Why FAP converted its debt fund to ‘dark green’

Berlin-based real estate advisory firm FAP, which specialises in raising and structuring financing for developments and investments, this month converted its open-ended debt vehicle into an Article 9 fund under the EU’s Sustainable Finance Disclosure Regulation.

Under SFDR, funds are categorised as Article 6, 8 or 9, depending on how focused they are on sustainable investment. Article 6 funds do not have a specific sustainability focus, while Article 8 applies to funds that ‘promote’ environmental or social characteristics.

Article 9 funds – known in financial markets as ‘dark green’ funds – are defined as those with sustainable investment, or a reduction in carbon emissions, as their objective.

The FAP Balanced Real Estate Financing I fund was reclassified from Article 6 to Article 9. Through the fund, which FAP describes as ‘core mezzanine’, the firm provides financing for construction projects and existing buildings. In February, it converted it from a closed-end structure and expects capital commitments to increase to around €400 million by 2024.

FAP said the fund is one of the first Article 9 debt vehicles in Germany.

Such funds remain relatively rare. According to research by rating agency DBRS Morningstar, Article 9 products accounted for 3.2 percent of funds under SFDR by the end of Q1 2023. Downgrades of funds to Article 8 ahead of tighter reporting requirements led to Article 9 funds’ assets shrinking by 1.5 percent in the quarter to €277 billion, the agency reported.

For FAP, the decision to convert BREF I to Article 9 was driven by the objective of future-proofing the vehicle from a sustainability perspective, explained Hanno Kowalski, managing partner with FAP Invest, the group’s real estate lending arm.

Kowalski told affiliate publication Real Estate Capital Europe the conversion had been in the making for more than a year. “It is not only a matter near to our hearts, something we want to actively drive forward, but also a risk-mitigation strategy encompassing the future values of the underlying assets.”

Around 65 percent of BREF I’s current portfolio is already compliant with Article 9 requirements, FAP said.

The relatively small proportion of funds classified as Article 9 suggests reticence among managers to commit to the associated sustainability requirements. According to Kowalski, many real estate market participants say they want full clarity on upcoming regulation on sustainable investments before they start work on their vehicles. “We believe that is a dangerous path as regulation in the sector will be a work in progress – just as the climate crisis or social change progresses. Criteria will continue to change over time, there will not be a ‘final stage’.

“If we do not start reconfiguring our portfolios now, the gap towards meeting new regulation – and the overarching targets – will become wider and wider.”

Measurable impact

For FAP to satisfy the requirements of an Article 9 fund, investments need a measurable positive impact on sustainability targets, such as those set out in the UN Sustainable Development Goals.

“In order to achieve that, we have developed an in-house scoring model to identify green loan opportunities,” explained Kowalski. “It includes, for example, the expected carbon emission levels and improvements, but also social factors such as tenant structure or the impact of an asset on its neighbourhood. It almost requires a second underwriting process to what is typically done in Article 6 funds. It is resource intensive but adds measurable value for our investors.”

All financing provided in 2023 by the company has been done so in accordance with the in-house green loan criteria, which features a scoring model devised in co-operation with an external advisory firm, in line with EU Taxonomy criteria and those of the Carbon Risk Real Estate Monitor.

Investor interest in sustainable products has risen significantly, Kowalski explained. “Particularly large organisations, such as insurance companies, have detailed sustainability policies at the corporate level and that also impacts their investment strategies. We often hear that new investments in Article 6 funds will not be considered anymore. Article 8 is the minimum requirement and funds allocated to Article 9 products are clearly on the rise.”

However, some investors were initially sceptical about the conversion, he added, mainly due to fears of reputational risk should the vehicle lose its Article 9 status following tightening regulation.

According to DBRS Morningstar, more than 300 Article 9 products were downgraded to Article 8 in Q1 2023, as SFDR Level 2’s regulatory technical standards were implemented, which requires asset managers to disclose more information on funds environmental, social and governance approaches. Managers reviewed their classifications ahead of the upgraded disclosure regime.

Kowalski accepts there is a risk of not meeting full criteria for sustainable investment once EU Taxonomy rules on the environment come into force. But he argued it will be far easier to adjust the fund to new targets than it will be for managers that have not started the process of making funds sustainable.

“No one wants to be seen greenwashing. We are prepared to meet stricter criteria and continue to develop our fund over time to further boost ESG performance of the assets we are investing in. The concept convinced all BREF I investors, which all had to agree to the conversion.”