Sustainable Lending in Real Estate Finance

Sustainability is now firmly at the top of the agenda, but the term has an enormously wide scope. Mirroring the approach of the bond market, two categories of sustainable loan are developing:

• sustainability-linked loans, where key performance indicators are used to set sustainability performance targets (SPTs) and there is an incremental pricing benefit for meeting those SPTs; and
• green loans, to finance green improvements or developments or to finance a green asset.

In this briefing we look at their use in the real estate finance market.

Impetus for change

The drive to create a green economy has accelerated, powered by a confluence of environmental and societal forces. ESG is now a core strategic focus of many businesses, and of their investors and lenders. There is a pressure and a desire to do something meaningful. The green and sustainable bond markets are relatively well developed compared with the equivalent loan markets, however. Further, central banks and financial institutions are recognising that the risks from climate change, and also from lack of biodiversity and nature-based risks more widely, are financial risks like any other, and this is likely to affect credit decisions.

The real estate sector will be absolutely key in the move to net zero and in real estate finance this means there will be a need to finance (and re-finance) green buildings and also to fund the development and improvement of existing buildings. However, the relatively nascent sustainable lending market means that there is a lack of consistency in the terms and the language used to describe the products, and also a variation in lenders' eligibility criteria for the products that they offer.

The scaffolding

The term sustainable lending encompasses both sustainability-linked loans and green loans. The loan market trade bodies globally have developed high-level market standards for each of these; for more detail on this please see BOX 1. These are not legally binding but are intended to provide some consistency across the market.

Inter-linked is the developing legislation and regulation, which can be used to answer the two key questions in sustainable lending:

1. Is it "green": How do you determine, in an objective way, whether the asset or development being financed is environmentally sustainable?
2. What if it isn't? How do you ensure that there is some accountability for borrowers and financial institutions, and counter sustainability-or green-washing?

The EU Taxonomy Regulation sets out how a decision is made as to which economic activities are environmentally sustainable. It is intended to be a tool to assess whether a financial product or business is environmentally sustainable, and to enable comparison of the "greenness" of different activities. See BOX 2 for more details. The UK is working on a similar taxonomy as part of its wide-ranging Green Finance Strategy: the Green Technical Advisory Group, chaired by the Green Finance Institute, will make the recommendations. It is expected to be broadly similar to the EU Taxonomy but there may be some differences in approach (for example a principles-based approach, rather than a prescriptive one, would have the potential to be more flexible).

Both the UK and the EU have already expressed an intention to impose ESG reporting requirements under their respective sustainable finance strategies. In the EU so far this focusses on the financial sector, but the UK has gone further by publishing a roadmap to mandatory Taskforce on Climate-Related Financial Disclosures (TCFD)-aligned disclosures across financial and non-financial sectors. This is coupled with increasing investor demand for enhanced disclosure of sustainability-related information. 

BOX 1: Sustainability-linked loans

BOX 2: EU Taxonomy Regulation

Sustainable lending in real estate

• Sustainability-linked loans have the advantage of flexibility because of the wide scope of the SPTs, the targets which must be met for the margin to decrease.
  • The SPTs can be set by reference to sustainability goals which relate to the borrower's business as a whole, aligning with its own ESG strategy; this is often the approach in corporate facilities. Typically 3 or 4 SPTs will be set, for example relating to improving the energy efficiency of an aspect of the business, using more renewable energy or reducing emissions of greenhouse gases.
  • Increasingly in real estate finance, the SPTs are more narrowly defined and linked to a particular asset or development being financed. For example, the margin decrease in a development financing could be contingent on certification as a Net Zero Carbon development in accordance with the UK Green Building Council framework at various stages.
  • A sustainability coordinator, or sustainability structuring agent, may be appointed from the lender group to assist in the process of setting the SPTs. In some cases, further external input may be needed to confirm that the KPIs and SPTs are appropriate.
• While there have been relatively few green loans to date, there is scope for these to be used more widely in real estate finance since tight controls over use of proceeds and rigorous reporting are already features of the market. For example, a loan could be made to finance or refinance a green building, or to fund capital expenditure for improving energy performance or water consumption in a building or portfolio.
• The sophisticated standards of measurement in use in the real estate sector can help in demonstrating satisfaction with lenders' eligibility criteria, whether in setting SPTs in sustainability-linked loans, demonstrating that an asset or development is green, or reporting on compliance with sustainability or green-requirements. See BOX 3 for more details.

BOX 3: Real estate activities

Challenges

• Lack of consistency across the market in terminology, in products and in eligibility criteria. There is no universal standard of what a green building is, for example, or what retrofit projects should qualify as a green project for the purposes of designating a green loan.
• Lack of a standard methodology for reporting: there is, so far, no accepted methodology for reporting on SPTs, in particular. Lenders will almost always require a level of verification, audit or third party review of the borrower's reports, which will add to the cost and time burden on the borrower of servicing the loan. In the real estate finance market, lenders usually want to have at least a contractual right to require external review, but the market has not yet agreed on who will fund this. It is possible that if borrowers see tangible pricing benefits from their loans being sustainable, they will be happier to bear this cost.
• The over-arching concern of lenders and also of regulators and investors, is avoiding green- or sustainability-washing in making sustainable loans. Individual lenders have their own eligibility criteria, and a fear of reputational damage may mean that these are more stringent than the Green Loan Principles or Sustainability-Linked Loan Principles (see Box 1) in some respects. This will affect the setting of SPTs, the eligibility criteria for green assets and developments, analysis of the overall impact of the financing, and also the reporting requirements.

Consequences of failure to meet SPTs or to be green

• In sustainability-linked loans, if the SPTs are not met, the margin may increase. One question is whether it will increase above the original level as a further incentive. If so, it is possible that the additional cost of servicing the facility could be diverted into improving the borrower's ESG performance, for example, since many lenders may not think it appropriate to benefit from a borrower's failure to meet its sustainability targets.
• It would be very unusual for the failure to meet an SPT to constitute a default in a sustainability-linked loan, although the provision of inaccurate information or a breach of a general reporting obligation may be a standard breach of covenant leading to an event of default.
• What will constitute a "green breach" under a green loan may also vary from loan to loan: the key message in the Green Loan Principles is that any breach of the use of proceeds provisions should be taken seriously and the loan should not be considered green from the date of occurrence of such event. What that actually means in practice is less clear.
• It is possible that a failure to apply the proceeds of a green loan towards a green project or asset could be deemed sufficiently serious to constitute an event of default however, in contrast with the consequences of failure to meet SPTs in a sustainability-linked loan.
• Alternatively, if a green asset fails to meet the relevant criteria in a periodic assessment, the lenders could require that the relevant loan is no longer referred to as "green" in any publicity materials issued by the borrower, and it is removed from any relevant lists which refer to it as such.

The future

Given the intense focus of investors, society, governments and regulators on sustainability, the direction of travel in this area seems clear. There may be further developments in greening the financial services sector, for example differentiating the capital treatment of green and sustainable loans, which would provide an added incentive for lenders. The development of the UK taxonomy, and the technical standards associated with the EU taxonomy will help a market position on eligibility criteria develop, and hopefully market practice around reporting standards and requirements will also coalesce.

Please do speak to one of our team to discuss this in more detail, and to see how sustainability-linked loans, green loans or other ESG requirements, may be relevant for your business. We have also issued a podcast on this topic, which is available here.