Teething problems: Applying SFDR to the real estate sector

What is SFDR?

The EU’s Sustainable Finance Disclosure Regulation (SFDR) was adopted in November 2019 as part  of the EU Commission’s Action Plan: Financing Sustainable Growth. The Plan aims to increase transparency on financial markets, with a view to directing capital flows towards activities which contribute to reducing emissions in line with the Paris Agreement.  

The SFDR applies to Financial Market Participants or Financial Market Advisors who conduct business in Europe. Its entity-level requirements became applicable in March 2021, while product-level  requirements were finalized in April 2022 and have applied as of January 2023.  

At a basic level, SFDR is a hierarchical classification system for financial products based on three  categories: 

• Article 6 Funds: products with no ESG objectives 

• Article 8 Funds: products that promote environmental and/or social characteristics, and may make some sustainable investments 

• Article 9 Funds: products dedicated to “sustainable investments” (within the meaning of SFDR) 

SFDR in practice

As a first-of-its-kind regulation, SFDR has understandably encountered some teething problems, due to investors misusing these three classification buckets as labeling categories. The result has been that Article 8 classification is increasingly being used as a baseline within investment strategies, while Article 9 is being seen as optimal or broadly the “impact” space. 

SFDR was designed primarily with the public markets in mind. As a result, there is a certain amount of mental acrobatics required when applying SFDR to the non-listed real estate sector. 

The European Securities and Markets Authority (ESMA) have clarified that for real estate funds to classify as Article 9, 100% of their assets must align with the definition of a “sustainable investment” on acquisition date. Such a requirement makes sense in public markets, where a snapshot of the ESG credentials of a pool of equities can demonstrate compliance as a result of careful, ESG-based stock selection.  

However, in the real estate sector this is particularly difficult in practice, as impact funds typically acquire older buildings with a view to increasing their value through renovation. As such, the current disclosure framework has the potential to create a perverse incentive whereby demolishing standing buildings and constructing them anew to ambitious or EU Taxonomy-aligned specifications is rewarded to a greater extent than retrofitting the existing building stock. 

This is particularly problematic in the context of recent research by the World Economic Forum which demonstrated that 80% of the buildings that will be standing in 2050 already exist. From a climate change perspective, the “value-add” approach is therefore of utmost importance if we are to decarbonize the building sector at the pace required. Yet, under the current SFDR obligations, this approach is placing Article 9 classification out of reach, thereby penalizing this approach by potentially shutting off access to capital from sustainability-inclined investors. 

Data availability

A great deal was learned in 2022 throughout the process of drafting Article 8 Pre-Contractual  Disclosures. It was a key test year for the regulation as asset managers grappled with the meaning of “promoting environmental and/or social characteristics” and choosing appropriate indicators/targets to demonstrate their achievement. This was made more difficult by the lack of guidance from ESMA on the level of ambition required by Funds wishing to classify as Article 8. 

With annual fund reporting deadlines approaching, many firms have spent Q1 2023 gathering 2022 data to use in their first periodic and Principal Adverse Impact disclosures. A key issue that has arisen has been a lack of data availability, a problem from which other sectors are certainly not insulated. In the absence of green lease contracts or effective tenant engagement strategies, asset managers can struggle to access the relevant data on metrics (such as energy consumption and GHG  emissions) needed to report on progress towards their SFDR targets. This results in further uncertainty around how to classify products appropriately. 

In practice, given the desire to attract capital from a market where investors increasingly require Article 8 as a minimum, the fear among some is that funds have classified as Article 8 to widen the pool of prospective investors without the relevant data collection mechanisms in place to back up sustainability claims. If data coverage remains consistently low, we may see a substantial number of downgrades from Article 8 to 6 as firms endeavor to reduce regulatory risk. Such decisions can impact liquidity, as investors seek out other, more credible Article 8 Funds. 

In response to their obligations under SFDR, and in reaction to the potential risks around reclassification, fund managers are increasingly placing data coverage at the top of their priority list by embedding green lease clauses in newly executed contracts, and by re-negotiating existing leases. Integrating GRESB reporting mechanisms within the SFDR disclosure process is also an efficient way to maintain oversight and ensure compliance. In this context, we are already seeing SFDR acting as a force for good, given the centrality of accurate and credible data when reporting on sustainability targets. As a sector which contributes roughly 39% to global carbon emissions, closer alignment between ESMA and the real estate sector would greatly benefit SFDR and help it to more effectively direct capital flows to economic activities which genuinely contribute to meeting our collective goals under the Paris Agreement.

By Patrick Rogers, Senior Sustainability & Energy Analyst at Longevity Partners.