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Lenders: Project Financing Availability is Key to EGD’s Success

EUPOPEAN GREEN DEAL - TOWARDS A ZERO-CARBON URBAN ENVIRONMENT, Part 5

By Christos Angelis, CAIA - Director at Masterdam

This is the fifth article in this series. For Part 1, please click here.

LENDERS TO PLAY A MAJOR ROLE IN THE SUCCESS OF EGD

As discussed in previous articles, the European Green Deal (EGD)[i] is expected to have a major impact on European real estate. Its goal to initiate a Renovation Wave[ii] in the existing building stock could be a catalyst for starting new refurbishment projects across Europe. These projects will require substantial investments in the form of equity and debt. Real estate investors rely heavily on debt financing typically exceeding 50% loan-to-value for income producing assets. Project financing can reach even higher to 75% loan-to-cost depending on the market, project size and risk profile of the asset. By default, real estate lenders are bound to play a major role in directing capital towards sustainability projects. Lenders have a great responsibility to support EGD, which requires deep understanding of the underlying risk and return factors of real estate sustainability investing.

GREEN FINANCING: MARKETING INITIATIVE OR A VIABLE BUSINESS LINE?

Traditional banks and alternative lenders have put significant effort in positioning their organizations as ESG lending focused. Their marketing campaigns typically feature green buildings, initiatives to help communities and support for small-medium size businesses. The reality is rather different. Green financing is a small part of the overall lending business despite a few sporadic but highly published sustainability projects, which tend to be the exception rather than the rule. Furthermore, lenders still have a lot to learn about real estate sustainability from a technical and investment perspective. The level of know-how is very different among organizations (international versus local lenders) and EU member states. The majority of loan officers have a business degree and their main focus is on deal origination and credit analysis. Without extensive training provided by the company or external parties, they will continue to lack the knowledge and expertise to correctly assess a sustainability project based on merit rather than marketing impact. This is a dangerous path because unsuccessful ESG financing programs might shake confidence in the capital markets. Green financing should make sense economically in order to be a viable business line for lenders.

The truth is that lenders have not been entirely idle towards learning more about ESG. There is a positive development within the industry with financial institutions hiring ESG specialists and creating dedicated ESG teams. Moreover, real estate industry organizations such as RICS, ULI, EPRA and INREV are increasingly focused on sustainability through white papers, guidelines and seminars. However, issuing annual sustainability reports and participating in ESG webinars might serve the lenders’ marketing agendas but it is not sufficient to make a meaningful contribution towards the goals set by EGD. The challenge is to incorporate ESG investment principals in loan origination, due diligence, credit analysis and loan monitoring processes. Changing the mindset of a whole organization takes time and requires a fresh look into economic drivers and credit assessment in line with the principles of sustainable real estate and circular economy.

REWARD FOR SUSTAINABILITY LEVELS

Debt providers are well-positioned due to their network to provide easy access to financing for retrofit projects. That is why local governments typically create partnerships with banks to run EU subsidy programs. In most EU member states, there are financing programs for energy efficiency improvements in residential properties, which are fully or partially subsidized by the EU. Furthermore, there are financing programs in co-ordination with major energy companies for the installation of solar panels in both residential and commercial buildings. Subsidies are a great way to kick-start the renovation wave in Europe. However, long-term measures are required for green financing to mature as an established business line.

One potential measure could be for banks to provide interest rates on mortgages based on the sustainability level of the properties. The higher the energy performance certificate, the lower the interest rate based on a well-defined framework. Properties with higher energy efficiency have lower operating expenses, which should result in higher valuations ceteris paribus. An increasing number of European banks have already initiated such programs for residential mortgages but the sustainability levels required are very high, which can only be achieved by new-built or heavily refurbished properties. Ideally, this mechanism should be implemented to both commercial and residential mortgages across the EU and be regulated by the European Central Bank (ECB). The interest “bonus” should be based on a step-up mechanism with the possibility for a lower interest rate during the mortgage term if sustainability levels go up. This will prompt real estate owners to focus on the sustainability profile of their properties before and during the mortgage term in order to achieve better financing terms.

REWARD FOR SUSTAINABILITY VALUE CREATION

The potential of lower financing costs for highly sustainable properties post project completion is less tangible for owners of properties with lower sustainability levels. As discussed in detail in our article about real estate owners, private landlords, especially in commercial real estate, are in need of technical and financial support in order to engage in energy retrofit projects. It is important for banks to lead this process by providing project financing for private real estate owners at favorable terms based on the targeted improvements in energy efficiency, waste management and other sustainability goals.

REWARD FOR CIRCULARITY

Lenders are typically excited about ground-up development projects for various reasons. First of all, ground-up projects with experienced developers backed by reliable construction companies tend to have predictable results in terms of budgeting and execution time. Secondly, the completed properties will most definitely be modern and commercially competitive in their respective submarkets. Thirdly, brand new properties tend to be eye-catching that makes them suitable for marketing purposes, which could generate more business for the lenders. On the other hand, lenders are cautious with refurbishment projects, which include energy efficiency retrofits, due to higher execution risk. Cost-overruns and project delays are rather common in heavy refurbishment projects since problems may arise when the buildings are being modified due to the uncertainty deriving from potential issues visible after demolition.

From an ESG perspective, real estate refurbishment projects have the highest environmental impact and they typically follow the principles of circular economy. EGD’s focus is on renovation rather than new development. Lenders should prioritize on refurbishment projects and certainly price the risk accordingly. Fixation on ultra-high certifications only achievable through new-built may be good for marketing purposes but it does not support EGD’s goals.

GREEN BONDS: INFLEXIBLE SOURCE OF FINANCING FOR RE PROJECTS

Green bonds have emerged as an interesting alternative to traditional mortgages for real estate investors with larger integrated platforms. Such bond issuances can be successfully placed with impact investors resulting in attractive financing terms. However, this source of financing is typically available to larger real estate companies with existing real estate portfolios and lower risk profile. Loan drawdown requirements can also be cumbersome, hindering the speed of execution for new acquisitions or projects. Many market participants with active acquisition / development pipelines argue that the limitations of green bond financing outweigh the benefits in terms of lower cost of debt and light covenants.

SUSTAINABILITY LINKED LOANS: A NEW HOPE

Sustainability Linked Loans (SLL) are an innovative form of financing that has emerged in recent years in an effort to provide tailor-made financing products to real estate sponsors. The beauty of these instruments is that the lender can agree on specific ESG targets as drawdown requirements or loan covenants, which are applicable to the specific sponsor. For example, if the sponsor has a low GRESB rating but has the ambition to increase it through targeted measures, the lender could structure a loan facility contingent on improving its rating in the foreseeable future through concrete actions e.g. increasing the energy performance of existing buildings or implementing sustainable building designs and construction methods for new projects. In this fashion, real estate owners are rewarded for their effort in improving the sustainability profile of their company and underlying properties. Lenders have the right to pull the plug on the loan facility if the ESG drawdown requirements are not met or the ESG covenants are breached during the term of the loan. The problem is that structuring and monitoring such financing programs require technical and investment expertise in ESG and real estate sustainability investing. Currently only modern European banks and a handful of innovative alternative lenders have the skills and capacity to offer such products. As ESG is becoming more integrated in the European financial system, we should expect a rise in SLL volume going forward.

HOW COULD EGD HELP?

Real estate lenders should be a key focus group for the EU in terms of their marketing and knowledge sharing campaign for EGD. If debt financing providers have a good understanding of the technical and economic aspects of sustainability real estate, they will be well-positioned to offer suitable products to their clients increasing awareness about the opportunities created by EGD.

TECHNICAL SUPPORT

Lenders should be in a position to understand the underlying risks and return drivers of value creation through sustainable property investing. The challenge for credit analysts is how to properly reflect improved property sustainability into lower credit risk and higher valuations. This requires interaction with specialized technical companies as well as the departure from the principles of traditional property valuation and credit analysis. EGD is committed to join market participants such as local governments, technical advisors, installations companies, real estate owners / investors and lenders in order to promote cooperation. This would be a great opportunity for debt providers to leave ivory towers and gain applied technical expertise.

ECB RULES

It would be highly encouraging for lenders to be rewarded for providing sustainable financing to real estate sponsors for retrofit projects. An effective measure could be implemented by the ECB regarding the level of risk capital required by lenders for green financing. The higher the sustainability profile of the loans, the lower the risk capital. This will prompt lenders to focus their efforts of this part of the market and create specialized ESG-financing departments. 

GUARANTEES

EGD has already announced the it will provide financial support in the form of guarantees through the European Investment Bank and other EU vehicles to green financing initiatives. Unfortunately, the EU is not known for its efficiency and speed of execution when granting financing or guarantees to 3rd parties. Red tape should be minimized for green financing. An easily accessible and straight-forward guarantee system would be very helpful for lenders to place new financing products into the market. Another idea would be for the EU to provide guarantees for securitization of green loans, which can be distributed to institutional investors.

CONCLUDING REMARKS

The real estate industry is relying heavily on debt financing for asset acquisitions and execution of new projects. Debt financing providers are key in order to increase the volume of retrofit projects in line with EGD’s objectives. Despite a handful of high-profile sustainability projects in a majority of their ground-up developments, the European financing system has a long way to go towards embracing green financing as a viable business line. One reason for that is the lack of expertise in sustainable real estate investing within banks and alternative lenders. EGD can be a catalyst for financial product innovation embracing the principles of ESG investing and circular economy. A great example of product innovation is Sustainability Linked Loans. These financing instruments are highly suitable to meet platform and project financing needs due to their tailor-made approach towards the ESG improvement potential of the sponsors. EGD can support lenders by providing technical expertise, preferential treatment of green loans from a capital risk perspective and guarantees for sustainable financing programs. The goal should be to mobilize as much private capital as possible towards renovation projects with economic merit. Lenders are bound to play a critical role in directing capital for sustainability projects and will be key in EGD’s success in the real estate industry.

CHRISTOS ANGELIS, CAIA

Director at Masterdam

Chris is a real estate corporate finance advisor at Masterdam and the Head of CAIA Netherlands. As an investment professional, he is committed to a better urban environment by supporting real estate innovators. He has more than 12 years of experience as a portfolio manager and investment advisor in European real estate markets. Chris holds a MSc in Finance & Investments from Rotterdam School of Management (cum laude) and has attended executive education courses at INSEAD Business School. He has been a Chartered Alternative Investment Analyst (CAIA) Charterholder since 2012 and a member of CAIA Netherlands executive committee since 2015.

[i] https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal

[ii] https://ec.europa.eu/commission/presscorner/detail/en/IP_20_1835