Mission Possible: Here’s how to bring debt funds in line with ESG

Until not so long ago, sustainability – or somewhat more broadly, ESG criteria – played only a minor role in the real estate debt fund industry. According to the annually published FAP Mezzanine Report, even just two years ago, very few investors were willing to seriously factor ESG into their lending decisions. To the contrary, the fear was that prioritising environmental or social or corporate governance objectives would be a drag on investment returns. But the market has been changing quickly and considerably. Many investors now only invest in projects that are expressly sustainable for a simple reason: to ensure that asset values are protected into the future. This includes real estate debt funds, despite their generally far shorter time horizons.

Despite this striking recent development, there are still many players in the market who prefer to wait and see while rationalising that the regulatory framework is not completely finalised, or that their reputations could be damaged by interim accusations of “greenwashing”. This thinking, however, is based on a fallacy: There is, in fact, no point in waiting for these regulations to be ultimately enshrined in some sort of ultimate final state, based upon which the industry can then orient itself for the long term, because these regulations will, by necessity, continue to change and evolve. For example, carbon limits will undergo further adjustments as the process of global climate change continues, and building materials and components will be benchmarked against evolving environmental as well as social criteria. On the investment side, sustainability-related regulations and standards will therefore likewise continue this process of dynamic evolution.

But there’s another good reason not to wait: Adapting a fund manager’s business model, which is a prerequisite for offering sustainable investments, is challenging and involves a lot of hard work. The earlier you start this process, the better. Even if it’s not possible to comply with, or even to predict, all of the nitty-gritty details of tomorrow’s regulations when launching or converting a fund today, the fund will surely be far closer to the ultimate objective of ESG conformity than one that doesn’t even attempt to start building these criteria into its investment processes. Even if the ultimate goal posts have yet to be precisely defined, these processes are undoubtedly moving in the right direction. And it’s the experience factor as well: Managers can only learn to compete in this new and dynamically changing market environment by gaining concrete practical experiences with the ESG transformation process, even if only preliminary or transitional.

Bringing ESG standards down to the individual property level is a major challenge

While the regulatory framework establishes specific requirements and standards, the practical details are often perplexingly vague. To take the example of Article 9 investments, the worthy goal is to promote specific actions to limit climate change and its impact and to make human habitats, especially urban agglomerations, more inclusive, safe, resilient and sustainable. Translating such ambitious standards – sometimes seemingly rather over-ambitious – to the investment holding and property level is the major challenge that debt fund managers must face and overcome.

Perhaps we might share our own experience: In converting our own debt fund from Article 6 to Article 9 of the EU Disclosure Regulation, we established new “green loan” criteria, and since the start of this year, we have been strictly limiting our financings to those transactions that fulfil these criteria. To do this, we worked over the past two years together with a specialised consultancy to create our own scoring model based on the criteria of the EU taxonomy, the Carbon Risk Real Estate Monitor (CRREM), and other relevant market standards.

In practice, the EU regulators can surprise with pragmatism

Another experience that has surprised us and others: When regulations actually have to be applied in practice, the EU regulators are often far more pragmatic than their fearsome reputation would lead one to believe. In fact, where details of regulations are subject to differing interpretations or ambiguities, or where there are other doubts or questions, these issues can often be clarified through open and candid dialogue with the regulators. In the case of existing investment holdings, for example, the regulations provide for transitional periods. We were able to reclassify our FAP Balanced Real Estate Financing I fund in accordance with article 2 para. 17 of the Sustainable Finance Disclosure Regulation (SFDR) with effect from 1 June 2023, even though only 65 per cent of the investment holdings were Article 9 compliant. That being said, we are working hard to steadily increase the percentage to 90 per cent, if possible by the beginning of 2024, and we have been also putting plans in place so that we can more efficiently react to future changes as they arise. That’s important for everyone to think about – because more stringent criteria will definitely come!

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