What affects the price of a green real estate loan?

As we explored in our previous article, the green real estate loan market is expanding rapidly. For borrowers, the cost of borrowing green loans can be lower than with conventional loans. However, the price differential between green loans and traditional loans depends on a range of factors and is changing all the time as understanding of risks evolves. In this article, we investigate why.

Loan pricing is only modestly affected by ESG considerations, reflecting risk perceptions

Real estate lending is competitive, and the competition is influential in setting the overall pricing of a loan, and the structural elements (such as covenants) within it. So, whilst a ‘green’ loan may have a slightly lower cost than a traditional loan from the same lender, strong competition and liquidity in the market can mean that any saving arising from green credentials may get ‘lost in the rounding’. A 5-15bps discount for ‘green’ features is typical, although we have seen a 20bps discount in one or two more recent deals.

However, if there is any pricing advantage to a green loan, it may not always be clear what exactly is driving it. Until very recently there haven’t been consistent criteria for deciding what counts as a green loan, beyond the general principles set out by the Loan Market Association (LMA). This is changing as LMA and other industry bodies are issuing more specific guidance aimed bring consistency to the market (for the details, see our previous article).

There are a number of reasons why we might see better pricing and bigger discounts for green loans in the future:

Better pricing reflecting actual environmental risk

Firstly, pricing should reflect (amongst other things) a risk assessment of the underlying characteristics of the asset being lent on. CBRE helps support/advise many lenders with their due diligence, often answering questions on sustainability, design, performance, etc. and how they might affect letting and hence value). We suspect this is not always the case, but would not be surprised for this to become the norm for all lenders in the future, so they can better understand the reduction in any lending risks associated with buildings which have strong environmental credentials.

There are a number of reasons why a focus on sustainability in any due diligence process might affect risk assessment and thus pricing. For instance, as part of any due diligence exercise it might involve a climate risk assessment (for example using CRREM) and/or regulatory risk assessments.

One such regulatory risk (which an assessment would pick up) is the UK’s proposed new minimum energy efficiency standard (MEES) – which, when and if this is brought into force, will render certain properties unlettable. This is because MEES holds out the prospect of rental income being suddenly cut off if a minimum EPC rating isn’t achieved – or, more likely, the prospect of significant additional capital expenditure being needed on the building in order to avert that outcome.

CBRE has done extensive analysis of how prepared the commercial real estate industry is for MEES generally.

When it comes to lending specifically, we believe the biggest risk is in poorer quality properties with higher leverage (a higher loan-to-value ratio), such as those owned by property companies or private family offices. These properties have the biggest refurbishment requirements, but they may also have the most debt attached.

Better pricing because wholesale pricing or regulated capital is cheaper

Secondly, green loans could be cheaper in the future either because the wholesale finance is cheaper or because the underlying equity supporting the lending is comfortable with a lower return.

Cheaper wholesale finance could materialise if banks manage to persuade regulators that mitigation of environmental risks makes real estate less risky to lend on, and thus the UK ‘slotting’ regime allows lenders to hold less capital in reserve in relation to such loans.

Although this would only affect regulated bank lending, a more transparent pricing benefit seems likely if this were to happen. It would mean that green real estate, if properly defined, had demonstrably lower risk than other real estate where no attempt to manage environmental risks had been undertaken.

Worse pricing for stranded or obsolescent properties

Thirdly (and working in the opposite direction) we see banks offering small discounts for green lending, but we don’t yet see big premiums for ‘brown’ lending – that is, lending on real estate with poor environmental performance.

However, we believe the moment may have arrived when real estate valuers will write down the value of increasingly obsolescent, stranded, or secondary assets, on the basis that they lack the environmental credentials necessary to remain attractive to occupiers or investors. Yields for such properties would start to rise. There is already some evidence (as shown in our research) of these price reductions.

Our view is that there will be two types of responses to this in the lending markets.

The more cautious lenders seem likely to simply put a new and higher floor under what they will lend on – for example, if the building has a low EPC rating. This is a credit risk judgment based on not really knowing what poor environmental credentials mean for occupier demand and thus for the future cash flow needed to service the loan. These lenders would rather say no than risk-adjust the pricing upwards, given their low cost of capital, low risk appetite and aversion to default.

This could create a financial logjam because too much capital is tied up in existing properties for them not to be refinanced.

This is partly because of the speed at which we estimate refurbishment would need to occur to meet environmental targets. The lack of pace on refurbishment to date presents a clear risk over the next five to ten years, because almost the whole of the UK investable real estate stock will be affected, and there is pressure on the Government from the recent Skidmore Review to go faster. CBRE IM have argued that the scale of the refurbishment challenge means that many landlords will need to seek external financing, and that this finance will need to come disproportionately from non-bank lending.

And indeed, non-bank lending such as private equity and the debt funds can take a different view to regulated lenders. Debt liquidity and pricing typically matches the equity strategy, but if there are specific credit risk circumstances in which lenders stop lending, then non-bank lending will need to step in to fill the gap. The equity behind such lending can take a risk-adjusted view and price it accordingly.

Conclusion: a new lending risk segmentation

Overall, a market segmentation does seem likely, with lending dividing in a ‘two tier’ market reflecting the risk profile of the underlying stock. There will be tight yield, institutional real estate lending only to top quality stock where environmental risk has been diligently understood and increasingly accurately priced; and ‘the rest’, with poorer (or poorly understood) environmental credentials with a more limited subset of lenders willing and able to lend on riskier assets.

In our next article, we’ll look beyond pricing, to the loan terms ‘green’ lenders impose on borrowers (and vice versa).