Sustainability-Linked Loans Series Part 5 – Applying Sustainability-Linked Loan Principles to Real Estate Financing Transactions

In our August issue of REF news and viewsWe continued our in-depth look at the core components (“Core Components”) of the Sustainability-Linked Loan Principles (“SLLP”), looking at loan characteristics, reporting of progress toward sustainability performance targets, and verification.

As a reminder, the SLLP established a framework that allows all market participants to clearly understand the characteristics of an SLL. The framework is based on the five core components, namely:

  • selection of Key Performance Indicators (“KPIs”);
  • Calibration of sustainability performance targets (“SPTs”);
  • loan characteristics;
  • reporting progress on SPTs; and
  • examination

In this part of our Sustainability-Linked Loans series, we will discuss the application of SLLPs to real estate financing (“REF”) transactions and consider some of the issues involved.

SLLPs in the context of real estate financing

In March 2022, the Loan Market Association (“LMA”) published guidance on the application of the SLLP to real estate financing and real estate development financing transactions (the “REF instructions“).

In response to increasing demand in the real estate finance and real estate development finance industry to integrate sustainability into their finance solutions, the LMA launched this initiative. Following the introduction of SLLPs by the LMA in 2019, SLLPs have become increasingly popular in the syndicated loan market. SLL volume started to outperform green loans. However, the real estate finance industry has not yet benefited from this surge in SLL popularity. Green loans are much more common in the REF market than SLLs.

This REF Guide sets out what borrowers, financial parties and their advisers should consider when aligning their transactions with the SLLP. It adds a REF focus to the existing SLLPs and accompanying guidance and includes sections on:

    • the roles of the parties involved in an SLL in ensuring the transparency and integrity of the SLL product;
    • Selection and disclosure of KPIs (with examples tailored and applicable to REF trades – which we will discuss in more detail below);
    • calibration of SPTs;
    • reporting and verification; and
    • Documentation considerations.

The LMA has previously published similar guidance on applying the Green Loan Principles to REF transactions. The REF guidance does not apply to residential mortgages or other forms of retail lending.

Problems using SLLs in REF

Historical use of SLLs in the context of REF and real estate development finance has been largely focused on real estate investment trust (“REIT”) finance and in relation to social housing projects, but the LMA has recognized that there are certain practical challenges in general that may arise when applying the SLLPs in connection with REF and real estate development finance.

These challenges are outlined in the REF Guide:

    • REF loans are typically made available to a borrower that is a special purpose vehicle (“SPV”) with no trading history. Such an SPV borrower is unlikely to have a pre-existing sustainability strategy and/or access to historical environmental, social and governance data. In an SLL, when data is not available, this can lead to challenges in selecting KPIs and calibrating SPTs. As the REF Guide recognizes, this may be easier when (i) a portfolio of properties is being financed, (ii) investments are required to fund retrofit work, or (iii) the property being financed is a business asset.
    • Generally, in REF investment financing, the borrower does not personally occupy the property being financed and may not have direct control over the amenities or day-to-day operations of the property. The borrower may have the ability to require its tenants to comply with the SLLPs or Green Loan Principles through provisions in the underlying leases. In practice, however, since the borrower cannot control the actual activities of the tenant occupying the property, he may be reluctant to commit to goals that are beyond his day-to-day control.
    • There is still disagreement in the market over what is considered “doing enough” in terms of improving sustainability performance in the context of REF and real estate development finance. This can raise concerns about greenwashing (iethe practice of gaining an unfair competitive advantage by marketing a financial product as green when in fact it does not meet basic environmental standards), which can cause reputational damage to both borrowers and lenders.

Notwithstanding the above issues, there were still various SLL deals in the context of REF and real estate development finance. The REF Guide notes that there is still significant potential for further growth of SLLs in the context of REF and real estate development finance due to a number of factors such as: (ii) improving the sustainability of construction methods and materials; and (iii) addressing the lack of affordable housing around the world.

REF-focused KPIs

The REF Guide sets out some common categories of KPIs to see in the context of REF and real estate development finance, along with an example of the improvements a KPI in that category might attempt to measure. Examples include:

    • energy efficiency: Improvements in the energy performance rating of buildings owned or rented by the borrower (often evidenced by a sustainable building rating, standard or certification). Energy efficiency improvements may relate to the usage performance and/or the fabric of the building(s).
    • Sustainable Sourcing: Increase the use of proven sustainable raw materials/supplies in the construction or renovation of buildings or funded projects.
    • Embodied Carbon: Reductions in embodied carbon associated with funded development.
    • Clean transportation: Improvements in the use of low-carbon transport and related infrastructure, including charging stations for electric vehicles and dedicated bicycle parking spaces.
    • Affordable housing: Increase the number of affordable housing units being developed by the borrower.

For more examples see REF instructions. Please note that the examples included in the REF Guide are not exhaustive and are intended only as a guide.

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