Sustainability and real estate: lending risk

21 February 2017

Sustainability in real estate is finally being taken seriously, says Jessica Pilz, but lenders need to do more to keep pace with this progress

Over the past decade, the real-estate market has witnessed a sustainability revolution. We have addressed our initial curiosity and scepticism about green buildings, discussed green premiums and brown discounts at length, and navigated our way through a plethora of benchmarks and rating tools. Today, we are coming to terms with the way energy-efficiency regulations, the health and wellbeing agenda and the Paris climate agreement will affect the properties we own, occupy, manage or finance.

However, despite this progress and the hope that sustainability is being treated as the norm, a large part of the market is still lagging behind. Sustainability has evolved, but the extent of this evolution varies across a number of disciplines in the real-estate market. In fact, sustainability remains a di£cult or even overlooked subject for many who are not directly involved with it. This is particularly true for lenders who, broadly speaking, are some way behind the equity side of real estate.

While the financial crisis of 2008 provided an opportunity for many to raise the profile of sustainability, it also resulted in an increase in the number of risks that lenders have to consider. As a result, sustainability has had to compete for attention with issues such as money laundering, legacy conduct, competition law, and anti-bribery and corruption legislation. While this remains the case, there has been a definite change in lenders’ attitudes towards sustainability over the last year.

What has changed?

A number of factors have prompted lenders to get to grips with the risks and opportunities associated with sustainability. The Paris agreement in particular marked an important step for lenders, especially those who signed the European Financial Services Round Table’s Statement on Climate Change and the Paris Pledge for Action. As a result of this commitment, lenders will be looking not only to reduce their carbon footprint but also to help customers, particularly those in carbon-intensive industries, to lower their emissions.

The widely discussed Energy Efficiency Regulations (Private Rented Property) (England and Wales) Regulations 2015 – more commonly referred to as the Minimum Energy Efficiency Standards (MEES) – marked a major turning point for lenders financing properties in England and Wales when they were approved in March 2015.

The potential effect of these regulations on a property’s cash flow – including rental income, void periods, capital expenditure and potential fines – will have forced many lenders to consider how substandard energy performance certificate (EPC) ratings may affect credit risk (see the related feature MEES: know the risks).

Customers have played an equally important role in getting lenders up to speed with these matters. Given that customers increasingly regard sustainability as best practice, lenders have had to improve their understanding of the relevant issues. Industry-led organisations such as the Better Buildings Partnership (BBP), UK Green Building Council and the Global Real Estate Sustainability Benchmark (GRESB) are helping property lenders to get to grips with sustainability.

In November 2015, the BBP launched an insight paper on the impact of the MEES for commercial real-estate lending, drawing attention to the need for lenders to take more seriously the risks  associated with sustainability. In addition, the partnership’s Commercial Real Estate Lending Working Group provides a platform to share and develop best-practice in sustainability for lenders.

Despite the slow start, lenders are more aware than ever of the contribution they can make to improving the sustainability of the real-estate sector – particularly since their influence on the market extends well beyond those who are leading the sustainability agenda.

Risks and opportunities

In order to embed sustainability, it is imperative for an organisation to determine what the concept means to it, and identify what the specific risks and opportunities are. The term 'sustainability' is used so frequently and has evolved so substantially over the last decade that it is unlikely to be applied in the same way by everyone.

There has been a definite change in lenders’ attitudes towards sustainability over the last year

In addition, the real-estate sector’s notorious variety of disciplines has made our definition of sustainability even more blurred. For instance, it is less likely to be a real-estate issue for a retail tenant and more of a supply chain matter. With a real-estate lender on the other hand, who has limited influence over how a building is managed, sustainability is more likely to be considered in the context of cash flow risk and reduction in values.

The introduction of the MEES has created an obvious concern for lenders, given that the legislation will prohibit the letting of properties in England and Wales with substandard EPC ratings from April 2018. Lenders should increasingly be looking to assess their borrower’s cash flow risk, which will be affected by the potential loss of rental income, additional capital or operating expenditure, longer void periods and penalties for non-compliance, the overall result being possible reductions in market values.

The MEES regulations have gained a lot of attention over the last year, but there are other environmental risks that have been considered by most lenders for some time now. This was highlighted in the GRESB Debt Survey in 2015, which confirmed that issues such as flood risk, building safety and materials, land contamination and natural hazards have been embedded in standard due diligence processes and third-party reports for some time. However, it also confirmed that other risks such as green building certification, flexibility of use and energy consumption have not yet been widely incorporated into standard third-party reports.

Beyond pure risk management, there are also opportunities associated with more sustainable buildings that lenders are now considering more often. Early findings from academic research in the USA support the case for incorporating sustainability characteristics into mortgage or bond underwriting.

One study, based on 22,000 loans by a large commercial mortgage-backed security pool, shows commercial mortgage loans secured on assets with an Energy Star rating have a 20% lower likelihood of default. The results for the Leadership in Energy and Environmental Design initiative were even stronger, showing a 30% lower likelihood of default for rated assets.

Future impact on lending

As lenders gain a better understanding of the risks associated with sustainability, it is inevitable that the market will see an increasing number of measures being implemented to manage these. Similarly, on the opportunity side, it is likely that more green loans and lending products will become available.

In the USA, one of the largest residential lenders offers a 10-basis-points reduction in borrowing costs to multi-family buildings with a green certificate. Closer to home, a number of UK and European Banks are focusing on ways to help their customers improve the sustainability of their properties, and we at Natwest are no exception. In addition to lending more than £1bn to sustainable energy projects in 2015, we have spent the last year improving the way in which we manage environmental and sustainability risks in commercial real-estate transactions.

Education, both internally and externally, remains one of the most important solutions for the lending community. Changing behaviour and processes, when there are already so many additional externalities to consider, is a challenge. It would be unrealistic to say all lenders have started to address  the risks and opportunities associated with sustainability, but the last year has seen a clear change in attitude by many.

As we embark on an uncertain future outside the EU, understanding known factors such as the MEES becomes even more important. As Warren Buffett famously remarked, 'Risk comes from not knowing what you’re doing.' For lenders in particular, it will only become more important to stay abreast of these risks and the ongoing evolution associated with sustainability.

Jessica Pilz is Property Environmental Manager, Portfolio Controls, Commercial Real Estate Credit, Risk Management, Natwest

Further information

• Related competencies include Investment management, Sustainability
• This feature is taken from the RICS Property journal (December 2016/January 2017)