The real estate sector is heavily regulated and is no stranger to environmental, social and governance ("ESG")-related policies and requirements. One imminent ESG-focused change affecting the UK real estate sector relates to landlords of commercial (or non-domestic use) properties. From 1 April 2023, commercial landlords will need to comply with the Minimum Energy Efficient Standards ("MEES") Regulations, which require (subject to certain exceptions and trigger requirements) commercial properties to have a minimum EPC rating of E. For property owners and landlords, these regulations can be onerous and expensive. In fact, in many cases, such investors need to borrow in order to finance the costs of the required changes (often only discovering that these changes are required as part of diligence conducted prior to financing the purchase of the property itself). This article considers some of the financing options that such property owners can consider.
The first option for property owners to consider is a green loan. The fundamental requirement for a green loan is that the loan proceeds are utilised for a green project or projects. This type of loan could be particularly useful for property owners who need to borrow in order to comply with laws such as the MEES Regulations or the newly announced implementation of Schedule 3 to the Flood and Water Management Act 2010 (the "2010 Act"), which will require sustainable drainage in new developments in England from 2024. Separately, a property owner may wish to undertake ESG-related capital expenditure on an asset purely for commercial reasons and green loans can also be available to meet such costs.
Whilst it is common for the purpose of the loan to be determined at the outset, it is also possible to obtain a green loan to fund different projects throughout the life of the loan, provided the purpose meets certain pre-determined eligibility criteria. This latter option could be incredibly helpful to property owners and sponsors that hold portfolios of properties, each of which they intend to upscale to meet their ESG strategies. In this case, the sponsor has the option to make multiple drawdowns, improving individual properties at different times. As one would expect, lenders will want to be involved at every stage, from ensuring that the project meets strict eligibility criteria before a drawdown is possible, to expecting periodic reports to ensure that the projects are progressing well and funds have been used for their intended purpose. Transparency and reporting are therefore key components of these types of loans. However, once a clear plan is in place, there is ordinarily ample discretion as to the use of proceeds, such that on one property a sponsor can use the proceeds to meet the MEES Regulations, whilst on another the sponsor can pursue solar energy sources, for example.
Whilst many property owners will make changes to their properties to address legal and regulatory changes, these green loans are primarily helpful to those actively pursuing whole-scale ESG strategies, as is increasingly common amongst funds and other portfolio owners. Research has shown that, irrespective of the reasoning, environmentally based changes have a positive impact on the reputation and credibility of sponsors and funds. It can be a powerful marketing tool when it comes to looking for tenants, but is also now a metric on which sponsors are expected to report to their shareholders, clients, suppliers and employees, to name a few. Green loans can assist in this way, as it is a specifically targeted loan – clearly showing a strategy and a means of achieving it.
Sustainability-Linked Loans (“SLLs”)
In contrast to green loans, SLLs can be pursued alongside a property owner's other funding needs, provided it intends to improve its sustainability profile. The property owner can, therefore, borrow money for any purpose, provided that the loan terms are aligned to ensure the borrower meets certain mutually agreed, material and ambitious sustainability performance targets ("SPT"), which are measured by achievement of key performance indicators ("KPIs"). In addition, the offer of a reduced margin incentivises the borrower to meet its SPT. A failure to meet the SPT will not normally constitute an event of default, but rather the company will not benefit from a ratcheting down of the margin. It is also possible that any previously achieved incentive will cease to apply or a margin premium could be applied instead. As with green loans, transparency will be required and lenders will expect quantifiable targets (achievable by means of assessment by an industry standard, for example).
It is easy to see how SLLs can be used as part of a real estate finance transaction – a sponsor can use the proceeds to fund the acquisition of corporate real estate and, provided it achieves a clearly defined KPI,– such as improving its EPC rating – it can benefit from a reduced margin. Whilst this sounds relatively simple, potential users need to be mindful of ‘sustainability washing', such that simply meeting the requirements of the law is not sufficient. The SPTs and KPIs needs to be ambitious and a ‘true reach' for the borrower. Accordingly, simply setting a target of achieving an EPC rating of E for a commercial-use property would not be sufficient, given the MEES Regulations apply from April. Instead, the property owner would need to set itself a higher EPC target – at least D and above. Property owners also need to be mindful of legislative changes in the future; for example, there are suggestions that the government is proposing a minimum EPC rating of C by 2027 and B by 2030, and also intends to extend the trigger events which prompt the need to obtain an EPC rating. As such, if long-term financing is intended, then the borrower and lender will need to readdress KPIs in the future to ensure they are more onerous that the regulatory requirements at the time. Helpfully, the Loan Market Association has published Green Loan Principles and Sustainability-Linked Loans Principles (along with accompanying guidance), which are aimed at assisting with understanding what would qualify as a Green Loan or SLL, respectively. Also, particularly helpful for the commercial real estate finance sector, CREFC Europe has a working group dedicated to considering advancements in this area.
As such, it is easy to see SLLs as a viable option for sponsors and property owners when first starting out on the ESG path. These loans provide a possible solution for obtaining financing for other needs and allowing the borrower to pursue ESG strategies at the same time (whilst benefitting financially for doing so!).
Legislative changes such as the MEES Regulations and the 2010 Act may seem onerous, but as the above shows, they can provide borrowers with an opportunity to not only improve their properties, but forge a path towards sustainability. There are suggestions that property owners and landlords who pursue ESG agendas benefit from these strategies, through: (i) fewer vacant possessions; (ii) higher rental incomes; and (iii) higher valuations and sales prices (resulting from greater demand for ‘green buildings'). If funding that is already needed can be aligned with a borrower's sustainability goals, then SLLs can be incredibly beneficial. For those who really embrace their environmental consciousness, green loans can be ideal. Either way, ESG and real estate financing can certainly be a match made in heaven.
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