How do green real estate lending terms affect behaviour?

In our previous articles, we discussed the growth of ‘ethical lending’ and the pricing of environmental risk within green loans. But the extent to which a green loan can really be described as green arguably depends on whether lender and borrower behaviour is affected by the loan’s terms. In this article, we explore how green lending terms are structured, what effect they have, and how such terms might evolve in the future.

How much effect do green lending terms have?

The lending terms within ethical or ‘ESG-friendly’ loans vary widely. They are most likely to include requirements for quarterly or annual reporting, aimed at keeping the lender appraised of the latest changes in the status of the underlying real estate, or the uses to which loan proceeds have been put.

If this reporting showed that the borrower had failed to meet any ESG requirements within a loan, we would expect lending terms to impose a small penalty such as a margin step-up at worst, rather than a default.

There will be some loan agreements which lenders can point to, where failure to meet certain ESG criteria risks lead to a default. However, the Loan Market Association’s green loan principles (explored in our previous article) do not require that there should be a default in such situations. This is quite different from (for example) a breach of a loan-to-value covenant which may require the borrower to inject fresh equity to remedy that position.

There are several reasons why failure to meet ESG terms are unlikely to result in a default under a loan.

Firstly, lenders ideally do not want to default a loan unless they have no other option; it is not only destructive to their balance sheet, but also will result in increased internal reporting / monitoring to their credit / risk teams. Lenders will not push a loan into default for a reason that they do not regard as structurally problematic. That outcome needs to be reserved for when the most serious risks to value or income crystallise.

Secondly, borrowers are not going to agree to loan terms that risk default if they relate to matters that might be beyond their control (for example, the energy consumption of their tenants). Therefore, lending terms need to align with ‘green lease’ clauses imposed by borrowers upon their tenants, so that risk can be transmitted to the party best able to manage it.

In future, environmental risks might fall into the category of risks serious enough to cause a default, provided they arise from the borrower’s own behaviour. Examples might include creating an extreme flood risk, or the loss of income arising from a failure to achieve a regulatory requirement like MEES. But it is not evident to us that lenders or their backers currently feel these risks are worthy of serious margin penalties, let alone default.

Is it a green loan if it’s not driving a change?

Most lenders are trying to do the right thing, but care is needed to ensure that green loan terms do not result in ‘greenwashing’. It is clear from recent regulatory announcements that UK regulators consider addressing this issue a ”core regulatory objective”. There are two key risks:

1. Firstly, in our experience, the documentation for some ‘green loans’ includes covenants which would feature in conventional loan agreements anyway
2. Secondly, lender credit committees may have a checklist of initial ‘green’ features that they will require, such as a green building certification, but this approach may simply enable lenders to classify the loan as a green loan at origination, rather than creating any new pressure to further improve the green features of the building – or even maintain those that already exist (such as renewing a green building certificate)

Either way, lenders risk being accused of rebadging loans they would have written anyway to buildings that happen to have green credentials – especially when financing the acquisition of standing stock.

On the other hand, there is plenty of good practice to draw on. CBRE encourages clients to include additional KPIs and covenants where appropriate, to improve the quality and standing of loans in the eyes of ethical investors.

Refurbishment: to lend or not to lend?

Lenders are entitled to refuse (and many do) to lend on poor quality buildings. There will be plenty of buildings going forward which just will not meet lender standards, but which need finance. Refusing to fund assets at risk of ‘stranding’ or in need of substantial improvement (see our previous article) could be seen as helping to penalise bad real estate, even if it does not actively encourage good real estate.

However, not least because of the risk of a finance logjam, we believe that lenders will increasingly have to lend against properties that need improvement to achieve credit committee ESG standards, as well as against properties which already achieve those standards. In these circumstances, lenders will be making a more nuanced judgement about whether the refurbishment plan is credible – including costs and timescales.

As we noted previously, not every lender will feel able to go down this route, but it is much easier to describe a loan as ‘green’ when it is a development loan, or an investment loan with a capex facility, and when the strategy is to improve the green credentials of the real estate.

Yet there is a potential risk that the standard for such lending might be set either too low or too high – or indeed that no-one is sure where to set the standard at all because the cost and reputational risks of inaction are not yet clear. A fear of ‘greenwashing’ could cause lenders to step back from setting the standard too high because they do not yet have confidence that their procedures can monitor and enforce that higher standard. Equally, setting the standard too low (including at the regulatory minimum) could mean that lenders are unable to attract discerning ‘ethical’ capital.

Conclusion: It’s going to get more forensic

Wherever lenders draw the line between acceptable and unacceptable lending, they are very likely to start asking for more data relating to the ESG performance of the borrower and their real estate. Understanding environmental performance is a prerequisite to accurately pricing (and reducing) the risk associated with it.

Consistent and more detailed data, measurement, and communication will be needed - from the original equity, through to the lender, the borrower, and on to the borrower’s tenants.

Ethical lending, ‘green’ or otherwise, is a complex space because of the difficulty in deciding how ethical factors affect risk. Furthermore, progress in higher quality lending depends on changing processes and practices across all of these parties, making it a slow process.

In this series of articles, we have illustrated progress in the way lenders are incorporating ESG criteria into their lending policies, better understanding risk, offering pricing discounts, and implementing measurable covenants in lending terms. But it’s clear there’s more to do.