Real estate loans in which the margin fluctuates depending on the borrower’s success in meeting sustainability targets are becoming increasingly popular in the European market. But panelists at PERE’s Debt & Financing Forum, held in London last week, debated whether they are an effective way to encourage asset owners to improve sustainability.
Martin Barnewell, investment director in Aberdeen Standard Investments’ commercial real estate debt division, said the main benefit of sustainability-linked debt is its ability to promote transparency between lenders and borrowers while ensuring “they are working towards a common goal.”
“First and foremost, we want to work with sponsors that are committed to improving the sustainability credentials of their buildings, so we set really ambitious ESG [environmental, social and governance] targets for them and reward them for meeting them.
“We will incentivize borrowers with small but meaningful margin reductions, of five to 10 basis points. That’s mostly to recognize that our credit risk has been reduced as they improve the sustainability credentials of their assets.”
Barnewell added that such loans encourage owners of existing buildings to make them more energy efficient. “To future-proof these buildings for the end of a loan in five years’ time, a lot of work needs to be done over that period and we want to make sure our borrowers stay on top of that.”
Stanley Kwong, who leads ESG origination and impact investment strategy for Aviva Investors’ real assets business, agreed that to truly tackle sustainability issues, it is important to focus on transitioning assets that already exist, rather than focusing lending on new, ESG-compliant buildings. He believes sustainability-linked loans can support such transitions. However, Kwong added, the greatest challenge for lenders is to ensure they set truly ambitious targets and link them efficiently to any reward mechanisms.
“The real challenge lies in how to match those ESG targets to incentives, which also protects the ESG risk that you [the lender] have assessed through your ESG integration process,” Kwong said. “Therefore, to ensure we are setting truly ambitious and impactful KPIs, we link them to existing industry benchmarks.”
In addition to setting meaningful targets and clear financial implications within loan structures to ensure ESG-linked loans have an impact, Kwong believes some sort of external review or assessment is also needed. “We always seek a second party opinion to ensure set KPIs are ambitious enough.”
Aside from margin ratchets, some lenders are exploring other incentives to ensure that their finance influences sponsors’ sustainability performance. Pontus Sundin, chief executive of the debt division at Nordic non-bank lender Brunswick Real Estate, said rather than providing margin discounts, Brunswick prefers to offer higher leverage to those borrowers with ambitious ESG targets.
“Rather than perhaps integrate margin discounts in a loan, we are happy to raise loan-to-value from 55-60 percent to, let’s say, 65 percent. I would rather lend a bit more, but both kinds of incentive can work.”
Shripal Shah, head of real estate finance at the UK division of Allianz Real Estate, said he is not keen on the margin discounts incentive. The reason, he explained, is that Allianz strives to finance only those projects that already meet the company’s definition of ‘green.’
Allianz, Shah added, believes a holistic view of ESG is necessary. “Rather than looking to the specific situation around each loan individually, we ask sponsors for their ESG policies and the governance around them. We are very selective on the sponsors and the assets we finance.
“We do not support margin discounts mostly because for us it is more about supporting the right projects from the start. For us, this is not about offering slightly cheaper pricing if they do certain things. We want every single loan we originate to be a green qualifying loan. They should be ticking all our boxes on the green side.”
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