The US commercial real estate market is less than 10 years away from its first key milestone on a path that is expected to lead to net-zero building emissions by 2045, with an aim to achieve a 50 percent reduction by 2032. But the necessary regulatory framework or push from within the industry to affect significant change on the lending or equity side does not yet exist.
Cities including New York, Los Angeles, Portland, Seattle, Pittsburgh and Washington, DC, have adopted strategies that will move them toward a carbon-neutral future. Additionally, a March 2022 proposal from the Securities and Exchange Commission would require SEC-registered companies to include climate-related disclosures, but implementing these strategies is proving to be difficult, market participants tell Real Estate Capital USA.
“One of the issues is that it is very difficult to steer the ship of a large asset management company encumbered by existing assets within successful fund franchises that do not contemplate carbon reductions with embedded assets that are in the encumbrance of funds,” says Joseph Sumberg, managing partner and head of real estate at Galvanize Climate Solutions, a climate-focused global investment firm that aims to invest and create value in a way that contributes to a broader decarbonization goal.
Sumberg, who has had a long career in real estate investment management, says the firm has been pleasantly surprised to have had conversations with lenders that want to affect change. He also believes it could be more difficult to affect change in the credit space. “In the equity space, our goal is to own these assets and make authentic, tangible change to the carbon footprint of these asset from an [emissions] perspective and improve profits.”
A major obstacle for US managers is that the market is broadly struggling with how to define what green lending is.
“We are only going to buy assets that allow us to achieve our financial and sustainability goals. We are not going to wait for lenders to roll out green lending programs or depend on peripheral pricing from a lender to do this,” Sumberg says. “When I speak with other investors, I get the sense they’re waiting for regulation to occur or carbon reduction efforts to become more economically feasible through government incentives or credit structures. But I don’t think this is the job of the credit markets to move along.”
Rather, Sumberg believes it is in the lender’s best interests to encourage the kind of capital improvements that will improve the resiliency of an asset. “Increasing that resiliency increases its value and creditworthiness,” he adds. “I think equity investors are waiting for a more material advantage from a lender to be able to effectuate a more comprehensive ESG strategy and, frankly, that is unlikely to come.”
In addition to the SEC’s proposed guidelines, individual cities and states have mandated efficiency upgrades with strict timelines for implementation. This is one of the reasons more owners are considering using C-PACE to finance energy efficiency or resiliency upgrades. Commercial Property Assessed Clean Energy programs give owners access to low-cost, long-term, fixed rate loans which are secured by a tax lien. C-PACE programs are enabled by state legislation and administered on a local level.
C-PACE, a financing structure in which sponsors can finance sustainability or resiliency upgrades for commercial real estate properties, is a bright spot. According to data from Sacramento-based consultancy PACE Nation, C-PACE financing has increased in usage steadily since 2009, when there was about $40 million of issuance to $4.2 billion through the end of the third quarter of 2022.
The potential for PACE is real, but sponsors and lenders have not historically widely adopted it as a strategy, says Lara Rapaport, founder and CEO of North Bridge, a New York-based C-PACE lender. The firm, which focused on institutional sponsors and lenders, is active in 18 states that allow PACE financing and focuses on institutional sponsors and lenders.
While the firm is fielding a substantial number of in-bound inquiries, North Bridge believes there is still a lot of education that needs to occur among sponsors, lenders and lawyers. “We are happy to help educate the market and hold people’s hands,” Rapaport says. Part of this education, she adds, is letting people know that PACE financing can be applied to new loans and refinancings. It can also be applied retroactively to give sponsors credit for work that has already been done.
Rapaport launched the firm after a career that started in the leasing market and included a long tenure in Lehman Brothers’ CMBS group and Tishman Speyer’s acquisition and development platform. She also spent nine years at L&L, where she worked on projects that included the redevelopment of 425 Park Avenue in New York. During her time at Lehman, Rapaport worked on some of the earliest European commercial mortgage-backed securities deals.
“There are a lot of similarities to where the C-PACE market is today and where the CMBS market was in Europe in the early 2000s,” Rapaport says, adding that her and her teams’ diverse real estate background has made it easier to understand and explain why C-PACE financing can be so important to sponsors. “We have sat in every seat so that when we look at PACE, we start with a blank sheet of paper and figure out the optimal structure for all. We know how to apply it to a myriad of situations because we understand what the other side or sides are thinking.”
Rapaport, like many of her peers in the US, notes the difference between what is going on stateside and how the UK and European markets are approaching energy-efficiency changes.
“What I became aware of during my time in Europe is how the Europeans were looking at buildings differently, on the acquisition, development and lending side. They clearly have been the trendsetters while the US has been more reactive than proactive,” she says.
Still, there is a sense that the commercial real estate market has an opportunity to create the right rules and guidelines for moving forward.
“There is not a guidebook of how ESG has been done or could be done,” Rapaport adds. “In this time of increased focus on ESG, borrowers are incentivized to improve their assets to maintain marketability and future value. The next buyer of a property will have certain expectations around sustainability, and the asset could trade at a discount if they aren’t met and the buyer has to pay to upgrade the building and avoid penalties.”
Avrio Real Estate Credit, a newly launched commercial real estate lender, opened its doors with sustainability as a main theme, says Lee Hodgkinson, head of sustainability and technical.
The firm’s investment thesis is that lending that measures ESG factors on commercial and housing-related assets is part of a larger shift that needs to happen.
“What I distill it down to [is the need for] a discussion about the needs of the economy in 2023 and beyond and they identified a big gap in the availability of credit and to be able to deploy that credit in a way that does good at the same time,” Hodgkinson says.
There is also a larger story around ESG that Hodgkinson believes can be missed – risk mitigation.
“ESG gives us the ability to incorporate more risk and more non-financial data into our investment process, which we think leads to better investments overall,” Hodgkinson adds. “In many ways, that is how ESG started – it was about identifying risk and incorporating that risk into investment decisions. It wasn’t about just quantifying the good you were doing, which is what I think it gets conflated with these days.”
The firm primarily originates short-term loans, with Avrio looking at the potential for physical risk or climate-related transition risk for a property when originating loans. “Even if our term is short, our relationship with borrowers, lenders and the community is long-term,” Hodgkinson says. “If you’re only looking at a loan based on today’s information or standards, you’re probably not informed enough on the risk of those investments. We try to look at a larger data set of what an asset can be exposed to over time.”
Data around these issues helps the firm to make better investment decisions. “The cheapest time to address that risk is upfront when you’re building and the most expensive time is being reactive when the insurer is stepping in,” Hodgkinson says. “We try to make the best decisions by asking those tough questions: ‘Do we tear down that building?’ or ‘Do we think that building will achieve what the borrower wants to in terms of energy and rent?’”
Jani Nokkanen, partner and CIO of Copenhagen-based real estate investment manager NREP, says implementing ESG principles is easier for US market participants than it may seem.
“It is very clear at this point that ESG makes sense from a monetary perspective. It is more about attitude and knowledge, and it is not complex,” Nokkanen says. “As a real estate owner, there are four or five things to do and there is a whole chain of consultants, engineers and suppliers. It is all about the attitude.”
Furthermore, adopting ESG principles is shifting in importance for investors. “The capital markets, clients and employees are also requiring this. Pension funds in Europe are required to have a portfolio that is moving toward green and if more institutional investors are moving that way, there will be a supply-demand imbalance for green assets over the next five to 10 years,” Nokkanen says.
The firm wants to push its green lending business further into Europe and is looking at the Nordics. “As banks are pulling out, there is a huge financing gap. As a credit provider, we want to push developers toward this. We see the financing gap as the most attractive opportunity today as banks are pulling out, the bond market is dead and loan-to-value ratios are going down,” he adds.
As the market heads toward a reboot, Duco Mook, head of Treasury & Debt financing at CBRE Investment Management, underscores it is more important for new deals to be ESG-compliant.
“On the lenders side, there is a flight to core and their additional risk premium for less straight forward transactions has increased. This leads to the riskier product becoming more costly. New transactions need to tick all the boxes, including the ESG elements,” Mook says. “I think ESG was already embedded by our investors but now that also includes the lenders. It’s not only about buying green assets, but it is about having a clear and ambitious strategy for each asset. When we started talking about the topic five to seven years ago, it was very much focused on the environmental aspect, but over the past two years, the social aspect clearly gained interest.”
Chris Bates, managing director and head of Europe Real Estate debt origination at Barings, believes there will be a greater push from investors that will help to spur forward decarbonization goals. The firm looks at properties with an ESG lens, with Bates concerned about what happens to assets in secondary locations or secondary markets that require significant capex to either maintain the current use or convert to another.
“Europe is ahead of the US and ESG is a hot topic for all stakeholders in real estate – occupiers, investors and financiers,” Bates said. “People are really in the nuts and bolts of it, how to make it work, and what is cost-efficient. One hundred percent of the loans that come in, we look at the ESG profile as this is not an optional extra.”
There is a growing sense that a main driver will be from local forces rather than a federal program, market participants tell Real Estate Capital USA.
“The regulatory aspect of things is coming on a local level, but it is not likely to be comprehensive on a federal level anytime soon,” Sumberg says.
But there is a silver lining, Sumberg believes.
“What we do know is that capitalism scales and if we’re looking to the government to fix this problem, if we’re looking to lenders and mortgage providers to fix this problem, we will be waiting for a long time. If we focus on what is profitable and use that to drive the change by showing people, then capitalism will do what it does best, which is to spawn ripple effects that others will follow to make money and profit. Once the market sees this, it will replicate it,” he says.