In our August issue REF News and opinionscontinued our deep dive into the main components of the Sustainability Linked Lending Principles (“SLLP”) (“Core Components”) and analyzed loan characteristics, reporting progress against 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 basic components, namely:
- selection of key performance indicators (“KPI”);
- calibration of sustainability performance targets (“SPT”);
- loan characteristics;
- report on progress in relation to SPTs; Y
In this installment of our Sustainability-Linked Loan Series, we will discuss the application of SLLPs to real estate financing (“REF”) transactions and consider some associated issues.
SLLP in a Real Estate Finance Context
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 Orientation”).
In response to the growing demand in the real estate financing and real estate development financing industry to integrate sustainability into their financing solutions, the LMA launched this initiative. Following the launch of SLLPs by LMA in 2019, SLLPs became increasingly popular in the syndicated loan market. The volume of SLL began to exceed that of green loans. However, the real estate finance industry has yet to benefit from this rise in popularity of SLLs. In the REF market, green loans are significantly more prevalent than SLLs.
This REF Guide sets out what borrowers, financing parties and their advisors should consider when seeking to align their transactions with the SLLP. Adds a REF approach to the existing SLLPs and accompanying guidance and includes sections on:
- the roles of the parties involved in an SLL to ensure the transparency and integrity of the SLL product;
- selection and disclosure of KPIs (with examples adapted and applicable to REF agreements, which we will analyze later);
- SPT calibration;
- reports and verification; Y
- documentation considerations.
The LMA has previously published similar guidance for applying the Green Lending Principles to REF transactions. The REF Guide does not apply to residential mortgages or any other form of retail lending.
Problems with using SLL in REF
The use of SLLs to date in the REF and real estate development financing context has largely focused on the financing of real estate investment trusts (“REITs”) and in connection with social housing projects, but the LMA has recognized that, in general, there are certain practical challenges that may arise in the application of SLLPs to the context of REF financing and real estate development.
These challenges are set out in the REF Guide:
- REF loans are generally made available to a borrower who is a special purpose vehicle (“SPV”) with no business history. Such an SPV borrower is unlikely to have a pre-existing sustainability strategy and/or access to historical environmental, social and governance data. To the extent data is not available, this can cause challenges with an SLL when selecting KPIs and calibrating SPTs. As the REF Guide acknowledges, this may be easier when (i) there is a portfolio of properties being financed, (ii) capital expenditure is required to finance refurbishment works, or (iii) when the property being financed is an asset. operative.
- Generally, in REF investment financing transactions, the borrower does not occupy the property being financed and, in fact, may not have direct control over the equipment or day-to-day operation of the property. The borrower may have some ability to require its tenants to adhere to SLLPs or green lending principles through provisions in the underlying leases. However, since the borrower cannot in practice control the actual activities of the tenant occupying the property, he may be reluctant to commit to goals that are outside his day-to-day control.
- There is still divergence in the market as to what is considered “doing enough” in terms of improving sustainability performance in the real estate development finance and REF contexts. This may raise concerns about greenwashing (namelythe practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact it does not meet basic environmental standards) that can damage the reputation of both borrowers and lenders.
Despite the above issues, there have still been a number of SLL deals in the REF and real estate development finance contexts. The REF Guide points out that there is still significant potential for further growth of SLLs in real estate development finance and REF contexts due to a number of factors, such as: (i) the need to decarbonise the existing real estate stock to meet with global climate goals, (ii) improve the sustainability of construction methods and materials, and (iii) address the shortage of affordable housing around the world.
The REF Guide sets out some common categories of KPIs seen in REF and real estate development finance contexts, along with an example of the improvements a KPI in this category might seek to measure. Examples include:
- Energy efficiency: Improvements in the energy performance rating of buildings owned or leased by the borrower (often demonstrated through a sustainable building rating, standard, or certification). Improvements in energy efficiency may be related to the performance in use and/or the structure of the building(s).
- Sustainable sourcing: Increased use of verified sustainable raw materials/supplies in the construction or refurbishment of the building(s) or development being financed.
- incorporated carbon: Reductions in embodied carbon associated with the development being financed.
- clean transport: Improvements in the use of low-carbon transport and related infrastructure, including charging points for electric vehicles and dedicated spaces for bicycles.
- affordable housing: Increases in the number of affordable housing units developed by the borrower.
For more examples, see the REF Orientation. We note that the examples contained in the REF Guide are not exhaustive and are intended to be indicative only.