Real Estate Lending and ESG: Observations from the 2015 GRESB Debt Survey

Saturday, August 1, 2015

Over the past three months, I’ve been speaking with real estate debt fund managers about the new GRESB Debt Survey, an assessment designed to evaluate and benchmark, but also, to guide, the sustainability engagement and performance of real estate lenders. Recognized as “at least a decade behind the equity side of real estate,” sustainability integration in real estate debt (aka lending, finance or credit), still seems to be an emerging concept. Furthermore, given the multitude of regulations and parameters lenders already face (and often respond to with great innovation), the prospect of another looming externality, like sustainability, doesn’t exactly give lenders a warm feeling.

During the Debt Survey engagement process, reactions have run the gamut, from, “though we haven’t begun implementing all areas addressed in the Survey, we are moving in the right direction and plan to participate,” to “we’re far removed from the property and we’re not going to tell our borrowers what to do, is that what you’re asking of us?”

By far the most common reaction, in one form or another, has been: As a lender, we have less control over properties than do borrowers/asset owners. Furthermore, we realize no upside as a result of energy efficiency or other cost cutting, sustainability-related property features and improvements. Why should we consider environmental, social and governance (ESG) issues relative to our lending platform and processes?

Here’s my response on why ESG matters for lenders – whether traditional balance sheet lenders or alternative lenders:

At best, lenders get their principal returned along with the spread they priced during loan underwriting. Because there is indeed no upside, risk management is the name of the game.

Financial/Credit Risk - Managing downside risk is critical to delivering a risk-adjusted return. Sustainability risks can adversely impact collateral value and a borrower’s ability to fully repay their obligations. A recent study conducted on 80,000 CMBS loans found 20-30% lower default rates associated with Energy Star labeled and LEED certified buildings. This study is supported by a growing body of academic literature that indicates green buildings have better rental rates, better quality tenant attraction and retention, and higher resale values compared to their non-green counterparts. Furthermore, as extreme weather events increasingly impact buildings, and tenant and investor preferences evolve, there is the risk of stranded assets (those unable to retain their value, resulting in unexpected write-offs).

This information may be compelling, but it only addresses a lender’s security or collateral. What about the sustainability risk associated with a sponsor (borrower or guarantor)? If the sponsor has environmental fines outstanding, these may be sizable and ultimately impede their ability to pay off, pay down or otherwise make whole their lender. Knowing the sustainability track record of a sponsor could provide valuable insight, not only with regard to how responsibly and efficiently that sponsor will operate and manage its properties, but also how likely the lender is to end up inheriting an under-performing asset or potential liability.

Whether collateral-level or sponsor-level, sustainability data and analysis can serve as a competitive edge if properly integrated into loan structuring, underwriting, due diligence and ongoing monitoring. How would pricing be impacted if sustainability risks were incorporated into probability of default (PD) and loss given default (LGD) models? Perhaps lenders would make many of the same decisions they do today, but with sustainability risks fully priced, it might mean fewer losses during downturns, more consistent lending operations and more stable returns to investors.

Compliance Risk – Staying ahead of evolving climate change regulation. While legislation varies across regions, global portfolio diversification is becoming a more common debt strategy. In some countries, there may be direct negative consequences for ignoring the environmental impact of collateral. For example, in the UK, the Minimum Energy Performance Standards (MEPS) regulation, calls for the unlawful leasing of properties with energy ratings below a defined minimum threshold, thereby impacting affected property cash flows and values.

Strategic risk – The capital to lend doesn’t exist in a vacuum. Whether delivered through the capital markets, via shareholders and bondholders, or collected as life insurance premiums, investor accountability is implicit. In the case of private debt funds, the relationship between lender and investor is even more intimate. Real estate debt funds are dependent upon private equity fundraising. 46% of institutions include real estate debt as part of their real estate allocation. Institutional investors have long-term investment horizons and are increasingly interested in seeing ESG integration extended beyond their equity investments, to debt and fixed income as well. Integrating sustainability into a commercial real estate lending philosophy and processes allows a debt fund to create a portfolio aligned with its investor’s values.

Reputational risk – The real estate sector contributes one-third of global energy consumption and greenhouse gas emissions. As financiers to building owners and operators, lenders provide the capital that makes positive or negative environmental outcomes a reality. It’s unclear whether lender liability will eventually extend to climate change risks associated with buildings (e.g. carbon emissions). But becoming the lender of choice to a market transformation by financing green rehabs, retrofits, and repositionings, as well as green development, can’t hurt.

The GRESB Debt Survey examines the ESG issues embedded in commercial real estate lending. I say embedded, because these issues already impact lenders and investors. The question is how aware they are and how they can begin to use sustainability data to their own advantage.

The deadline for the GRESB Debt Survey is August 21, 2015 – three more weeks for lenders to show investors the actions they’ve taken on ESG issues thus far.