Sustainability and Real Estate Debt: The Elephant is Back

Nils Kok

There are many ways to invest in real estate, but a typical university textbook would show a variation of this graph:


real estate investment


The top row shows equity investments: buy shares in a listed property company (REIT), or take a stake in a private equity real estate company or fund. (You could of course also buy an asset directly.) The bottom row shows the debt market, which represents the other side of the real estate capital stack. Debt comes in the form of corporate bonds (general obligation financing) or mortgages (where the property collateralizes the financing). As it goes, textbooks never fully reflect reality, and in the absence of banks providing capital post-crisis, alternative lenders such as real estate debt funds have stepped in to fill the financing gap. Just add those to the right-side of the bottom row.

Over the past 10 years, leading equity investors have become increasingly interested in the sustainability features of their real estate investments – often described with respect to environmental, social, governance (ESG) attributes and performance. A growing body of literature shows the implications of such ESG performance on the performance of real estate equity investments (read this GRESB Insight post for much more information on the relation between ESG and performance of general equities. Here’s a study looking at the “greenness” of REITs and their financial performance).

Real estate lenders have been notably absent from conversations reshaping equity investment. But over the past couple of years, the situation has changed – the elephant is starting to move. Let’s begin with recent academic evidence that supports the business case for incorporating sustainability characteristics into mortgage or bond underwriting.

  • Reduced default risk for commercial property. New research by Gary Pivo and Xudong An examines commercial mortgage default risk as it relates to a set of sustainability features (including Energy Star and LEED). The research is based on more than 22,000 loans from a large CMBS pool, and shows that “ceteris paribus” (keeping everything else constant), commercial mortgage loans made to an asset with an Energy Star rating have a 20 percent lower likelihood of default. The results for LEED are even stronger, at a 30 percent lower likelihood of default for rated assets.
  • Cheaper credit. Closely related, but complementary to the first study is work-in-progress by my colleagues Eichholtz, Holtermans, Yonder and myself. This study investigates the pricing of both commercial mortgages and corporate bonds issued by REITs, over the 2000-2014 time period, and the effects of green building certification. The results show that Energy Star and LEED rated commercial assets obtain more attractive pricing on mortgages — 29bp and 53bp, respectively — and those REITs with a higher fraction of green buildings in their portfolio obtain lower bond spreads and higher credit ratings.
  • Reduced default risk for residential property. Third, I wrote about this paper on default risk in single-family homes a while ago. It shows that households in homes with an Energy Star label are significantly less likely to default on their mortgage. The paper has some shortcomings (are certain households just more likely to sort into efficient homes?), but it is the first of its kind, and worth a look.

Then, there’s exciting news on the business side of real estate lending:

  • Greater transparency. An increasing number of banks are starting to monitor their loan portfolio on sustainability characteristics, for example the energy label (in Europe) or distance relative to public transport nodes. Now, this observation is mostly based on conversations with banks such as ABN AMRO and FGH Bank (part of Rabobank), and I still have to see hard evidence of banks asking for sustainability at the time of underwriting or refinancing. But watch this space!
  • New financing opportunities. On the corporate bond side, the green bond market has made some significant strides, and for real estate in particular, we have seen 5 REITs/property companies issuing green bonds (VasakronanRegency CentersVornado, Unibail-Rodamco issue I and II, and Stockland). The proceeds of these general obligation bonds (i.e., the corporate securitizes the bonds, not a specific building/project) will be used to “green” up the portfolios of these companies, for example through the construction or renovation of buildings to green standards (BREEAM, Green Star and LEED are all used). Some of the proceeds are also used for “social” purposes, such as tenant and community engagement. While many questions remain and new supporting tools are needed, the interest of the capital market has been significant, with all bonds oversubscribed. This success paves the way for more capital raising with the specific purpose of improving the performance of new and existing buildings.
  • New sources of capital. Fourth, alternative lenders, including real estate debt funds, are a part of the debt market that is fairly new, at least in Europe. This part of the market is certainly new to incorporating sustainability into underwriting practices, which is why GRESB released the GRESB Debt Survey on May 1. This assessment is specifically aimed at real estate debt funds and will trigger this emerging group of alternative lenders to think more about how sustainability factors may impact their loan portfolio (this is not just about fat-tail climate change risks, but also about regulatory risks, tenant preferences, and other market developments).

With banks and other lenders recognizing the impact that sustainability factors may have on their business, the real estate market will increasingly face sustainability-related questions when financing buildings and portfolios. More information, and particularly more granular information on the ESG performance of buildings and portfolios will be needed in order to have informed discussion and integrate sustainability into underwriting models.

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Nils Kok