It is widely accepted that sustainability considerations are now ever more important in European real estate markets. A rising regulatory focus and tightening legal standards, combined with the increasing trend of occupiers and buyers seeking assets providing best-inclass credentials, means environmental considerations are now a crucial aspect of delivering investment performance.
As a consequence, there is a significant opportunity for private real estate debt markets to help institutional investors deliver on their ESG ambitions and obligations, through driving an improvement in building quality and supporting a reduction in carbon emissions, while continuing to generate attractive risk-adjusted returns.
Over the last five years, both the market and regulatory environment have changed significantly. At property level, minimum energy performance standards have tightened across Europe (and will likely continue to do so) while in the financial markets the EU taxonomy regulations came into force in July 2020, and SFDR in March 2021.
At the same time, innovations have been developed in loan structures. The Loan Market Association, an industry body, first published its ‘Green Loan Principles’ in 2018; with guidance for sustainabilitylinked loans (where the interest rate is linked to agreed performance targets) following in 2019. Most banks and private debt fund managers now account for environmental factors in their underwriting and loan structuring; some will offer green or sustainability-linked financing.
Undoubtedly this greater focus in the lending community is welcome, but undertaking a general review of sustainability credentials, or even offering modest incentives, is unlikely to be the most compelling way of helping drive change unless it is done in support of an action plan for delivery.
The environmental imperative applies to existing real estate as much as new build. Approximately 35% of European building stock is over 50 years old and almost 75% deemed energy inefficient.1 However new developments alone will not mitigate climate change - in the UK, the RICS estimates that 35% of wholelife carbon is emitted in the build phase. Stock refresh rates are low and, as a consequence, there is a strong argument that renovation of existing assets offers the widest range of opportunities, and is where the greatest environmental gains can be realised. Often, it also avoids the need for planning and permitting, which in many countries is challenging and time consuming - even for those buildings with leading sustainability credentials.
A thoughtful way of supporting improvements in the built environment - and to allow investors to ensure their capital is being used actively to help drive change - is to support these renovations and upgrades of existing assets, rather than being passively invested in buildings that already comply with current standards.
Supporting this ‘green transition’ through backing business plans which improve assets over the loan term can also result in positive credit migration - the underlying property value is likely to increase through the completion of a renovation project, and the loan-to-value (LTV) ratio may reduce as a consequence. This may not be the case when financing brand-new buildings, where there is often limited opportunity to add further value during a typical loan term.
Happily for investors, these ESG ambitions can be realised while securing strong investment outcomes. As renovation projects will initially carry more risk than fully-leased properties, this typically allows lenders to charge higher interest rates or other fees. Yet when the project has completed, the lenders will benefit from an enhanced property (often with best-in-class sustainability credentials), at a lower LTV ratio but at the same high interest rate, and with potentially enhanced liquidity upon exiting the loan.
1 In focus: Energy efficiency in buildings (europa.eu)
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