ESG Integration Best Practices for Commercial Real Estate Debt Investors
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Benjamin Lemire, Vice President, ESG, Alternative Investments, TDAM
Myles Routly, Vice President, Real Estate and Mortgages, TDAM
While integrating Environmental, Social and Governance (ESG) considerations into real estate investment decisions has become mainstream over the past decade, the role of lenders in this evolution has often been overlooked. Real estate lenders are increasingly integrating ESG considerations into origination, underwriting and due diligence processes — as well as engaging with borrowers on sustainability considerations throughout the life of the loan. Identifying and incorporating into the lending process ESG factors which are material – meaning, omitting, obscuring or misstating these factors could be reasonably expected to influence investor decisions - may help mitigate risks at the underwriting stage and ultimately de-risk assets through the holding period to loan maturity
ESG-Focused Lending and Risk Profile Enhancement
Lenders who rely solely on comparable market transactions for underwriting, without incorporating material ESG risk factors and important non-financial information, may fail to address issues that transform into tangible financial risks. As a result, investors ignoring material ESG considerations may misprice investment opportunities and potentially suffer higher loan impairments or losses.
Further, by engaging borrowers on material ESG issues throughout the holding period, lenders may gain an opportunity to improve income security and predictability and may nudge borrowers toward mutually beneficial ESG performance improvements that help drive positive property-based outcomes.
ESG Integration in Real Estate Debt: A Practitioner's Guide
Many of the ESG integration approaches from real estate equity investing are transferable to commercial mortgages. The key to adapting equity-focused practices for debt investing is determining how to right-size ESG information requests and streamline the integration approach. ESG integration should be considered across three stages in the commercial mortgage debt issuance process:
- Origination/Underwriting: Collecting and assessing ESG information during this stage is crucial for contextualizing a commercial mortgage opportunity. Sophisticated lenders are increasingly using ESG checklists during underwriting to obtain enhanced visibility on material ESG issues, which significantly impacts mortgage attractiveness and the negotiated terms. Factors to consider include (but are not limited to):
- Sustainability-focused building certifications: These can offer third-party validation of a property's environmental and/or social attributes — and position it to be more competitive from a tenant attraction/retention and operating perspective.
- Operational performance of the underlying asset: Objective measures of operating efficiency, such as the ENERGY STAR Portfolio Manager score (the industry benchmark for commercial buildings) as well as energy use intensity and operating costs, can influence the borrower's debt servicing abilities.
- Reputation: The borrower's operating reputation, existing community/stakeholder relationships and potential controversies (e.g., a history of "renovictions" for multi-family building owners) can impact a lender's outlook on the property's income and value creation potential.
- Proximity to key amenities and transit: Objective measures such as a property's walk, bike and transit scores can influence its ability to attract and retain strong covenant tenants.
- Due Diligence: At this stage, select ESG metrics are measured, assessed and folded into the investment thesis. Red flags at this point will often change the trajectory of the investment, at a minimum requiring a revisit to the underwriting. For example, lenders can issue an ESG survey or checklist that builds on information gathered during the underwriting phase, such as:
- The governance capabilities of the borrowing group, including assessing their policies and governance structures through borrower group interviews.
- Property condition and climate resilience considerations through a review of third-party Building Condition Assessment reports and assessments of exposure to natural hazards (e.g., seismic) and physical climate risks (e.g., flood, wildfire, sea level rise), while also ensuring adequate insurance coverage is in place.
- Environmental contamination or pollution risk assessment, ensuring an Environmental Site Assessment report and detailed findings are considered.
- Compliance with regulatory reporting requirements for energy use, water consumption and/or greenhouse gas emissions, which could result in fines or penalties to the owner if not in compliance.
- Post-Underwriting (Holding Period): Sustainability considerations can be integrated into portfolio management processes primarily through engagement with the borrower. For example:
- Alongside annual financial statement requests, lenders can request property-specific sustainability information (e.g., planned sustainability retrofit projects and ongoing initiatives) to facilitate constructive dialogue on sustainability-focused opportunities for the property.
- Lenders can discuss sustainability-focused operational enhancements or retrofit financing opportunities (e.g., "green loans").
By proactively engaging borrowers on ESG considerations throughout the life of the loan, lenders not only position themselves for success during the holding period, but also for potential mortgage renewal and follow-on financing opportunities.
Case Study: ESG Integration in Underwriting May Lead to Improved Financing Terms
Property: New build, downtown Toronto office
Notable Features: Platinum certification from Leadership in Energy and Environmental Design (LEED), the most widely used green building system, with on-site renewables
The property was built in 2016 to far exceed building code requirements with energy and water efficiency-focused features. As a result, it achieves operating costs (excluding realty taxes) approximately 25% below competing properties. This reduction has allowed the borrower to remain competitive while charging a higher net rent. In the event of market turmoil and falling rental rates, the borrower's cash flow stream will likely remain more resilient than its competitors'. The lender also considered the LEED Platinum certification, LEED's highest rating level, to further protect itself from downside risks as it meets tenants' ever increasing sustainability requirements.
As a result of the sustainability attributes of the property, the borrower was able to increase the financing proceeds by about 10% while maintaining loan fundamentals consistent with market-leading pricing. Consequently, the lender's broad understanding of ESG impacts allowed it to be more competitive than peers whose underwriting was based solely on market standards.
As outlined, there are good reasons for lenders to expand their influence with respect to ESG engagement in commercial mortgage lending. Those include creating a more resilient loan portfolio, benefiting from broader market trends due to valuation premiums or discounts based on a property’s ESG profile, and a recognition that tenants have increasing leverage in some property types to force concessions. Integrating ESG considerations can help provide downside protection as well as the potential to strengthen relationships with borrowers through constructive dialogue.
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