When real estate debt deals are announced, lenders and borrowers are increasingly likely to badge them as ‘green’ or ‘sustainable’. But it is not always clear how they are beneficial to the environment or to wider society.

In recent years, investors in real estate have recognised the importance of managing environmental, social and governance risk. The industry, a major contributor to carbon emissions and rarely celebrated as a positive contributor to society, has been criticised for its sluggish progress in this area. Now, those who build, buy or manage property are expected to ensure their buildings meet environmental standards, have a positive social impact, and that stakeholders in them operate in a responsible manner.

Yet for those supplying the buildings’ owners with debt finance, who are one step removed from the bricks and mortar, integrating ESG into their activities is less straightforward. As industry leaders contemplate a landscape irrevocably changed by covid-19, ESG matters have been propelled higher up the agenda. That has placed an onus on debt providers to consider how all three aspects of ESG can be part of their activities.

According to Emmanuel Verhoosel, global head of real estate and hospitality in French bank Natixis’s corporate and investment banking division, more progress in this area can be expected in 2021. “The wider financial industry is evolving more rapidly than the real estate sector on ESG,” he says. “Occupiers are also driving this, as they require better assets from a sustainability point of view.”

Energy behind the ‘E’

So far, the E is where real estate lenders have made the most progress. Loans written using environmental financing frameworks have become a market feature. Facilities in keeping with the Green Loan Principles, published by the Loan Market Association in 2018, are the most common.

“The wider financial industry is evolving more rapidly than the real estate sector on ESG”

Emmanuel Verhoosel

These must be allocated to financing the acquisition, development or refurbishment of assets that meet the finance industry body’s definition of ‘green’.

The LMA’s Sustainability Linked Loan Principles, published in 2019, are also increasingly used. The proceeds of such loans can be used for general purposes but must offer the borrowers incentives to meet sustainability targets.

There is a lack of data on what proportion of European real estate loans are structured using these principles. However, Bloomberg and Nordic bank Nordea recorded that, in 2020, real estate companies worldwide had announced $7.7 billion of green loans and $6.5 billion of sustainability-linked lending facilities.

The problem is that such frameworks are not specific to real estate finance and leave considerable room for interpreting what the words ‘green’ and ‘sustainability’ mean. Thomas Garnier, originator in Natixis’s green and sustainable hub, says his bank’s solution was to create its own definitions. “We have built our green framework of eligibility criteria for each kind of asset class and type of financing opportunity,” he says. “For example, in a refurbishment, to be eligible for a green loan, the borrower would need to demonstrate that such renovation will improve the building’s energy efficiency by at least 30 percent in absolute terms.”

Aviva Investors, the investment manager of UK insurer Aviva, in December launched a proprietary framework for ‘climate transition’ loans for commercial real estate. Stanley Kwong, who leads ESG origination and impact investment strategy for Aviva Investors’ real assets business, says this enables the company to identify existing buildings that need improvement.

“To truly tackle climate change, it is important to think about this as a transition,” he says. “You are transitioning assets that already exist, rather than focusing on shiny, brand-new buildings.”

Since 2016, German bank Berlin Hyp has provided loans that incorporate a 10-basis-point discount for developments or investments that fulfil its green criteria.

Like Aviva, it is now expanding its green lending repertoire.

Bodo Winkler-Viti, head of funding and investor relations at Berlin Hyp, explains: “Being aware of the still high number of buildings that do not meet the green building criteria yet, the bank is currently working on the creation of a ‘transformation loan’, which is intended to enable the financing of transformation measures in the building sector, such as energy-efficiency optimisation.”

Green vs brown

Such products raise a question: will just choosing to finance the market’s best assets, which typically have the highest environmental performance credentials, be enough to earn the kudos of being a ‘green lender’, or should the onus be on funding the transformation of brownfield sites or underperforming buildings into sustainable assets?

Most of our sources argue there is a need for both types of finance. The most important consideration, they say, is the availability of clearly defined loan products aimed at the right outcome.

Christian Janssen, head of Nuveen Real Estate’s European lending business, says a loan must include conditions linked to the collateral’s environmental performance. “If there is not a meaningful reward-penalisation mechanism to incentivise sustainability performance, then it is just a normal loan,” he says. “We have to try to avoid weakening the aim of a green loan, which seeks to bring a real benefit through the use of proceeds for new or existing green projects, or through incentivising a borrower’s behaviour to be more sustainable.”

Loans in which the margins fluctuate depending on the borrowers’ success against sustainable key performance indicators are not new, but they are gaining traction. In September, listed UK property company CLS Holdings sourced a £154 million ($218 million; €168 million) loan from Aviva, featuring a 10bps margin reduction if the company hits targets including reduction of carbon usage.

Andrew Kirkman, CLS’s chief financial officer, says it is a real incentive. “On this loan, 10bps means we will be saving £150,000 per year,” he says. “This is not what will make us work towards sustainability improvement, but it will definitely incentivise us to do more.”

Sources agree that meaningful targets and clear financial implications within loan structures can ensure green loans have an impact. Benjamin Cliquet, head of sustainable finance business development at Vigeo Eiris, an ESG rating and research agency that provides firms with a second opinion on sustainability matters, says one of the firm’s main duties is helping organisations avoid accusations of ‘greenwashing’.

“In order to be credible, lenders and borrowers need some sort of external review or assessment, although they do not have an obligation,” he says.

Janssen agrees that green targets need to be clear in loan deals: “Some lenders might be tempted to have minimal green targets but are aiming to gain a publicity-led green halo, which is something the industry should discourage to avoid the ESG drive becoming meaningless and devalued. The European taxonomy and disclosures regulations should help address this.