In the very near-term future, ESG and sustainability disclosure will become as important and will require as much due diligence and rigour as financial reporting, according to Hospitality Investor’s Investor Council.
At Hospitality Investor’s recent Q2 Investor Council meeting, when discussing the direction of travel in relation to ESG reporting and disclosure, investors noted a rapid migration from voluntary and fragmented reporting and disclosure to mandatory and regulatory reporting.
“This change is being driven by the International Financial Reporting Standards (IFRS) and it's significant because the IFRS sits under the auspices of the world securities regulators, regulators from 140 countries around the world including the G20. The longer-term direction of travel is that financial and ESG and sustainability reporting are actually going to become integrated into one set of reports.,” the Council stated.
Ultimately the new general requirements being brought in are so that investors can have more clarity in the capital markets so there can be more effective underwriting, with auditors being trained to audit these reports with the same diligence as they do financial reporting.
“Things like climate disclosures Scopes 1, 2 and 3, climate adaptation and the risks to business will be looked at, as well as opportunities such as cost reduction, potential increases in revenues and mandating the reporting of this information as part of your reporting process,” the Council stated.
The Investor Council added that the system will be designed to show the link between sustainability performance and financial performance.
“What impact is it having on cost? What impact is it having on P&L? What impact is it having on your EBITDA? And that’s the direction it’s going. This is being done for the capital markets and is driven by the requirement to have a level playing field. The stability of global financial markets relies on having these standardised and very clear metrics,” the Council noted.
A Council member stressed that due diligence will be much more intensive going forward, adding: “80 per cent of the building stock we’ll have in 2050 is already here so regulators are starting to turn their attention to technical building standards and what we need to do in order to drive retrofitting and refurbishing, and taking old stock and making it fit for purpose for the future.”
Core consideration
The topic of ESG continues to be a core consideration for investors within their asset management strategy, with the Council noting that while in the past, the sector’s conversation around ESG was all about the basics and not really what it meant for real estate institutional investors, that has evolved a lot.
“There has been a huge step up in engagement; even if ESG isn’t necessarily being embedded into the acquisition processes, they’re asking the question about what they need to be considering. On the capital market side, they’re asking what they need to be considering from a liquidity point of view and when it comes to time to exit,” a member of the Council noted.
They noted that institutional platforms are a lot more focused on net zero carbon because they need to comply with regulations such as EU taxonomy as well as sustainable finance disclosure regulations, which means that they have to be a lot more rigorous around their due diligence checklist for acquisitions and how assets are going to fit into their overall ESG strategy.
“So the focus has pivoted not just to cover certifications but is now about energy performance because ultimately, the operational energy performance ties into energy use intensity and carbon emissions, what that means for the asset and how it aligns to net zero carbon annual targets.”
When looking at acquisitions, questions are asked around EPC and energy consumption data so there can be an assessment of where the asset might be in terms of energy use intensity and potential stranding. Larger PE funds or institutional investors may consider getting carbon audits, which will give an indication of how assets are performing and what may need to be done to improve resilience.
However, a Council member pointed out instances in which hotels may have high EPC ratings and be outstanding on the face of it but may be considered stranded because operational energy consumption is too high as a result of not being operated in the most efficient way.
The Council also addressed the matter of whether more sustainable hotels command green premiums, noting that while it’s difficult to assess the existence of green premiums, there has been evidence of brown discounts.
“There are a lot of transactions which are not proceeding and there are brown discounts where groups say ‘this hotel is not as efficient as I would like it to be, it doesn't have the right amount of climate resilience, our insurance premiums have gone up and therefore we can't support this price.’ We're seeing a lot more of that happening.
It’s not transacted and it’s not something that’s necessarily recorded so it’s more market intel that lawyers and advisors are more likely to know about.”
On whether investors were considering ESG-related capex, 60 per cent of respondents said they were factoring in that capex and 30% said they would be considering that in the next 12 to 18 months, taking the total percentage of investors considering ESG-related capex to 90 per cent.
“So all of that transition capex is likely to have a bigger impact on pricing. However, it’s more likely to have a bigger impact on the larger transactions rather than the smaller transactions where there are more high net worths and owner operator groups. But nonetheless, the questions will still come up because it's ultimately a point about liquidity and it's about asset resilience.”
The Council also noted that while there has previously been friction around brand standards being out of date and at loggerheads with the aim of owners to achieve ESG goals, there is now some pressure on brands to engage with owners. This is as a result of more emphasis now being placed on things like certifications, hotels being on a net zero carbon pathway and brands not just making commitments to achieving net zero but also actually amending their brand standards in order to achieve net zero carbon in operations.
Cautious optimism
Turning to other matters, backed up by the latest Hospitality Investor Sentiment Index, the Council expressed optimism that both corporate and leisure demand in the next 12 months will expand despite consumers continuing to be squeezed by higher living costs.
Joe Stather, market lead for Questex's operational real estate portfolio stated: “Some of the expectations around rising demand are supported by expectations of the return of the Asian traveller but that’s tinged with the fact that while energy bills are set to fall from Q3, higher mortgage rates cloud the outlook as households continue to refinance at significantly higher rates throughout the year.”
Looking at total revenue and profitability, stronger demand expectations are feeding into an improved outlook regarding top line revenue. This, coupled with a lower operational cost pressures around utilities and payroll has improved the prognosis regarding profitability, albeit profit remains below 50 (a score of +50 on the sentiment survey signals an increase in confidence and below 50 indicates a decrease in confidence).
“So while the outlook remains challenging, it’s less negative in relation to Q4 2022 and Q1 2023,” Stather explained.
Turning to the amount of unallocated capital, the survey found that the amount funds have to deploy into hospitality remains high even through market turbulence. The total cost of capital along with rising interest rates have driven up hurdle rates and there has been a moderate strengthening in Q2 around the view that hurdle rates will continue to increase. The appetite to commence material asset management strategy has continued to grow since q2 2022.
The data also suggested there may soon be some alignment on buyer and seller expectations and therefore an increase in deal flow, with a quarter-on-quarter increase in optimism that there will be greater levels of available stock moving forward. The competition to acquire hospitality investments is expected to become increasingly fierce, which in turn is expected to support pricing.
To conclude, the focus on hospitality investment relative to other property types remain strong, albeit there has been a minor tapering in Q2 with some investors anecdotally starting to look at other asset classes where, in the short term at least, there's more opportunity to put capital to work.