Member Article

With those operating in the living sector now facing the risk of older assets becoming stranded – obsolete to funders and residents - Liz Sweeney and Liana Di Ciacca examine the journey to retrofitting stock and embracing ESG.

The use of sustainability linked loans grew rapidly in the real estate finance market during 2021.

Bloomberg revealed that over 40% of revolving credit facilities approved in Europe last year were tied to borrowers’ Environmental, Social, and Governance (ESG) goals. This shift means ESG is now becoming fundamental to modern-day real estate strategies and financing.

As a result of this expansion, the ESG market is evolving at pace. This poses those operating in the living sector with a variety of challenges and opportunities when considering financing options.

Dealing with older stock

Europe has a large proportion of real estate assets that were built more than 20 years ago.

As a result, there is a risk that assets may become ‘stranded’ - considered too old, of poor quality and no longer fit for purpose. This is likely to affect assets such as hotels, care homes and student accommodation. Investors or operators with this type of stock may find it difficult to refinance, with investors potentially preferring to invest in newly-built assets that already integrate ESG.

To avoid obsolescence, those operating in the living sector must consider retrofitting assets in order to reposition or physically futureproof them. By doing so, they can take proactive steps to increasing investor interest and delivering a positive impact - either through developing more environmentally sustainable buildings or supporting communities and wider society.

Retrofitting assets is, of course, easier said than done. Older assets need a significant amount of capex and financing to bring them up to a higher-standard or change of use proposition.

For smaller operators, the cost of upgrading assets to improve specifications may not be financially viable with capital values and rental levels on properties not supporting premiums for retrofitting. Larger operators, conversely, may be looking beyond factors such as energy efficiency and pursuing net zero – taking into consideration the whole life carbon implications of retrofitting buildings.

There are two areas of the living sector that have been significantly impacted by Covid-19 - accelerating plans to either refurbish, retrofit or replace them with ESG-led assets.

The first is care homes and wider senior living sector where the pandemic has accelerated the closure or upgrading of outdated assets. Given social distancing measures, there are key focuses on reconfiguring developments to improve virus control, as well as resident experience and safety.

Bed supply also remains a topic of concern amongst an ageing demographic. The level of home closures and the slower rate of new beds being built means that there is an imbalance between supply and demand - creating competing interests between retrofitting or building new homes.

Many hotel operators will also be considering their assets following pandemic-related closures. The same challenges around obsolescence are relevant here and there is an anticipation that newer or refurbished hotel stock will be more easily refinanced.

What this often boils down to is who is going to pay for this retrofitting, the freeholder, the operator or tenant?

Often, in an investment property, the answer is nuanced. The tenant may have a repairing liability, but the landlord may want more extensive works to be completed than what the tenant is liable for.

In these circumstances it may be a trade-off, with the tenant wanting to extend its lease and so a deal can be done. The costs of upgrades can be wrapped up in a more general lease re-gearing conversation, perhaps with contributions for major works from the landlord.

Owners and operators will not have the luxury of this conversation and may simply have to consider capital investment in their property portfolios now. Clearly, this issue is not going away.

Digging deep to fund ESG upgrades in the short term should mitigate against the risk of a stranded asset and ensures the company will continue to have financing options in the medium to long-term.

Current landscape

With real estate accounting for 40% of carbon emissions, the sector has the potential to play a significant role in combatting climate change, as well as delivering a wider positive social impact.

Many larger operators already have ESG policies in place, with the resources to either drive these forward internally or instruct specialist consultants to support this. Smaller operators do not have the same deep pockets, which does risk a ESG divide between different levels of the market.

Lenders also face the same management capacity and resource challenges. While some larger lenders may not have specific ESG criteria written into their loan agreements, they are keen to know what strategies their borrowers have in place. The danger of this is ESG being seen as a ‘nice to have’ rather than an obligation from the lender side and requirement for refinancing.

We are now seeing ‘green premiums’ coming through in the market. A recent JLL report identified that occupiers are willing to pay higher rent for more sustainable buildings – leading to higher occupancy rates and net operating income trajectory. Where this is linked to a financing, it could result in lower interest rates.

Intervention

Lenders are likely to have legacy loans and properties on their books that are at risk of obsolescence.

There is, therefore, a pressure on lenders to lead the way in retrofitting and upgrading assets to better incorporate ESG. This has to be matched by further intervention, with lenders educating and encouraging borrowers – in the living sector and across wider real estate – on the risks of not following this route, highlighting that it will be difficult to obtain financing if not.

Lenders must support borrowers to get their assets up to an acceptable standard – but how, apart from refusing to lend? One solution could be sustainability linked loans. These are facilities that incentivise the borrower to hit certain ESG metrics by way of reduced costs of lending.

Aside from making ESG compliance attractive through better pricing or punishing non-compliance through lending criteria, lenders are now coming under significant pressure from regulators to report the relevant data and demonstrate a requisite level of ESG lending.

The key to achieving this will be in establishing a consistent way of measuring and assessing ESG metrics, as if lenders are expected to play a more interventionist role, there needs to be a consistency and fairness in approach.

Working together for the better

It is clear that the market is driving change, with asset owners, especially in the living sector, now facing the prospect of holding stranded assets that are less appealing to both lenders and residents.

Focusing on the opportunity though, by improving the quality of their buildings and integrating ESG, operators can achieve higher rents and better occupancy rates.

Asset owners, however, cannot do this alone considering the major capital commitment required.

This opens the door to lenders that can secure financial returns and deliver on their ESG strategy through funding this type of activity. It is critical that lenders bring both smaller and larger clients along on this journey by incentivising - or where needed taking on a more interventionist role - borrowers to retrofit their assets and avoid the risk of obsolescence.

This article features in Shoosmiths’ new report: Operating in living

 

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