equipped to manage climate-related challenges over time. Many lenders are achieving this by enhancing due diligence, resulting in a deeper understanding of borrower risks and opportunities, leading to more informed decision-making.
Strategies for Integrating Sustainability into Real Estate Debt
EVORA Global’s Sustainable Finance team assists clients in creating and implementing strong sustainable debt strategies that align with industry standards. We collaborate with our clients to minimise exposure to various significant ESG risks that may arise during the lending process and help them recognise and capitalise on sustainability-related opportunities when they arise. Our CRE8 Sustainability Principles are designed for a successful and sustainable approach to commercial real estate lending.
To effectively implement a sustainable lending strategy, you must approach it systematically. Establishing governance practices, documenting processes, and assigning roles and responsibilities are foundational steps in your sustainable debt approach.
Within the real estate sector, various organisations and sustainability initiatives have developed numerous standards and guidance to bolster the structure and credibility of sustainable financing programmes. Although there’s a wealth of information available, sifting through it can be daunting. Determining which standards and guidance align with your business and fund strategy is sometimes tricky. However, once harnessed, they can be invaluable in enriching and shaping a robust sustainable debt strategy.
A key distinction between real estate debt and equity investment lies in the level of control and influence over sustainability-related decisions during the holding period. For lenders, identifying points of influence in the decision-making process is crucial. In the case of debt, the primary opportunity rests in the underwriting and due diligence stage. To effectively promote sustainability and engage borrowers, sustainability considerations must be integrated into these phases.
A diverse set of ESG tools is at your disposal to bolster your approach to sustainability as a lender. Although standard industry due diligence questionnaires provide a good starting point, they can sometimes be too generic for specific strategies.
That’s why we stress the importance of tailored, bespoke tools that align with your business and sustainable debt strategy. Furthermore, these due diligence questionnaires can be complemented by third-party tools like Physical Climate Risk and CRREM analysis. By combining these tools, you can effectively screen and quantify the sustainability profile of borrowers and their underlying real assets for more informed investment decisions.
To maintain a strong sustainability perspective in your real estate debt investment, we suggest regular and ongoing engagement with borrowers. Monitoring their progress against predetermined sustainability criteria throughout the loan term is essential. This keeps you informed, fosters positive partnerships focused on sustainable performance, and ensures continued borrower engagement during the investment period.
Having a structured reporting and disclosure process that encompasses sustainability is of growing importance. Stringent legislative requirements and investor expectations demand diligent collection and reporting of sustainability data for your investments.
As new information, standards, and solutions emerge, it’s crucial to consistently review and enhance your sustainable debt strategy and implementation to adapt to changing circumstances. To achieve this, you must establish a comprehensive and informed approach for evaluating and improving your sustainable debt strategy in alignment with industry practices and market expectations.
Successfully integrating sustainability into your real estate debt programme can be a complex endeavour, and the stakes are high. With tightening regulatory requirements, a more informed market, and increasing investor expectations for sustainability considerations, seeking expert assistance is often the best approach. We have a successful record of supporting a variety of clients, including financial services companies, investment banks, and alternative lenders, in developing their sustainable real estate lending strategies.
Transform your sustainable financing with EVORA Global’s expertise. Contact us today.
Aoife Busher, Associate Director, and Jamie Anderson, Junior Sustainability Consultant, EVORA Global