Real Estate Lenders Wake up to the Value of ESG

Sunday, November 1, 2015

Today it would be rare to find a sophisticated investor in commercial real estate that does not have a sustainability strategy. We know that the sustainability credentials and performance of commercial real estate assets have at least some kind of impact on the drivers of income and capital value over the short to medium term (let alone longer term). Therefore, it is standard practice for real estate investors to develop a sustainability strategy and put in place a program to manage risk and drive performance. How that program is implemented, the degree to which the work is done internally or outsourced, the level of ambition and how it is measured, varies dramatically. However, it would take an incredibly brave and risk-immune commercial real estate investor to pay no attention to sustainability…

Of course when I talk of “real estate investor” above I am referring to direct investment (or equity investment) in real estate. What about the other form of investment in the commercial real estate sector, namely debt (or commercial real estate lending)?  Providers of debt secured against commercial real estate assets are in a different position to the equity investors to whom they lend. They are further removed from direct sustainability impacts that have led equity investors to develop strategies and programs. Consequently, until recently they have paid little or no attention to the topic. However, two significant developments over recent years mean that the tide is now turning and sustainability is beginning to bite for real estate lenders as well as equity investors.

The first development is legislative and UK-specific, though it may well be replicated in other countries. Whereas all buildings in the EU need to have an Energy Performance Certificate (EPC), typically rating them from A (good) to G (bad) at the point of sale or letting, it has generally been left to markets to determine what commercial impact (if any) this energy labelling will have. However, the UK Government managed to boost the commercial significance of EPCs a few years ago when it introduced legislation now known as Minimum Energy Performance Standards (MEES). This will make it unlawful from 2018 to let any building if its EPC is below a certain minimum standard, currently set at an E. The exact workings of this legislation are slightly more complex and beyond the scope of this blog post, but the impact (many years before the legislative deadline) has been clear. It validated and reinvigorated the work that many equity investors were already doing to assess and improve the energy performance of buildings in their portfolios. Beyond that it also made commercial real estate lenders wake up to the fact that energy performance of buildings is a relevant and material risk issue that can affect collateral value and ability to repay, and should therefore not be ignored in the context of lending due diligence, underwriting and portfolio monitoring.

The second development was the launch earlier this year of the GRESB Debt survey. This provides recognition that capital invested in commercial real estate debt can also be subject to measurement and management in terms of sustainability. It goes much further than the relatively narrow issue of the MEES legislation risk highlighted above. It’s clearly the beginning of a journey and will take some time to unfold. However, it is already starting to awaken and impact the market.

My personal involvement in this topic has primarily been through work I lead for the Better Buildings Partnership (BBP) and reflects the trends described above. The BBP is a UK based organisation bringing together 26 of the largest commercial property investors to collaborate on solutions to commercial real estate sustainability. Since 2008 the BBP’s toolkits, working groups, case studies, and events have driven and enabled great progress for the industry. However, it is no surprise that this was solely focused on equity investment in real estate.

In 2013, with MEES on the statute book and its deadline on the horizon we also saw many BBP members were increasing their activities in providing real estate debt. Yet we had no sustainability strategy to speak of in relation to that element of our businesses. So we formed the BBP Commercial Real Estate Lending Working Group. It gathers professionals from the real estate lending community including funds, alternative lenders and some banks, as well as industry bodies such as CREFC Europe and the LMA, to share ideas and industry best practice on how the real estate lending community can incorporate the MEES legislation and broader sustainability issues into risk management strategies. It also provides a platform to discuss how the lending community could move beyond risk management and explore opportunities that provide positive social impact as well as commercial benefits, such as borrower engagement strategies and green lending products. Along these lines, the BBP Lender Sustainability Working Group has developed an industry insight paper on MEES risk for lenders with practical guidance on steps that can be taken to identify, underwrite and mitigate risks.

In conjunction with GRESB and CREFC Europe, the BBP has organized Real Estate Lending and Sustainability: The Case for Better Risk Management. This event, to be held on November 5, will see the release of the BBP’s industry insight paper, GRESB’s 2015 Debt Results, and a panel discussion to be moderated by CREFC Europe. It promises to be an exciting opportunity to engage the real estate lending community on the materiality of sustainability.