How is the ESG real estate loan market evolving?

The CBRE Capital Advisors team works with over 100 lenders in the course of our work, finding the best finance for each real estate project on which we are retained. This article reflects on our experience of how and why lenders are embracing ‘ESG-friendly’ lending, how new guidance is accelerating progress, and what borrowers need to do to meet the new requirements which lenders are asking for.

Lenders are increasingly focusing on ESG issues

Until recently, the real estate lending community has been somewhat behind other areas of the industry in engaging on environmental, social and governance (‘ESG’) issues. This is partly because lenders have not always been sure how to address the issues. Individual lenders also don’t want to put themselves at a ‘first mover’ disadvantage, as it’s a very competitive market.

But some momentum is now being found in a variety of industry-wide initiatives. For example, the Loan Market Association has produced Green Loan Principles (see Box 1). In addition, CREFC Europe are working with lenders to develop uniform guidelines on ESG topics specifically for real estate. These include an ESG due diligence questionnaire, which if widely adopted by CREFC Europe members would raise standards, increase consistency and improve objectivity in the questions which lenders ask borrowers. This in turn would reduce first mover disadvantage.

How lenders are taking account of ESG

The most advanced ‘ESG-aware’ lenders are those with institutional parentage, such as pension funds. This is because the parent companies have strong ESG policies which they want to implement across all their activities. It’s been driven from the top down, particularly over the last 3-4 years. This in turn is often because of pressure on the parent companies from their own equity investors. These firms can’t now credibly commit to (for example) a net zero target without including the lending part of their business in it.

Some individuals within the lending teams of institutional firms may not have believed initially that ESG issues applied to them. However, this is no longer the case and most have it high on their agenda. Internal and external forces have meant they now need to pay attention:

• As soon as policies set at the top of the organisation get fed into credit committee processes, then individuals writing loans need to react to that; and
• Accounting for so-called ‘Scope 3’ (indirect) greenhouse gas emissions has become much more important to these firms. Scope 3 requires firms to look at the downstream greenhouse emissions created by their customers – in this case, borrowers

Non-bank lenders are also affected. Most debt funds also raise funds from third party investors (such as insurance companies and pension funds). So It doesn’t matter who you are – whether bank lending or non-bank lending, almost everyone is now being required to consider ESG when making loans.

One of the first questions these lenders will now be asked by their investors is “what is your ESG and Sustainability policy?” Even if there is a current overlay of concern about inflation and interest rates, the ESG question is still present.

The effect on borrowers

A growing number of lenders, while they may not have a green loan programme per se, do have one in practice, applying minimum criteria relating to ESG as a benchmark for any new lending; if you apply for a loan, but don’t meet certain ESG criteria, then you are making it much harder for a credit committee to approve the loan.

This is at least partly about lenders’ risk management. The risk is not necessarily about creditworthiness, but about screening out borrowers with a poor ESG profile.

So, it is important that any presentation to a lender sets out very clearly the borrower’s ESG strategy overall, as well as the ESG strategy for the building or asset portfolio in question.

Of course, having strong ESG credentials is not in itself enough. The application would still need to meet core credit metrics. However, the more the borrower can illustrate how the green features will increase income, ’future proof’ the building and lower the risks of the transaction, the more the credit metrics can in theory be improved.

Where next for ESG-friendly lending?

This is just the start. In future, lenders are likely to be asking increasingly searching questions not just about the corporates undertaking the borrowing, but about the performance of the underlying assets.

We therefore anticipate more detailed due diligence requirements, specific improvement (capital spending) requirements in the lending agreement, and ESG performance monitoring, with specified KPIs, as part of the loan servicing.

These emerging requirements can already (at least partly) be seen in the guidance specifically covering real estate from industry bodies. For example, LMA guidance (see Box 1) recognises that “Where the real estate … finance transaction includes asset backed security, it will generally be expected that most, if not all, KPIs will be linked to the asset being financed.”

As we’ve shown here, lenders are increasingly integrating ESG into lending decision making, with lending eligibility criteria becoming more commonplace. Borrowers should be mindful of this when capital raising in order to obtain finance at the best terms from the widest pool of potential lenders.  We will explore pricing and terms in a future article in the series.