Article | Intelligent Investment
The importance of sustainability credentials in underwriting for lenders
July 15, 2024 5 Minute Read
After an uneventful first half of the year, investors and lenders alike are eagerly anticipating a shift in the European commercial real estate landscape. It remains uncertain whether this will materialise in the remainder of the year. Despite growing optimism, the recovery in investment activity is likely to be gradual.
Lenders, according to CBRE’s recently released 2024 European Lender Intentions Survey, have rather positive lending activity expectations for 2024. Almost two-thirds of respondents expect to increase lending activity and subdued levels of investment were most frequently cited as the main challenge to the lending market. However, despite this optimism, lenders remain conscious of risks in the market and a third of respondents indicated tightening underwriting requirements. When asked in which areas they would be more conservative, 30% of lenders indicated that sustainability credentials are a key focus area for implementing tighter loan standards in 2024.
Figure 1: Changes to underwriting policy. In which areas will lenders be more conservative?
A multi-lane road
When discussing lending conditions through a sustainability lens, it is important to make the distinction between the following scenarios:
- Loans for acquisitions: assets with or without sustainability credentials
- Loans for refinancing:
a) Sustainability profile of an asset has or has not improved since the acquisition.
b) Existence and most importantly, the viability of the sustainability upgrade roadmap. - CapEx financing for retrofitting/sustainability upgrades
- Development financing: greenfield or brownfield developments which must comply with in-place sustainability regulations and investor demand.
In many cases, the lending roadmap will have more than one lane. For example, an asset with poor sustainability credentials might need both a refinancing loan and a CapEx loan for asset upgrade. These two lanes will follow different paths and, in most cases, will have varied financing conditions. The CapEx loan is likely to encounter more restrictive terms (e.g., a higher margin or lower LTV), as the very need for this loan complicates refinancing negotiations. This is because in some cases retrofitting the asset will require the building to be vacated by the tenant(s), presenting a risk to stable cash flow.
This argument counters the risk of collateral value depreciation if no upgrade takes place, implying that both action and inaction are related to risk. However, their relevance and potential impact depend on the observer’s perspective.
Need for specific financial products
This complex set-up points to the importance of encouraging the development of specific financial products to finance sustainability-related upgrades. As most of the finance will continue to be channelled through general purpose lending, financial institutions should encourage their clients to undertake the necessary steps (including investing in upgrading their assets), to transition to sustainable activities. Institutions should also voluntarily disclose these products and increase their transparency to attract private investments. Financial institutions will ultimately have to report on the climate impact of their lending and investment portfolios. Furthermore, they will be encouraged to progressively increase the proportion that contributes to the achievement of the Paris Climate Agreement.
Indeed, over half of lenders who participated in the survey are willing to offer margin stepdowns for the origination of assets with strong ESG credentials. Most of them are in the range of 5-20 bps. However, this is highly fragmented across the region and dependent on local market practices.
Figure 2: Are lenders willing to offer margin stepdowns for assets with strong ESG credentials?
Figure 3: How much of a margin stepdown are lenders willing to offer?
The way forward
For many commercial real estate market stakeholders, one of the most important considerations is the availability of clearly defined loan products that can be used for the right outcome. This emphasises the need for a system of rewards and penalties, that could be achieved through tying conditions to the environmental performance of the collateral.
The survey results are encouraging, indicating that many lenders are already implementing or at least willing to implement some sort of incentives for upgrades. However, the ESG financial ecosystem appears to be in its early stage of development, as the frameworks and metrics used need to achieve a standard and consistent level. For green financing to reach the scale required, debt providers need to transition from being reactive to becoming proactive.
Contacts
Dragana Marina
Head of Research and Data Intelligence, Denmark & Sustainability Research Lead, Continental Europe
Ludovic Chambe
Head of ESG & Sustainability Services, Continental Europe
