Environmental Disclosures Play Bigger Role in Commercial Property Loan Investing

For decades, credit rating firms have taken into consideration environmental concerns such as flooding and wildfires when they analyze commercial properties. But that process has come to the forefront over the past few years with the rise across all business channels of so-called environmental, social and governance considerations.

The ESG risk assessment divisions of ratings firms have grown in size, scope and recognition along the way. And their ESG work is now being featured prominently in assigning ratings to two forms of repackaged loans sold to investors: commercial mortgage-backed securities and commercial loan obligation issuances.

The five major U.S. rating firms — Fitch Ratings, Moody’s Investors Service, Kroll Bond Rating Agency, DBRS Morningstar and S&P Global — provide diverse levels of assessment in determining ESG risks. However, with calls for wider disclosure coming from banking, insurance and securities regulators, their roles are likely to grow, according to the firms, with assessments becoming more consistent.

While the question of environmental and climate change risk has gained attention in recent years, particularly around Earth Day, it hasn’t affected commercial mortgage securities ratings for several reasons. Multi-borrower deals have a wide diversity of properties, property types and locations. Many of the offerings have short loan terms of two to 10 years. Loans within the deals can also be paid off or substituted. And property owners can take mitigation efforts to lessen the risks.

However, even though environmental assessment of CMBS and CLO deals is most often neutral, the disclosure is increasingly important to lenders and investors, particularly in terms of providing data, said Britt Johnson, a senior director on Fitch Ratings’ CMBS team.

“Investors are either investigating climate data providers or they already have them,” Johnson told CoStar News in an interview. “So, I think a lot of times we are helping them either confirm some of their analysis that they are doing to how similar it is to what we are doing and what we may be doing in the future. Really the data is where many people are focusing and what Fitch is looking at as well.”

The information is also important for investors that are developing or advancing their own ESG strategies, Natasha Aikins, director of ESG analytics and structured finance for Fitch, told CoStar News. The structured finance group handles ratings for all securities backed by loans on any asset class, including commercial real estate.

“Many investors in terms of structured finance are also trying to determine how to build out their own ESG framework,” Aikins said. “It is not simple because you have so many layers. Do you look at the ESG from a collateral standpoint? Do you look at it from the structure and all the various other parties to the transaction? There are a lot of nuances within structured finance. [The information is] helping to inform them as they look at their own internal ESG frameworks to leverage how we have approached it from a credit standpoint.”

Moody’s points out climate risks in all of its loan presale analysis, an initiative that began in 2020.

“Over the coming two decades, the risk of heat stress, water stress, sea level rise, extreme rainfall and flooding, hurricanes, and wildfires is likely to worsen in certain regions of the U.S.,” the agency said. “Climate risks can in the near-term interrupt access and operations, inflict infrastructure damage, and, if events like this become chronic, undermine the longer-term viability of an asset.”

Climate hazards will be increasingly reflected in insurance costs and capital expenditures, according to Moody’s, as well as the valuation of some commercial properties. The agency warned of higher utility costs because of increases in energy demand or lack of water supply, usually through shifting temperatures and humidity levels. Water shortages can also increase the risk of droughts to real estate owners and users.

For example, in four CMBS presale reports issued so far in April, Moody’s has disclosed climate risk levels on 220 properties backing nearly $5 billion in loans. The highest average scores for risk were assigned to water stress for properties in markets where the demand for water exceeds the available amount during a certain period of time or when poor water infrastructure restricts its use.

Moody’s is currently unique among the four bond rating firms in that it discloses assigned environmental risks levels to each property financed in the CMBS and CLO deals it rates. Those levels come from Moody’s sister company Moody’s ESG Solutions and are assigned without consideration of mitigation efforts on the property, such as adequate levels of property insurance.

“The climate scores we provide in our presales highlight environmental risks across property types and geographies,” Blair Coulson, vice president and senior credit officer for Moody’s Investors Service, told CoStar News in an interview. “They indicate risk relating to that specific consideration, not necessarily the creditworthiness of the entire transaction.”

One additional point, Joseph Baksic, an associate managing director at Moody’s added, is that “we are providing additional ESG information to enhance analytical transparency. While ESG information is useful to certain investors for varying reasons, we include this data in our credit opinions, so they know how we conduct our analysis and what we care about.”

In the lead-up to Earth Day, Moody’s noted it places “sustainability at the core of what we do, as we strive to build a better business, support better lives, and provide better solutions to create long-term value for society, the economy, and the world. We understand the pivotal role we can play in creating a more sustainable future by both helping to accelerate market transformation and leading with our own example.”

Multiple business groups and regulatory agencies are also taking steps to make climate risk disclosures more transparent.

The CRE Finance Council, which facilitates the development of best practices and industry standards for CMBS reporting, launched a sustainability initiative last year to identify climate-related disclosure — in terms of energy efficiency, greenhouse gas emissions and property resiliency — that commercial real estate investors need and asset owners can provide.

And the Securities and Exchange Commission is taking comments on proposals to expand required climate risk disclosures for public offering filers.

“If adopted in its current or near current form, the rules will represent a sea-change for how companies in the U.S. consider, report, comply with and integrate climate-related risks and opportunities in their day-to-day operations,” Fitch analysts noted in their public comments filed with the SEC. “Requirements to disclose information about the oversight and governance of climate-related risks by the registrant’s board and management will make climate governance a priority for boards and executive teams.”

The SEC noted that its proposed rules will not apply, at least initially, to issuers of CMBS deals, even though they also file and register with the SEC, while it considers how, to what extent and in what format the sector would need to make climate-related disclosures.

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