How lenders and sponsors should approach ESG property retrofitting

Proactive sponsors may benefit from a current supply shortage of assets with strong energy performance certificate (EPC) credentials. Proactive lenders may benefit from stronger loan-to-value covenants and more favourable disclosure reporting on the emissions impacts of their financings, and are more likely to find financing opportunities and retain or grow market share. Failing to promptly address this issue could lead to assets becoming stranded.

Regulatory and reputational pressures

Much of the current commercial property stock in the UK does not comply with anticipated requirements for commercial property to be rated EPC B or better by 2030, in addition to potential interim uplifts to EPC C by 2027. Anticipating this, tenants are seeking leasing space that will comply with these requirements. Savills estimates that 60% of the office space leased in 2022 benefitted from the highest energy performance accreditation. However, this office space only accounted for less than 10% of total London office space. This statistic highlights how practical regulatory concerns are driving market activity in this space, alongside reputational requirements. 

Lenders – whose loans are ultimately funded by tenants – will continue to favour assets with strong EPC credentials at the expense of assets that do not. It is no surprise to see a growing number of investors realising the value of a “brown to green” business model. The largest landlords and tenants are now likely also to have set their own public and Paris Agreement-aligned ‘net zero’ targets and to be subject to increasing mandatory requirements to make climate-related financial disclosures, as will lenders. Commercial landlords and tenants may become subject to public performance-based ratings targets based on actual energy use if and when the government implements the policy it has announced in this area.

All these measures lead to increasing reputational pressure to do the right thing and minimise greenhouse gas emissions from their buildings.

Growing focus on embodied carbon too

In addition, at least 80% of todays’ buildings will be in place in 2050, the date at which the UK has legally binding target to reach net zero emissions. There is an increasing realisation that embodied carbon emissions – the emissions from building materials and the construction process – represent a significant and growing share of the emissions from the property sector and there are loud calls from industry bodies and from the UK’s Climate Change Committee for regulation of embodied carbon through building regulation requirements and the planning system.

If these calls are met, it would mean disincentives for demolition and re-build projects and more incentives for retention and re-use of existing buildings, increasing the drivers for reducing emissions through retrofitting. Already, a number of local authorities are beginning to require an assessment of the embodied carbon in the case of large developments.

Actions for sponsors and lenders

For commercial property assets that will not comply with anticipated EPC requirements, sponsors and lenders should actively engage to agree a funding programme for how back books can be brought up to the required standards. There is an alignment of interest among sponsors and lenders in maintaining the value of secured property and loan-to-value protections in financing agreements, preserving commercial relationships, and in taking advantage of significant potential financing opportunities around retrofitting. 

The type, extent and cost of retrofitting required – and its impact on property cashflows – may vary significantly.

Some properties may require little or no retrofitting and any retrofitting that is required may be capable of being funded from an ancillary capital expenditure funding line, or by the sponsor, without the need for tenants to vacate the property. Where significant changes are required, a much fuller development-type financing may be required with tenants having to vacate the property and lenders being satisfied that the property can be re-let quickly and on favourable terms. 

Factors such as the extent of the works required, cost, impact on valuations, impact on lettings and the covenant of the sponsor – including its ability to fund all or part of the retrofitting works – will likely be important. Repurposing may also be needed alongside retrofitting to make it financially viable.

At the same time as retrofitting for energy efficiency, decarbonisation of heating sources – which will be increasingly considered as EPC methodology develops – and any need for increasing the resilience of the property, such as against overheating risks, should also be considered. Proper planning for works across portfolios around voids at lease ends will minimise adverse cashflow impacts.

Some lenders have developed tools to help sponsors to understand the cost, payback times and impact on valuations of retrofitting properties to comply with forthcoming EPC requirements. Sponsors who engage early with their lenders and can provide considered and properly costed plans to lenders to retrofit back books of commercial property stand the best chance of obtaining support from lenders for plans to fund retrofitting. 

Evidence of a planned retrofit strategy opens the prospect of sustainability-linked loans with preferential margins dependant on achievement of KPIs related, among other things, to reductions in emissions. They may also receive a value boost from the supply shortage of quality EPC assets. Those sponsors that fail to address these issues will see property values and tenant and lender appetite eroded in the next few years.

Early action here will be critical and early adopters will benefit disproportionately.