IMPACT FINANCE SERIES: Part III – The Assets
So far, our Impact Finance series has defined the relevant investment styles (responsible, sustainable, impact and transition) and themes (environmental, social, climate and green), whilst also exploring recent trends in the capital markets across equity, debt and insurance. Now, in this third article, we explore how the real estate market is using and driving sustainable finance solutions, whilst also considering the financial risks for those that are out-of-step.
In London, some property owners are in the vanguard of innovation in ‘green’ debt finance. In July 2019, Lloyds provided Blackrock with a £200m loan to finance energy efficiency improvements in the Blackrock UK Property Fund. Later that year, Derwent agreed a £450m revolving credit facility (RCF) of which £300m was designated as ‘green’ and will fund the construction of efficient buildings and improvements to their existing assets. CBRE Global Investors followed in March 2020 with a £60m green RCF to fund specific energy improvements to an industrial asset. These facilities are utilising the “Use of Funds” concept which is embedded in the IFC’s principles for green bonds and the LMA’s principles for green loans.
By February 2020, GPE had taken this innovation one step further by agreeing an RCF which was not only linked to the proposed use of funds for environmental purposes, but also includes financial downside risk for GPE if environmental outcomes are not delivered. GPE has to hit KPIs on energy usage and biodiversity across its portfolio, and embodied carbon in its new buildings and major refurbishments. If GPE hits the targets, then the margin on the facility will decrease by 2.5 basis points; if not it will increase by the same amount. Either way, the difference will be given by GPE to registered charities focused on environmental issues. This is clearly a genuine financial incentive for GPE to hit its ESG targets and a clear acknowledgement by the lenders that management of ESG risk is fundamental to credit risk. Therefore, a reduction in ESG risk can be tied to a reduction in the interest rate attached to the loan.
The understanding that ESG risk and credit risk are intrinsically linked is not new. Since 2016, Lloyds has offered discounts of up to 20 basis points for clients meeting sustainability targets. Similarly, since 2017, ING has offered sustainability improvement loans for corporate clients, providing a lower interest rate for improved sustainability performance. The integration of ESG risk to the pricing of credit is clearly growing: GPE’s lenders included Santander, NatWest, Wells Fargo, Lloyds Bank plc and Bank of China. Others will follow.
Financiers are also seeking to take these innovations beyond the corporate market. The Green Finance Institute has convened the Coalition for the Energy Efficiency of Buildings to bring lenders, builders, advisers and government together to accelerate capital flows towards retrofitting and developing UK homes to net-zero carbon, resilient standards. This will require not only innovation and a willingness to try a number of approaches, but also resilience and a willingness to learn lessons from failure. There are obvious examples.
The UK Government previously created the Green Deal Finance Company: a lending structure which turned builders into loan originators and energy companies into debt collectors. It failed – both financially and in its mission to catalyse energy efficiency improvements across the UK’s housing stock . The idea had potential, but warnings were ignored and the ultimate method and structure of implementation were fatally flawed.
‘Green’ Debt Securitisation
Other innovations in the residential market have been more successful. In the US, Fannie Mae (or FNMA, the Federal National Mortgage Association) launched its Multifamily Green Financing Business in 2010. This offered ‘advantageous’ lending terms to owners of multifamily rental properties who were willing to commit to target reductions in energy and water consumption. Since 2012, Fannie Mae has raised additional finance by using these loans as the basis for green mortgage-backed securities (MBS) and became the world’s largest green bond issuer with more than $50 billion issued by Fannie Mae by the end of 2018. Various private lenders now offer preferential mortgage rates to borrowers buying highly energy efficient homes, and low interest loans for those wishing to make energy performance upgrades.
The natural progression in the private sector is, therefore, for more lenders to issue green MBS (mortgage backed securities). This is already happening, including issuers such as Natixis and Goldman Sachs in the commercial mortgage market  and Obvion (part of Rabobank) and NAB in the residential space . In both markets, the securitisations tend to be labelled “green” on the basis that the underlying buildings against which they are secured are high quality from an energy performance perspective. The “green-ness” can of course be debated in that most building ratings are based on the assumed performance of the building based on a hypothetical reference model. Actual performance in use may – almost invariably does – differ. Likewise, these ‘green’ badges tend not to take into account embedded carbon related to the building process and materials used for construction, nor the other environmental implications of the building (such as locational implications for transport, impact on green space or biodiversity, water and waste efficiency etc).
However flawed the labelling, this is a start. As we saw in the first article in this series, regulators and industry bodies are now stepping in to clarify and clean up the labelling. So, what of this trend for ‘green’ mortgages and the related securitisations? Do they help to decarbonise real estate stock? Probably not. The assets underlying these structures are being built for low and zero carbon performance due to increasing regulation and occupier demand. But they do help investors to understand what they hold. If you are holding a portfolio of MBS of which only 5% is labelled ‘green’, then you can assume that the other 95% is not only underperforming from an environmental perspective, but it is also exposed to significant regulatory risk and is off-trend in terms of what occupiers increasingly expect. Thus, the 95% is exposed to pricing and demand risk, possibly even stranded asset risk (which undermines the residual value assumptions which will have been made by the originator). Investors can now see clearly where some material financial risks sit in their portfolio, and therefore start grappling with quantification, disclosure and reduction of these risks.
Energy performance is not the only relevant risk. Beyond the “in use” energy efficiency of buildings, real assets can be exposed to risk around water and waste efficiency, extreme temperatures and weather events, and other physical climate-related risks (flood, wildfire, mudslide, coastal erosion, rising sea levels). Very few asset owners have a strong understanding of the full financial implications of these risks. All climate-related risks which lead to financial risk must be considered by the 1,000 banks, asset managers, pension funds, insurers, credit rating agencies, accounting firms and shareholder advisory services which have declared their support for the Task-Force on Climate-related Financial Disclosures (TCFD) and which control balance sheets totalling $120 trillion. The labelling of certain assets as “low” risk on one climate-related measure should serve as a red flag for investors with regard to the rest of their portfolio, and the rest of the risks to which they are exposed.
Social, Green, Sustainable & Impact Real Estate Funds
There has also been significant growth in the use of ‘sustainable’ and ‘impact’ labelling and messaging in real estate equity funds (albeit ahead of the formalisation of the term ’sustainable’ in EU legislation). Here too we see significant variance in the type and extent of environmental and social risk management available to investors.
Pension funds – especially the very large funds – are becoming arguably more sophisticated in this space than some of the intermediaries which dream of building lasting relationships with them. Evidence of this can be seen in the levels of sophistication of the sustainability policies these organisations publish, and their increasing appetite for co-investment, where they can exercise a greater degree of strategic control of directly held assets.
Mainstream balanced or sector-focussed funds targeting the institutional market have tended to include at least some commentary on their sustainability performance in either their marketing documents or investor reporting (albeit often in the form of one-off development or refurbishment case studies rather than wholesale portfolio improvement programmes).
Some funds claim they are good for society because the assets themselves have intrinsic social utility. Classic examples include affordable and social housing, and social infrastructure assets such as care homes, medical facilities and schools. Some of these funds are taking the development risk and creating new assets which can be used to serve under-served communities. However, others are simply buying standing assets and often benefitting from long-term, government-backed revenues. One has to question how these managers would answer the third impact management principle which requires that they establish their own contribution to the achievement of the impact.
In the environmental space, there tends to be a more active approach. The Columbia Threadneedle Low Carbon Workplace Fund, launched in 2010, actively seeks office assets which are in need of refurbishment in order to improve their carbon performance. The Fund’s objectives include that occupiers should either meet best practice emissions benchmarks or demonstrate year-on-year improvements.
The Triodos Real Estate Fund, launched in the Netherlands in 2004, sought to improve the performance of its portfolio to the point of reaching net zero carbon emissions (with the use of some renewable energy generation and carbon offsetting). Likewise, the Credit Suisse (Lux) European Core Property Fund Plus, launched in 2016.
It will therefore be very useful for investors to look at labelling and marketing materials again once the new EU regulations come into force. Some funds may have to dampen their marketing claims, and potentially even change their fund name. Others who may not have felt comfortable in using the term ‘sustainable’ given the level of debate in the market may now step forward with more confidence. Likewise, investors should be expected to make reallocations in favour of those funds which they can now clearly identify as ‘sustainable’.
The real estate market has clearly been innovating, but what next? In the next and final part of this series we will explore what the future of the market might look like, potential new product innovations and the joining up of the sustainable and impact equity, debt and insurance financing worlds. We will also consider how this might create winners and losers, and dramatically alter our pricing and management of environmental and social risk.
 IFC – Green Bond Principles
 LMA – Green Loan Principles