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What are CRE credit and ESG risks?

Explainer by Gregory Autin

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Last updated on 18 December 2020Comments

CRE Debt Seniority

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The first-lien mortgage is the senior-most loan secured by real estate having priority claim against a property. It is first in the chronological order in which all mortgage loans are filed and recorded and payment upon the property's disposition. The senior mortgage has priority over all junior encumbrances and gives its holder priority to foreclosure proceeds in the event of borrower default.

A sponsor may take out a second-lien mortgage on a property where a greater total loan amount is desired and to increase leverage. A second-lien mortgage is secured directly by the property it is financing but subordinate to the first-lien mortgage.

Real estate sponsors frequently increase their leverage in property through the use of mezzanine debt. In real estate finance, a mezzanine loan is debt financing common in acquisition (investment) financing that is junior to the mortgage loans but senior to sponsor and preferred equity and with a senior interest in the pledged sponsor equity.

Amounts owing to mezzanine lenders are typically contractually subordinated in a subordination agreement or intercreditor agreement to all principal and interest owing to senior lenders. They are also structurally subordinated when mezzanine debt is advanced to the parent company and downstreamed to a subsidiary that is a senior loan borrower.

A revolving credit lender typically has the first priority security interest in liquid assets, a term lender the first priority in machinery and equipment, and a mortgage lender the first priority in real estate. An intercreditor agreement could assign to each lender a junior interest in the others' collateral.

An intercreditor agreement (ICA) regulates the respective rights and ranking of creditors throughout the term of a financing, especially upon default. Where two or more lenders have a lien on the same collateral of various categories, their relative priority will be different with respect to each category.

CRE Credit Risk Metrics

For commercial real estate loans, the income-generating capacity of the property to support the loan must be carefully analyzed and fully understand. The underwriting of CRE loans traditionally considers net operating income, debt-service coverage, and loan-to-value:

  • Net operating income (NOI) - The overall performance of a firm's operations before considering nonoperating revenue and expenses, extraordinary items and income taxes, it equaling gross potential income (GPI).
  • Debt-service coverage ratio (DSCR) - A ratio of net operating income to annual debt service, including insurance and maintenance, which indicates the ability of a property or a tenant to service its debt.
  • Loan-to-value (LTV) - The maximum loan amount a lender is prepared to advance as a percentage of the value of the eligible collateral, it being the ratio of the loan amount divided by the market value of the property and other collateral securing the loan.

For income-producing properties, NOI equals the total rent possible from the property if it were 100% leased at market rates plus ancillary income less vacancy and collection loss and operating expenses, excluding debt service, depreciation charges, and income taxes.

LTV generally depends on the nature of the borrower (individual or business), the type of real estate serving as collateral (residential or commercial), and the property used as collateral. The appropriate LTV considers the particular risks presented by each loan and property type.

The loan-to-value for a commercial mortgage may be 50% to 80%. LTV ratios for a new business with no trading history might be a maximum of 50% of the purchase price of the property, while owner-occupied businesses, such as offices or shops, with a trading history may have an LTV of up to 80%.

Loans for development or other higher-risk properties call for relatively low LTVs and more equity. Loans that are secured by stabilized property having little volatility in cash flow and value get higher LTVs.

ESG-Compliant CRE Lending

ESG risk is the possibility of suffering a negative impact on a company arising from environmental, social and governance (ESG) factors. Sustainability risk (SR) is an ESG event or condition that could have a negative impact on the value of a financial product.

Sustainability performance targets (SPTs) are ESG metrics used to identify assets that adopt sustainability principles. Most loan documentation specify certain SPTs for borrower compliance with general lending requirements.

Green loan principles (GLP) provide a standard for borrowers to apply in business operations with the objective of improving their sustainability performance, complying with environmental regulations, or ensuring long-term financial and operational stability. Green loan principles are based on green bond principles (GBPs), which are voluntary guidelines for the issuance of bonds that promote transparency, disclosure and reporting in the green bond market.

Green loans and green bonds aim to facilitate corporate social responsibility and sustainable financing and investing. Their proceeds are used exclusively to finance or refinance new and existing "green projects".

Sustainability-linked loans (SLLs) promote sustainable development by inducing borrowers to achieve ambitious, predetermined sustainable performance targets. By directly linking a loan's financial terms to sustainable performance targets, borrowers are encouraged to improve their sustainable development management.

Sustainability-linked loan principles (SLLPs) set a standard for determining how financing can facilitate positive corporate performance by achieving measurable growth in financing for sustainable development - however, not restricted to green purposes. SLLPs are based on the borrower's (1) overall corporate social responsibility (CSR) strategy; (2) sustainability performance targets (SPTs); (3) reporting on their SPT achievement; and (4) sustainability performance verified by independent external review.

Besides the risk of greenwashing, there are several challenges to the wide use of green loans and bonds for company financing. The obstacles include the lack of harmonized global standards, perceived higher costs, the lack of product supply, and infancy of the market.

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Gregory Autin

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