Introduction

Environmental, Social, and Governance (ESG), is a framework for analyzing investments related to their environmental impact, social outlook, and corporate governance. While ESG has been a hot topic among the largest institutional investment managers and investors for years, it is becoming a focal area throughout commercial real estate investment and finance, illustrated by the dramatic increase in ESG terms and requirements posed by institutional investors, lenders, and tenants.

The COVID-19 pandemic created a unique set of circumstances to facilitate the conversation around ESG. Environmentally, investors witnessed firsthand the positive impact of a slowing of everyday pollution from activities like transportation, demonstrating the natural environment's ability to recover. On the social side, we all observed the disparate impacts of the pandemic across socio-economic groups and a surge in global awareness of (and focus on) the need to address racial injustice. From the governance point of view, the growth of more vocal non-institutional investors led to a demand for greater disclosure of corporate governance details.

Most real estate ESG initiatives have focused on attempting to address environmental impacts of property development and operations. Sustainability-focused real estate investments can alleviate adverse impacts by pushing for solutions like renewable energy, energy efficiency, water conservation, and recycling programs in buildings. While environmental impact has most often been the focus of ESG in real estate, investors have steadily turned their attentions to social and governance considerations. Concerns on the social and governance side include ensuring equal access to opportunities, fair compensation schemes, ethically sourced materials and labor, diversity in corporate leadership and boards, safe work environments, financial transparency, and ethical business practices.

Client/investor organization and prioritization

Most institutional real estate investment managers have had ESG policies in place for some time and are accustomed to providing in-depth ESG insights for investors’ due diligence questionnaires. There has been, however, an increasing formalization of policies, with many investors creating designated organizational structures and roles dedicated to ESG. One very public example of this was the announcement in June of Hines’ new ESG strategy, including the creation of a dedicated new global ESG team. This team will be led by Peter Epping, manager of the Hines fund recognized by Global Real Estate Sustainability Benchmark (GRESB) as the most sustainable fund in Europe of all diversified portfolios. This followed a few months after Blackstone’s announcement of the expansion of their global ESG team creating five new dedicated senior positions across the U.S., Europe, and Asia.

Real estate investment vehicles are becoming more and more specific about the actual ESG initiatives they will pursue via their investment criteria, asset management plans, etc., and how they will measure and report back to stakeholders. While the impetus for reporting came from investors, many tenants are including their own ESG requirements or rating criteria when assessing potential real estate to lease. Additionally, the market supply of debt with beneficial terms for ESG performance is growing. All this market momentum is shifting economics such that ESG-oriented investing will soon move from competitive advantage for those doing it well to competitive disadvantage for those not effectively incorporating such principles.

The global awareness of and shift toward ESG priorities has yet to drive meaningful market standardization of data capture, reporting, compliance, or enforcement measures. Critical analysts highlight instances of greenwashing for marketing purposes or unsubstantiated sustainability claims. In the absence of uniform data capture and measurement standards, investment managers tackle the challenge of setting and living up to broadly accepted mandates that are interpreted differently by various investors, benchmarks, standards, and certifications. Any investment manager or service provider who has contracted with the largest pension funds can attest to their differing requirements in the absence of more defined global ESG standards.

Real estate debt

Across the globe, the number of real estate debt sources and types with ESG qualifications or economic benefit to borrowers meeting ESG criteria continues to grow. This is increasingly prevalent in loans securitized as CMBS, U.S. multifamily agency mortgages, and corporate debt issuances.

The Freddie Mac Multifamily Green Advantage® loan program offers better pricing and greater loan proceeds for borrowers who reduce whole property energy and water consumption by at least 30% (which can be any combination of 15% energy reduction and a reduction of either energy and/or water whole property consumption by an additional 15%). They also offer discounted loan pricing for affordable rental units with any of nine industry-standard green building certifications.

This past June, the largest ever fixed-rate SASB CMBS issuance closed on SL Green’s One Vanderbilt Avenue (OVA) as a green bond issuance on which Chatham advised. Wells Fargo, as lead originating lender, hired Sustainalytics US, Inc. to review SL Green’s OVA Green Bond Framework and provide an opinion on eligibility, compliance, and reporting. OVA exceeded the Green Bond Framework’s minimum standard of LEED-Gold certification by being certified LEED-Platinum. The Green Bond Framework was drafted in compliance with the Green Bond Principles 2018 published by the International Capital Markets Association.

Europe is further advanced than the U.S. in incorporating sustainable bond and loan frameworks into debt programmes. During a recent Chatham webinar, non-U.S. respondents polled three times higher than U.S. respondents in prioritizing ESG initiatives. So far this year, there has been over EUR 19B of bond issuance including over EUR 1B (equivalent) from Canary Wharf group, EUR 600M from Vonovia (formerly Deutsche Annington), and most recently EUR 500M for Segro. Most of the larger banks are offering margin discounts for linking funding to ESG KPIs. From a bond issuer's point of view, an ESG framework in Europe is a "must have" rather than a "nice to have", particularly for real estate which is seen as a late adopter of ESG in comparison to other capex heavy businesses such as utilities.

Derivatives/hedges

Sustainability-linked derivatives (SLDs) have been largely a European market feature, although there has been some nascent activity recently in the U.S. and APAC markets. A simple example structure is an interest rate swap for a corporation or project that sets certain ESG performance goals. The counterparty receives a 3–5 basis point reduction in the fixed rate paid based on which goals are met. While this may seem straightforward, two issues are front of mind: (1) valuation and accounting treatment, and (2) performance measurement and reporting for compliance.

Chatham’s Global Head of Hedge Accounting, Dan Gentzel, actively engages with the International Swaps and Derivatives Association (ISDA) and the Financial Accounting Standards Board (FASB) around accounting for and valuing SLDs, as well as deliberation on whether the ISDA definition of a derivative needs to be expanded to more properly include SLDs. From his recent experience, Dan notes that certain ESG provisions in real estate debt may ultimately be defined as embedded derivatives that may be required to be bifurcated and accounted for separately if current accounting standards are strictly applied. While our current stance is that there should be a carveout for the ESG features, as they tend to be immaterial (e.g., 2–5 bps on average) compared to the complexity of separately accounting for them, there is much yet to be defined and standardized in this area.

With respect to measurement, ISDA recently published Sustainability-linked Derivatives: KPI Guidelines to address the market’s need for education on principles of SLDs, including framework guidance of best practices toward market standards that will support integrity and liquidity. As often happens in rapidly developing nascent markets, there is a tension between innovation and standardization that must play out constructively. Since any suspected greenwashing will erode confidence, clear KPIs with trustworthy mechanisms for measurement, reporting, and accountability are key.

Conclusion

Given our $2 billion average daily global transaction volume, Chatham has a broad perspective on the latest market structures and terms to leverage on behalf of our clients, including ESG-oriented structures. Please contact us with questions. We’re happy to review indicative terms and to share our most recent perspectives.

Footnote on the future

This past summer, Chatham’s Global Real Estate team got an encouraging glimpse of the future of our industry as we hosted five exceptional interns. Calliope Cortwright, Brian Keller, Jaxon Kim, Ryan McLaughlin, and Kevin Polanish brought such energy, enthusiasm, and thoughtfulness to their projects that we can’t help but be excited about this next generation of talent and leaders. They also took a keen collective interest in researching various topics and developments in ESG, providing the impetus and foundation for this article. We thank them all for their contributions and wish them all the best in this academic year and beyond.