How Green Bonds Work in Real Estate

While the movement to make commercial real estate more sustainable is already several decades old, a new tool has been steadily taking hold in the marketplace that makes financing costly environmental upgrades attractive to investors and issuers. Green bonds have grown from just $12 billion in 2013 to over $36 billion in 2014. This year looks to see green bonds continue to sell at the 2014 level. Investors and issuers have both found a lot to love in green bonds.

What Makes a Bond “Green”?

Green bonds refer to debt financing instruments that are issued for the purpose of creating new developments or upgrading existing infrastructure in a way that is environmentally sustainable. Traditionally the biggest issuers of green bonds have been the World Bank and various national governments and municipalities. However, increasing private corporations are issuing green bonds to fund the renovation of buildings to make them more energy efficient and other environmental upgrades.

There are not any internationally accepted standards for what makes a bond “green”, but lenders often tie the issuance to specific and verifiable conditions that the borrowers must follow to qualify. With the rapid growth of this sector further regulation and an international consensus about green bond standards seem likely in the near future.

How Are Green Bonds Being Used?

In the United States one type of green bond that has been especially attractive are tax free bonds issued by federally qualified organizations or municipalities to clean up brownfield sites. Brownfield sites are specific areas that are underdeveloped or are in a state of urban decay. Often these areas have low levels of industrial pollutions as well.

Under the federal Qualified Green Building and Sustainable Design Project Bonds program, developments can qualify for tax free bond status if it meets three conditions:

  • The development project will receive at least $5 million dollars from a municipality or state
  • 75% of the development buildings register to receive LEED Certification
  • The building or buildings are at least 2 acres in size

Beyond this federal program, cities, counties, and private lenders are creating more green bond programs. Investors seem eager to invest in these instruments because of their relatively good yields and the social dividends they produce.

Many organizations are also looking at securing green bonds as a way to finance much needed energy efficiency upgrades to HVAC systems and to lower occupancy costs by improving the overall energy footprint of their buildings.

The powerful GRESB recently released a set of comprehensive guidelines for green bonds for the real estate industry. Among the recommendations is that lenders tie the bonds to the borrowers securing energy efficiency certification from a third party such as Green Star, LEED, or BREEAM.

Currently most real estate green bonds are used for projects that fund construction of green buildings, energy efficiency upgrades, on site renewable energy generation such as solar panels, sustainable waste management upgrades, and sustainable water management.

Tax and Interest Rate Advantages of Green Bonds

Green bonds may be aimed at a social good, but unlike many attempts at using market mechanics to make social gains, green bonds do not require any type of good conscience premium. The returns on green bonds are in line with other conventional bonds. This is goods news for supporters who see green bonds as a chance to reward private investment in environmentally friendly development.

Because many green bonds are issued by government entities many are tax free bonds. Investors looking for safe investments with reliable cash flow and tax savings are drawn to green bonds.

Some private borrowers are drawn to green bonds because they give companies a certain “green” cache and allow them to get dedicated funding for projects that make sense to the bottom line like installing solar panels or upgrading the energy efficiency of a building by improving ventilation or electricity conservation.

Downsides of Green Bonds

But, not everyone sees green bonds as a great social win. Instead of growing in the first half of 2015, demand for green bonds remained steady. This disappointing trend is particularly stark after the huge spike in the sector the previous year. One of the main drags on the industry is a lack of standards.

Any project could be labeled “green” and marketed to potential buyers under that premise. The lack of standards has some investors who should be excited about investing in green bonds worried.

The lack of clear standards has also affected borrowers. Many lenders want to make sure a project is objectively “green” and require many levels of verification as a requirement to issue a green bond. Borrowers are wary of the extra time and costs required. Some worry that the savings they hope to gain will be postponed a year or two further down the road because of the costs of getting certifications and meeting the lender’s verification requirements.

Critics question whether green bonds are more than a public relations move for companies that could get the same types of projects funded under more conventional terms. They note that unless a code of green bond standards emerges, the industry really is dependent upon the good feelings investors get for putting their money into green projects. The worry is that the good feeling of investors is not a sustainable trend.

The Future of Green Bonds

Green bonds have rocketed out of obscurity just a few years ago to become a major force in the bond market. While there is currently a surplus of solid debt options for investors, green bonds seem unlikely to recede back into obscurity.

The public relations benefits of green bonds look to continue to be significant, and many aging buildings continue to need major environmental upgrades to remain profitable and attractive to future tenants and buyers. The single biggest obstacle for the wider acceptance of green bonds is the lack of standards.

However, with groups like the GRESB becoming more involved in pushing common standards, an industry standard for green bonds seems likely to evolve in the coming years. It also seems highly unlikely that the SEC will let a segment as large as green bonds continue to exist without tighter standards to protect investors from the unscrupulous issuers of standard bonds in green bonds clothing.

For now, whether you are an investor, an issuer, or a borrower, there is a lot of money at stake in green bonds, and the sector isn’t going away. Through solid due diligence all sides of a green bond transaction can still get a great deal and profit handsomely, while also making the planet a cleaner place to be.