Green Finance in Real Estate: History and Current Trends

INTRODUCTION

Environmental, Social and Governance (ESG) considerations are becoming more and more relevant to Investors and managers, and as a result, green finance is seeing significant growth. What is green finance? As defined by the World Economic Forum, “Green finance is any structured financial activity that’s been created to ensure a better environmental outcome."[1] Green finance only takes into consideration the environmental aspect of ESG, and is not to be mistaken with sustainable finance, which considers all three pillars of this equation—environmental, social and governance alike. Green finance relates to any financial activities that are structured to safeguard a better environmental impact and outcome, with the goal of managing risks and taking on opportunities that provide environmental benefits with feasible financial returns. In our latest blog, Alliance Global Advisors (Alliance) studies the history of green finance, analyzes the current trends and shares insights on what this practice means for the real estate industry.

We would like to thank Warren Friend, Founder of Pemaquid Advisors, LLC and Katie Orr, COO and Head of ESG at Lebec Consulting, for their contributions to this blog.

GREEN FINANCE: THE BASICS

For banks, financial institutions and governments, green finance is a means of implementing ESG strategy in real estate development. The most common of the green finance instruments is the green bond. The green bond market also happens to be the most evolved financial instrument in terms of green finance definitions and tracking, with the issuance of the Green Bond Principles (GBP) in 2014 by a group of international banks, Investors and issuers in collaboration with the International Capital Market Association (IMCA). The GBP provides guidelines to issuers on the key components involved in launching a credible green bond and ensuring the availability of sufficient information to evaluate the environmental impact of a green bond investment. They also assist underwriters with facilitating transactions through standard disclosure processes.[2] As defined in the GBP by the IMCA, a green bond is any bond instrument where the proceeds will be exclusively applied to finance or re-finance—in part or in full—new or existing eligible Green Projects that are aligned with the four core components of the GBP. The foundation of a green bond is the utilization of the proceeds of the bond for eligible Green Projects.[3] The four core components of alignment include (1) Use of Proceeds, (2) Process for Project Evaluation and Selection, (3) Management of Proceeds and (4) Reporting.

A green loan is similar to a green bond in that it raises capital for eligible Green Projects and specifies that 100% of the proceeds should only be used for these projects. However, the loan is typically smaller than a bond and structured as an instrument between two parties: a lender and a borrower. A green loan also follows different but consistent principles as a green bond.

HISTORY

Over the last two decades, institutional Investors have been working to develop financial solutions to minimize real estate’s impact on the environment. In November of 2008, a pivotal moment occurred with the issuance of the first green bond by the World Bank, setting the stage and framework for today’s green bond market. The green bond was the first of its kind to reduce risks for the Investors and make a positive impact on the environment. It raised awareness of the challenges of climate change and formed the basis of the above-mentioned GBP.

That same year, Property Assessed Clean Energy (PACE) finance was launched in the state of California. PACE is a way to finance an array of energy and water efficiency, renewable energy and hazard reduction improvements attached to rental and commercial properties, and is an assessment of the property and not the property owner.[4] The program provides financing for such improvements without requiring a down payment or payment for the full or partial upfront capital cost of the improvement. These programs have served as a tool to implement California’s energy, environmental and greenhouse gas (GHG) policy goals. Dependent on what has been authorized by local jurisdiction, PACE financing can be used for residential, commercial or municipal properties. Soon after the launch of this program, the residential programs faced difficulties, as the Federal Housing Finance Agency (FHFA) had concerns that the residential PACE assessments had a lien status superior to that of existing mortgages underwritten by Fannie Mae and Freddie Mac.[5] In 2010, Fannie Mae and Freddie Mac stated that they would no longer purchase mortgage loans secured by properties with outstanding PACE loans—effectively stopping the residential PACE programs, except for several pilot programs. Since 2010, a resurgence of residential PACE programs in California has come to fruition, with the facilitation of several developments, including the passage of state legislation (SB 555).

Why is this practice so heavy on Investors’ minds? Advancements in sustainability legislation worldwide are driving demand for asset managers to adopt new technologies and allocate capital expenditure on improvements to assets within their portfolios to align with ESG principles.

Below we explore a timeline of the changing regulatory environment, highlighting why it is more important than ever for investment managers to focus on ESG initiatives.

  • 2008: The first green bond is issued by the World Bank

  • 2008: California becomes the first state to pass legislation for PACE financing

  • 2009: GRESB, the global ESG benchmark for financial markets, was launched

  • 2015: The Paris Agreement—a legally binding international treaty on climate change—is adopted by 196 parties on December 12, 2015, and entered into force on November 4, 2016. For the first time, a binding agreement brought nations together for a common cause to undertake efforts to combat climate change

  • 2017: The Task Force on Climate-Related Financial Disclosures (TCFD) released climate-related financial disclosure recommendations to help companies provide information to support informed capital allocation

  • 2020: Larry Fink, the CEO of BlackRock, penned a letter to CEOs, entitled A Fundamental Reshaping of Finance. He also wrote a letter to clients, entitled Sustainability as BlackRock’s New Standard for Investing, addressing how sustainability must be the new standard for investing

  • 2021: The European Union’s Sustainable Financial Disclosure Regulation (SFDR) came into effect on March 10, 2021, requiring all investment fund managers to disclose how sustainability risks are integrated into their investment decisions for all funds they manage, as well as the likely impact of sustainability risks on returns

  • 2021: On May 20, 2021, President Biden signed an executive order on Climate-Related Financial Risk, aiming to help the federal government address the climate crisis and mitigate the economic risks of climate change

  • 2025: Bloomberg estimates global ESG assets are on-trend to exceed $35 trillion by 2025

CURRENT TRENDS

ESG considerations are currently at the forefront of institutional Investor decision-making. Institutional Investors need to stay abreast of an increasing regulatory and legislative environment that demands sustainable investments. For instance, Local Law 97, included in the Climate Mobilization Act, was passed by the New York City Council in April 2019 as part of the Mayor’s New York City Green New Deal. Under this law—one of the most demanding the industry has seen—most buildings over 25,000 square feet were required to meet new energy efficiency and GHG emissions limits by 2024, with stricter limits coming into effect in 2030.[6] As a result, Commercial Property Assessed Clean Energy (C-PACE) has emerged as a common trend in today’s capital markets.

C-PACE is a tool used to finance energy efficiency and renewable energy improvements on commercial property, using borrowed capital to pay for the up-front costs associated with such improvements. The borrowed capital is repaid over time via a voluntary tax assessment.[7] Warren Friend of Pemaquid Advisors, LLC further echoed this sentiment, having expressed concerns that the intensity and severity of carbon emissions, as they pertain to commercial real estate within U.S. cities, are not being fully appreciated.  “The largest 25 cities in the U.S. have identified commercial real estate as being the number one source of carbon emissions, ranging from approximately 40% to 70% to total carbon emissions within each of those metropolitan areas. These 25 cities in the U.S. account for 70% of the total value of commercial real estate in the U.S., or approximately $14 trillion,” shares Warren. “In New York City, the landmark Local Law 97 has become the template for most of the major population centers in the U.S. What is fascinating about Local Law 97 is not the initial rules that go into effect in 2024, but the harshness of the rules that start in 2030; no building currently existing in NYC can meet those rules, so how does an investment committee allow for the purchase of or the consent to lend beyond that time line on any building in NYC without presenting a significant risk disclaimer. And if there is a major risk to the investment, does that not lead to concern about values? And if values decline, does that not affect the number one source of tax revenues for the cities? It is a well woven web of intricate intersections.” As we look back to this Law in New York City, and other plans across the country, C-PACE financing will allow owners to tackle the cumbersome carbon retrofitting by providing them with additional leverage to build, upgrade or retrofit their properties.   

JLL recently shared insights on a correlation between an increase in green lending based on sustainability performance and building certifications. ING Bank is offering green building incentive loans to fund energy-efficient retrofits, and Allianz Real Estate provided a £140 million green loan to the Canary Wharf Group in London, to name a few.[8] So what is at the forefront of this uptick in a growing green finance market? ESG has welcomed a new era in real estate and evolved into a top priority for both LPs and GPs worldwide, although there has been relatively low consistency in terminology, projects and eligibility criteria for what constitutes a Green Project. For instance, there is no universal standard for what constitutes a green building or what retrofit projects should qualify as Green Projects to designate a green loan. Further, since there is a lack of standard methodology for reporting and lenders, regulators and Investors face concerns about avoiding greenwashing in making sustainable loans.[9] Banks and financial institutions, governments and international organizations define green finance according to their underlying motivations—with financial institutions focused on sustainability indices; banking associations defined guidelines for green lending and bonds; and international initiatives for sustainable investing. The Sustainable Banking Network is motivated to encourage local banks to adopt sustainable banking practices. In contrast, the United Nations Principles for Responsible Investment (UNPRI), the largest global reporting project on responsible investment, is motivated to better understand and prevent and reduce ESG risks.[10] Today, the market is witnessing a growth in green finance due to an increase in agreed-upon standards. The UK Loan Market Association’s Green Loan Principles and Building Research Establishment Environmental Assessment Methodology (BREEAM) scores were critical factors in Allianz’s decision on loans. Fannie Mae also recently accepted BREEAM Residential Plus as a standard for assessing loans under its Multifamily Green Initiative in the U.S.[11]

Additionally, investments in green real estate could increase the value of buildings, leading one to the concept of “green premiums.” Studies on this concept have shown that green certifications yield a 6.0% rent premium and a 7.6% sales premium.[12] Today, with increased Investor demand and a changing regulatory environment, sustainability is no longer focused primarily on increasing the value of a building, but also on preserving the value of buildings to avoid the risk of simply doing nothing at all.

CONCLUSION

As institutional Investors continue to prioritize ESG in the years to come, green finance will become more prevalent and more standard in our industry. Real estate investment managers will need to recognize the long-term social and economic value of green finance to ensure that they can create value in today’s world.

“Nearly 40% of global carbon emissions come from the real estate sector today. And with a price tag of $5.2 trillion to decarbonize the built environment over the next decade, there’s a great need for green finance in real estate,” says Katie Orr of Lebec Consulting. “We already know that green strategies can drive higher occupancy, higher rents, higher tenant retention and overall higher value—meaning it’s not only crucial to the sustainability of our planet, but it also poses good value for real estate investors. In good news, we’ve seen a steady upward trajectory in global green finance that’s all but certain to continue—having grown 100-fold over the past decade. This will be crucial for us to even have a chance of meeting the Paris Agreement’s goal of cutting emissions 50% by 2030 and achieving net zero carbon by 2050.”

For more information on our research in this area, please contact Alliance. By providing education and guidance, we can help investment managers navigate the rapidly evolving ESG landscape.

ABOUT ALLIANCE GLOBAL ADVISORS

Alliance Global Advisors (Alliance) is a women-owned consulting firm focused on developing strategic growth solutions for real asset investment managers. Advising clients with over $400 billion in assets under management (AUM), Alliance partners with organizations to provide an informed, independent perspective, continued education and an innovative approach to attracting capital in a competitive market environment. Our experienced team is committed to empowering the real asset investment community to elevate best practices. Our partnerships allow senior management teams to focus on what matters most: diligently managing Investor capital, creating value and delivering exceptional returns in a performance-driven market.

Disclaimer: This blog was originally published in July 2022 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance.

[1] https://www.weforum.org/agenda/2020/11/what-is-green-finance/

[2] https://www.ifc.org/wps/wcm/connect/12ebe660-9cad-4946-825f-66ce1e0ce147/IFC_Green+Finance+-+A+Bottom-up+Approach+to+Track+Existing+Flows+2017.pdf?MOD=AJPERES&CVID=lKMn.-t

[3] https://www.icmagroup.org/assets/documents/Sustainable-finance/2021-updates/Green-Bond-Principles-June-2021-140621.pdf

[4] https://www.sciencedirect.com/science/article/pii/S0301421519306743

[5] https://www.pleasanthillca.org/1068/Frequently-Asked-Questions

[6] https://www1.nyc.gov/site/sustainablebuildings/ll97/local-law-97.page

[7] https://www.energy.gov/sites/prod/files/2017/10/f39/FL1710_WIP_CPACEv2.PDF

[8] https://www.us.jll.com/en/trends-and-insights/investor/how-real-estate-is-starting-to-embrace-green-finance

[9] https://www.herbertsmithfreehills.com/insight/sustainable-lending-in-real-estate-finance

[10] https://www.ifc.org/wps/wcm/connect/12ebe660-9cad-4946-825f-66ce1e0ce147/IFC_Green+Finance+-+A+Bottom-up+Approach+to+Track+Existing+Flows+2017.pdf?MOD=AJPERES&CVID=lKMn.-t

[11] https://www.us.jll.com/en/trends-and-insights/investor/how-real-estate-is-starting-to-embrace-green-finance

[12] https://www.weforum.org/agenda/2022/01/green-real-estate-sustainability-corporate-priority/