While the sometimes obtrusively advertised focus of some market parties on sustainability has over the past few years been regarded as lip service by many, sustainability has by now swiftly become a factor that can really no longer be ignored by financiers, investors and borrowers alike. It is clear that many stakeholders are willing to and are now feeling the urgency to apply an ESG (environment, social and governance) policy. Real estate, in particular, is a sector where sustainability can play a specific and crucial role. In addition thereto, legislators and supervisory authorities are setting new green and sustainability standards and imposing legislative requirements, compliance with which is also resonating in real estate finance. Still, many stakeholders appear to be uncertain as to the exact "why and how" of these legislative requirements. This blog briefly sets out the background of sustainability requirements that are particularly relevant in the context of commercial real estate finance and, accordingly, the bankability of commercial real estate investments and sheds light on what to expect in this regard going forward.
A changing regulatory landscape to suit an urgent agenda
The main Dutch banks have for some time been requiring that borrowers comply with sustainability standards, for the most part set by the individual bank concerned and more or less based on (future) legislative requirements. In exchange for complying with these, borrowers could directly benefit from economic incentives such as margin decreases in addition to wider benefits, such as cost savings in the longer run, an enhanced reputation and more interest from (prime) tenants, investors and financiers in their commercial real estate developments or investment portfolio’s. Not all financial institutions have been equally involved with setting sustainability standards. This is expected to change over the coming years considering that the focus on sustainability has increased on a global level and regulations aimed at setting standards for sustainable investments have been introduced This is most welcome towards overcoming a lack of consistency that has made it more difficult for market parties to pursue an effective sustainability agenda in the past. It also entails that going forward non-compliance with these standards may lead to compliance issues for banks.
- On a European level, the EU Sustainable Finance Action Plan of 8 March 2018 (the Action Plan) has been a catalyst for sustainability related legislative initiatives with respect to financial investments. The Action Plan came into force with a view to the 2016 Paris Climate Agreement and the 2030 Agenda for Sustainable Development of the United Nations. As a first step within the Action Plan, the Taxonomy Regulation ((EU) 2020/852) has entered into force on 22 June 2020, which should provide clear standards for financial investors as to what can be regarded as a green and sustainable investment. Reporting under the Taxonomy Regulation shall become mandatory for financial institutions as from 1 January 2022 in relation to the first set of objectives relating to climate change mitigation and adaptation (the remainder to follow as from 1 January 2023).
According to the European Commission, "establishing clear green criteria for investors is key to raising more public and private funding so that the EU can become carbon neutral by 2050 and to prevent “greenwashing” –the process of providing misleading information about how a company’s products are more environmentally sound."
- Stakeholders should also take into account sustainability requirements on a national legislative level. As of 1 January 2023 an energy label C, indicating the energy-efficiency of the property, will be the minimum label required for office buildings in the Netherlands and office buildings not complying with this requirement may not be occupied. By way of illustration, as per 1 October 2021, 12% of office buildings in the Netherlands had an energy label D or lower and 46% had not yet obtained an energy label, meaning that only 42% of all relevant office buildings (67,000 in total) currently comply with the legal requirements. This has consequences for property owners and tenants alike and therefore, Dutch real estate finance loans financing office buildings entered into over the past few years already include provisions to the effect that the loan is provided subject to the condition that (in any event before 1 January 2023) such energy label is obtained. This will become even more relevant as it is expected that all office buildings must comply with an energy label A as of 1 January 2030 and be carbon neutral as of 1 January 2050. This can only be achieved by making the necessary investments which in their turn can be financed by lenders.
- In 2019 the Loan Market Association (LMA), together with the Asia Pacific Loan Market Association (APLMA) and the US Loan Syndication and Trading Association (LSTA) published the Sustainability-Linked Loan Principles (SLLP), lastly updated in 2021. The SLLP define sustainability linked loans as:
"…any types of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance objectives. The borrower’s sustainability performance is measured using predefined sustainability performance targets (SPTs), as measured by predefined key performance indicators (KPIs), which may comprise or include external ratings and/or equivalent metrics, and which measure improvements in the borrower’s sustainability profile”.
The clearly defined KPIs and SPTs will differ from transaction to transaction and are based on the property or development being financed and benchmarked against external factors (such as similar assets). On the basis of the SLLP, a loan agreement will include a margin ratchet, which is linked to the performance by the borrower and its property against predetermined KPIs, meaning that a premium or discount on the margin may be provided from time to time if a target is missed or made, respectively.
A borrower is required to meet reporting requirements on a periodical basis, allowing the lender to monitor the performance of the SPT's. On the basis of the SLLP, it is also encouraged that regular verification is sought by an external party and where possible, to make such findings publicly available (although it is acknowledged in the SLLP that the latter is not always possible). On the basis of the reporting and the verification, the lender will be able to evaluate the performance of the borrower. The LMA acknowledges that currently there is no market standard for dealing with a SLLP breach under a loan agreement. It is in any event not typical that such breach would immediately lead to an event of default, but rather only have economic consequences, such as the margin premium referred to above. However, based on the standard information covenants, non-compliance with SLLP reporting requirements and/or providing inaccurate information may (indirectly) lead to an event of default, depending on the exact wording of the facility agreement.
- Separately, the LMA, APLMA and LSTA published the Green Loan Principles (GLP) in 2018 and the Social Loan Principles (SLP) in 2021, providing a similar framework for so-called green and social loans respectively.
Current practice in loan documentation
Currently there is no firmly developed market practice when it comes to sustainability requirements in the Dutch real estate finance market, although we do expect this to change taking into account the above-mentioned developments.
What we do see is that financiers more frequently ask for sustainability requirements and reporting provisions to be included in loan documentation, varying from soft worded covenants to actual conditions which could lead to a breach under the documentation in case these are not met. The latter is mainly applicable in case of project financing, where a financier will usually require proof that the financed property complies with current sustainability requirements. In this respect a BREEAM certificate and written confirmations from the lender instructed project monitor on compliance with agreed sustainability benchmarks will usually have to be obtained upon completion of the project.
By now most financiers also anticipate on the legislation with respect to energy labels and are already requiring an energy label A either as a CP to granting of their loan or as a hard condition to be met within an agreed timeframe post-utilisation of the loan. In loans with the purpose of (amongst others) financing CAPEX-related investments, we see a variety of conditions included to ensure that these works are performed in a sustainable way.
Even though there is a willingness to step up, stakeholders acknowledge that including full-blown sustainability requirements such as the SLLP requires capacity and expertise from both the financier and the borrower involved which is not yet readily available, for example in relation to (checking) compliance with the reporting requirements. This may be one reason why these requirements are not yet commonplace in loan documentation. In any event, lenders would be well-advised to, as a minimum, include an undertaking for borrowers to comply with sustainability information requirements where such lender is required to obtain such information on the basis of (European) legislation, in particular taking into account the upcoming Taxonomy Regulation reporting requirements.
Should a breach of a sustainability requirement lead to a margin premium, a lender may consider applying the proceeds thereof towards the ESG performance of the asset, which of course requires a legal basis in the loan documentation.
It should also be considered that lenders remain wary of "greenwashing" on the part of their borrowers and consequential reputational damage. Consequently, lenders may set the barrier for a loan to be considered as sustainable or green higher than what is strictly required under the SLLP, GLP or legislative requirements, which will in turn affect the criteria and reporting requirements included in the relevant loan documentation.
It is clear from the above that sustainability is a hot topic, which no longer can, nor should be ignored in Dutch commercial real estate financings. We expect that the EU Taxonomy Regulation in particular will shape the market standard which will make it easier to apply throughout the market.