Hotel market insights: ESG considerations moving up the agenda and driving change

• What are the current and proposed legislative requirements?

• Evolving investor and lender preferences set to drive change

• ESG is growing in importance as part of lender due diligence and credit approval processes

• Difficult to quantify the scale of the environmental challenge facing existing stock

Key statistics

The issue of climate change has evolved from being a peripheral matter to a global priority. Over the last decade, awareness and experience of climate change and other environmental issues have increased dramatically, and the need to alter the planet’s current trajectory has risen up the political agenda at local, national and global levels. It is imperative that society commits to fundamental changes today to limit the extent of global warming in years to come and to avoid the permanent degradation of the Earth’s resources, habitats and species.

In November 2021, the UK hosted the 26th United Nations Conference of the Parties (COP26) in Glasgow. This meeting of political leaders, negotiators, government representatives, businesses and citizens was convened to accelerate action towards the goals of the Paris Agreement and the UN Framework Convention on Climate Change. On 13 November 2021, COP26 concluded with all countries agreeing the Glasgow Climate Pact “to keep 1.5C alive” with “consensus on urgently accelerating climate action.” Numerous international agreements, governments initiatives and private sector commitments were announced throughout the summit, covering a range of issues from fossil fuels to deforestation to finance.

In order to try and deliver on this pact to accelerate climate action, the UK government is looking to ‘green’ the built environment. Considering that the built environment accounts for approximately 40% of the UK’s carbon emissions, this is essential. However, much of the legislative requirements introduced and proposed have had limited read through for hotels. Considering that hotels are one of the least energy-efficient and highest polluting property sectors, this will no doubt change.

While legislation can be a key driver of change, the consumer-centric nature of hotels means that action is likely to be largely driven by guest demands and preferences. This could mean that hotels have the potential to implement some of the greatest carbon and efficiency improvements across the property sector.

What are the current and proposed legislative requirements?

Much of the focus of ESG and real estate, in particular, the ‘E’ (environmental) aspect, has centred on office and residential stock, rightly so considering it accounts for a significant volume of the built environment. This is reflected in current and proposed legislative requirements, particularly minimum energy efficiency standards (MEES). Below is a brief summary of relevant legislation.

• MEES legislation. From April 2018, MEES was introduced, which made it a legal requirement for all privately owned properties to have an Energy Performance Certificate (EPC) rating of at least an E before they are sold or let (the legislation applies to both domestic and commercial properties, although there are some exemptions, for example, if a property is a listed building).

• Proposed changes to MEES could mean that commercial rented buildings should be at least EPC B rated by 2030 (assuming upgrades are cost-effective). It should be noted that owner-operated commercial buildings are not covered by the current proposals. With only 2% of hotels leased in the UK, these current proposals would have relatively limited impact on the sector in their present form.

• Mandatory disclosure of net zero transition plans for the UK’s largest firms. The UK will become the first G20 country to make it mandatory for its largest businesses to disclose their climate-related risks and opportunities, in line with the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations.

The EU has introduced its own ESG financial rules;

• With effect from March 2021, the introduction of the Sustainable Finance Disclosure Regulations (SFDR) by the European Commission will initiate the compulsory disclosure of ESG-related risks, impacts and objectives. This will increase the transparency of future acquisitions and is therefore likely to generate further promotion of sustainable investing.

• The EU’s Taxonomy for Sustainable Finance aims to define and classify what counts as a ‘sustainable’ investment. It is designed to encourage capital into sustainable investments with the goal to achieve the EU Green Deal objectives, namely a Carbon Neutral EU by 2050 (and interim 2030 target). It should allow greater transparency and assist fund managers in validating their sustainable investments. The onus will be on operators and owners to capture ESG data for their assets and report objectively and clearly.

Alongside these legislative initiatives, we have also seen non-government organisations launch programmes that look to address the carbon challenge facing the built environment. For example, The UK Green Buildings Council (UKGBC) launched its Net Zero Whole Life Carbon Roadmap (including stakeholder action plans) which aims to achieve net zero carbon in the construction, operation and demolition of buildings and infrastructure and meet the UK net zero target of 2050. Its publication includes specific action plans for 14 key industry stakeholders. For example, investors (including banks) are advised to include operational energy performance and embodied carbon targets in their project funding criteria, while developers should require mandatory disclosure of supply chain data and track construction site emissions.

Evolving investor and lender preferences set to drive change

While legislative requirements will be a key driver of improving hotel operational and building efficiency and driving down emissions, much of the immediate change is likely to be driven by ESG considerations in the equity and debt markets. Investors and lenders, driven by their consumers, regulators and a need to sustain future income and asset values, are aligning their investment strategies with ESG. The shift will not be immediate, but we are seeing a greater analysis of property and portfolio environmental performance and an increasing number of ‘green’ or ‘sustainable’ financial products being brought to the market.

The higher importance placed on ESG considerations is demonstrated by some of the survey responses in the ULI & PwC’s 2021 Emerging Trends in Real Estate report. Seventy-nine per cent of survey respondents (largely made up of asset managers) stated that ESG risks are an important factor in investment decision-making, and 49% stated they would be willing to divest from companies that are not taking sufficient action on ESG issues.

We are still waiting for hard evidence that ‘greener’ assets can produce enhanced returns and deliver a value premium, but it is clear that they offer investors a level of ‘de-risking’ – providing greater protection from 1) future environmental regulations, 2) costly decarbonisation works, and 3) high operating costs (from energy inefficiency or fossil fuels price fluctuations). As a result, greater institutional demand for ESG compliant properties could mean the emergence of a yield spread with tighter yields being achieved on ESG assets versus their non-ESG compliant counterparts.

A number of hotel owners have also sought to benefit from the significant growth in the ‘green bonds’ market. Green bonds are fixed-income instruments designed specifically to support specific climate-related or environmental projects, such as improving energy efficiency, protecting ecosystems or improving water management. Capital raised can be used to invest in existing portfolios or purchase new, appropriately environmentally accredited properties. Green bonds are one type of bond within the wider ‘Sustainability Bonds’ market, which also includes Social, Sustainability and Sustainability-linked bonds. Noteworthy and successful green bond issuances in the hotel sector include:

• In September 2019, BBVA and Pestana Hotel Group became the first hotel company to issue a green bond. The €60 million bond has a maturity of six years and was placed among professional institutional investors. The funds raised were used to refinance two new, sustainable hotels: Pestana Tróia Eco-Resort and Pestana Blue Alvor.

• In October 2019, Host Hotels & Resorts became the first US hospitality REIT to issue a green bond; a US$650m, ten-year green bond with a coupon of 3.375%. Host stated that the proceeds would go to finance the acquisition and development of hotels that had received or are expected to receive LEED Silver, Gold or Platinum certification, as well as refurbishments to properties in order to significantly improve energy efficiency and/or water efficiency. The deal refinanced the acquisition of Andaz Maui and the 1 Hotel South Beach, each of which has received LEED Silver certification. In 2021, Host issued a further $750 million of green bonds.

• In February 2021, Whitbread (owner of Premier Inn) issued £300m of May 2027 and £250m of May 2031 green bonds with coupons of 2.375% and 3.000%, respectively. The funds will be used in accordance with the company’s Green Bond Framework (which includes investing in green buildings, sustainable procurement practices and renewable energy) and support initiatives to halve carbon emissions by 2025 and 84% by 2050 (compared to a 2018/19 baseline). As part of the company’s Force for Good programme, Whitbread also aims to eliminate single-use plastics by 2025, halve food waste by 2030 and improve water management. All of Whitbread’s hotels and restaurants are already powered by renewable energy, and 600 rapid electric charging points are to be installed over the next three years (in partnership with energy company ENGIE). Investor interest for the green bonds was high and led to an order book reportedly ten times oversubscribed, illustrating strong demand for bonds of companies with clear reporting, considered strategies and ambitious targets.

ESG is growing in importance as part of lender due diligence and credit approval processes

Commercial property lenders are following a similar ESG route to investors, becoming more aware of how the environmental characteristics of a property can impact long-term value and loan security and increasingly asking more questions of their borrowers. But it is not just a matter of value preservation. Many lenders have made their own commitments to disclosing ESG-related strategies and/or align their lending strategies to a 2050 net zero goal. ESG is also moving up the agenda as part of lender due diligence and credit approval processes and we expect standardised sustainability requirements (or assurances that such requirements will be met) to become part of lending criteria going forward.

In terms of financing new commercial developments, ‘green loans’ are becoming much more commonplace, as asset managers, developers and investors move towards their individual sustainability targets. Green loans are also available to undertake key sustainable improvements to existing properties. Notable examples of green loans in the hotel sector include:

• In September 2021, Cerberus and Highgate secured green financing from Aareal Bank for the purchase of the Dorsett City Aldgate, London. The hotel met green eligibility criteria for the bank, in accordance with its Green Finance Framework, and the borrowers have committed to maintaining this standard. The four-star hotel opened in 2018 and achieved a BREEAM Very Good rating.

• In May 2021, Qatari Diar secured a £450 million green loan from HSBC and Credit Suisse (amongst others) for the construction of its luxury hotel complex, The Chancery Rosewood, in London’s Grosvenor Square. The hotel is intended to be the first five-star hotel and the first UK hotel to receive a BREEAM Outstanding rating for sustainable development. The hotel will feature extensive green roofs, implement energy efficiency measures and reduce water consumption.

• The first ‘green loan’ in the UK hotel sector was for the development of Edwardian Hotel’s new Londoner Hotel, Leicester Square. A £175 million green loan was secured from HSBC, with funding being used to ensure the property exceeds a BREEAM Excellent rating.

Difficult to quantify the scale of the environmental challenge facing existing stock

As seen with the green bond and green loan examples cited above, much of the focus has been on new development hotel projects that can deliver on environmental targets. But, with only 4% of UK hotels built within the last five years, the bigger issue is the need to ‘green’ existing stock.

But, how ‘un-green’ is existing hotel stock?

The simple answer is that we do not know the full extent of the challenge as EPCs have only been required for hotels if they are leased or have been marketed for sale. For example, looking just at branded hotels in England and Wales, close to half do not have an EPC rating.

While absence of information on the environmental performance of a significant proportion of hotels makes it difficult to quantify the ‘greening’ challenge facing existing stock, analysis of EPC ratings, where they do exist, suggests that for some parts of the market, the required improvements needed may not be significantly onerous. Again looking at branded hotels, a third have an EPC rating in the top two bands of A and B, with over half (58.7%) rating either C or D. Only 8.4% fall into the bottom three categories of E, F and G. However, we are aware that for other parts of the hotel market, building performance, as measured by EPCs, may be significantly different and is something we will continue to analyse and make available in future research notes.

ESG has evolved from being an ‘added bonus’ to an essential and risk-led factor in business strategies, and all stakeholders will need to work collaboratively to realise the changes that are necessary. It appears there is enthusiastic engagement and willingness to act to achieve a net zero future, but perhaps the sector as a whole still requires greater information and direction on how best to make this a reality and further establishment of widespread, standardised reporting to allow greater investment.