Octopus: How ESG is changing the shape of real estate financing

This article is sponsored by Octopus Real Estate

Incorporating ESG into real estate investment has not necessarily been straightforward, but perhaps that’s starting to change?

I definitely think it is. If I think back to conversations we’ve had with institutional investors over the last five years, in the beginning discussions were very much around the process of due diligence where investors wanted to make sure you were approaching things in the right way. But ESG wasn’t front and centre in their thoughts, it was a hurdle you had to jump over in the same way as having good information systems or a good risk and compliance function.

Things have certainly changed over that time period and questions around ESG are among the first to be asked rather than being part of a box ticking exercise. It’s now seen as a really big opportunity and sometimes the entire purpose of the fund. Even if it’s not, it has to be front and centre – not just something that you give cursory attention to but embedded in what you’re doing. That’s the biggest change for me, and UK and European investors are further in this process than perhaps US or Asian investors. We’re aware of conversations where ESG is the first point that gets raised and is central to the goals investors are trying to achieve. In some cases, this comes from the pension fund world and what the underlying members of pension schemes are demanding from them.

Does the impetus for ESG advancement come primarily from fund managers or investors?

I think it’s a bit of both. It will increasingly be driven by the investors. It depends on the type of investor, but multi-manager clients are saying they want their managers to deploy money into specific areas that deliver goals beyond a financial return. Whether it be linked to climate change or achieving certain social goals, they want more “so what” behind their money, they want to understand what the money is actually doing. So rather than just a list of excluded sectors, which is what it was a few years ago, it’s about wanting to know what that money is achieving beyond a target return and I think that’s more and more driven by the investors.

How do you set objectives and what sorts of things can be delivered by your investments in an ESG context?

To take one example, we launched a partnership with Homes England recently called the Greener Homes Alliance, which is a funding partnership between Octopus Real Estate and the government’s housing delivery agency, which works to help achieve the government’s target of building 300,000 new homes a year in the UK.

Homes England also has a mandate to nudge the market in areas like delivering highly energy efficient homes or using modern methods of construction like modular housing. Our partnership with Homes England is a £175 million (€210 million; $237 million) scheme where we are, through our development lending team – which lends money to housebuilders – providing loans to small and medium-sized housebuilders of between £1 million to £20 million to develop new flats and houses in England.

“A lot of SME housebuilders want to… deliver these highly environmentally friendly homes, but they don’t know what to do”

So far, that sounds exactly like what we’ve done for many years but the difference here is housebuilders who borrow from the scheme can get up to a 2 percent interest rate saving based on the Energy Performance Certificate rating they deliver. If they deliver EPC ‘A’, which is the highest, they’ll get a 2 percent discount. That’s 2 percent off their interest rate, so if they were borrowing at 7 percent, their interest rate becomes 5 percent, which is material. Those savings can be used to fund the technologies they need for the EPC A rating, such as triple glazing, air source heat pumps, roof-mounted solar panels, all the things you need to achieve those high EPC ratings. That’s the first part of it.

The second part is education. We’re working with Octopus Energy, our sister company, together with McBains, which has an environmental sustainability practice, to educate housebuilders. A lot of SME housebuilders want to do this, they want to deliver these highly environmentally friendly homes, but they don’t know what to do so they get free advice from Octopus Energy and McBains. We help guide the design process and make modifications to achieve their aims. We’re quite excited about that because we hope it will deliver 750 new highly energy efficient new homes in the UK. We also like that we’re working at grass roots with small housebuilders, and that they will go on and do this as part of their normal course once they’ve been through the process.

How did that partnership come about and are you looking for more of that type of thing?

It came about through a meeting that one of our founders had with Homes England, funnily enough at a conference in Tokyo. They bumped into each other, had a chat and we got to meet the Homes England team and things grew from there. It was a meeting of minds in terms of the aspirations we had for the sector. We are keen to do more and since we announced that partnership there has been quite a lot of interest from institutional investors looking to do similar things in the area of delivering highly energy efficient buildings into the UK.

And you are also involved on the social side as well, in terms of care homes and retirement homes?

We are a big landlord of care homes and we have a strategy with operators and developers to bring new care facilities into the UK, with over £1 billion in that strategy. It’s an impact strategy which effectively means it’s not only looking at delivering a steady, inflation-linked return to investors, but also at the impact that we’re having.

That impact equates to the number of high-quality care beds that we deliver into the UK. And high quality for us is in two parts – it means the quality of the real estate, which is about modern purpose-built facilities, all bedrooms having ensuite wet rooms, the way care homes should be designed; but also it’s about the quality of the care that’s being delivered in those homes. That’s how we underwrite the operators who are entering into leases. Our development lending team also provides development funding to care home operators, so we deliver UK care homes as a landlord, as a forward funder, but also as a lender.

“One of the challenges is going to be how we link up institutional funding, government incentives and all the other parties in the sector to help retrofit and future proof existing buildings”

With retirement living, whereas care homes are very much an environment where you’d live later in your life, the retirement community is for younger residents who would be looking to buy property – in some cases renting, but mostly buying – and that’s much more of a lifestyle move. We have a strategy with Schroders where we’re delivering modern purpose-built retirement communities into the UK with the average length of stay being about 10 years. Typical buyers of these properties still tend to drive cars and are much more active with communal facilities and organised activities plus care if they need it.

That’s really more about providing a community that’s combatting the loneliness that you often have when people are living in family homes by themselves or with their husband or wife. The benefits of living in an integrated retirement community versus living on your own have really shone through during the pandemic.

Could you explain a little about how the risk-return metrics work for sustainable real estate investments?

If you take what we’re doing in the Greener Homes Alliance, we incentivise developers to deliver to higher Energy Performance Certificate standards. If you took a different example, say the funding of a care home, we would look at Building Research Establishment Environmental Assessment Methodology (BREEAM) ratings as one way of looking at the sustainability of a care home.

The sort of discussion we would have in the investment committee is when an operator or developer is seeking funding for a new care home, and they are targeting a BREEAM rating of ‘good’. What additional investment would be required to increase this rating to very good, excellent or outstanding? We think that’s the right thing to do because it often doesn’t cost a lot more to increase BREEAM ratings and it creates a building that’s going to be more sustainable and in the long term it will produce real estate with a higher value.

You could look at that and ask why you would spend extra hundreds of thousands of pounds on a construction contract that could be, say, £8 million, when it might not produce any additional value on day one. We think over the medium to long term it definitely will, so in these discussions we are not met with resistance from our investors when they realise that we will sometimes invest a bit more into a care home to deliver it at a higher standard.

Our care home strategy is evergreen, so these are assets that are going to be around for the long term, where it makes sense to spend a bit more and build something that we’re proud of. Five or more years ago, some of these discussions might have been more difficult but I think now you are really pushing at an open door when you’re talking about this.

Finally, there’s a huge need for capital. How does enough of it get into the area of sustainable real estate?

One of the challenges, which I don’t think we as a sector have properly gripped, is how we are going to fund all of the retrofitting and bringing buildings up to standard. There’s a concept of embodied carbon where you look at a building and measure the carbon that’s embodied in that building – what’s required to build it, to run it and then potentially dispose of it at the end.

What a lot of people talk about is shiny, brand-new buildings and the energy ratings and efficiency of those buildings. If you’re doing that on a greenfield site that’s one thing, but if you’re knocking down an existing building which has been around for 30 or 40 years, there’s a carbon cost in doing that. So, I think one of the challenges is going to be how we link up institutional funding, government incentives and all the other parties in the sector to help retrofit and future proof existing buildings rather than knocking everything down and starting again, which we clearly can’t do.

You’re seeing some of the pressure of this in the residential sector with the government starting to deliver incentives for homeowners to adopt air source heat pumps. There’s a lot more work to be done in this broad area because clearly there’s billions and billions of pounds of investment needed for both residential and commercial property – and you can’t just start again.

Benjamin Davis is chief executive officer of Octopus Real Estate, the London-based specialist real estate investor