Today’s market conditions and current and future sustainability and ESG legislation are threatening hospitality real estate valuation. Realize this: The biggest impact the transition will have is not on the operational side of their business, but on the capital side; capital availability could drop and capital costs could rise excessively for those that do not incorporate ESG into their strategy. The sector seems to be facing a perfect storm, which will threaten most, but will also present opportunities for the wise navigators.
Before the specific threats and opportunities for hospitality real estate can be discussed, background info on ESG regulations and the financial system need to be addressed.
REGULATORY ENVIRONMENT
On the regulatory side, things are moving quickly; perhaps, too quickly. In a recent FSI paper (FSI Briefs No18), researchers
Rodrigo Coelho and Fernando Restoy warn that certain policies aimed at addressing climate-related financial risks might actually jeopardize the stability of the financial system. Both authors, key members of the Financial Stability Institute of the Bank for International Settlements (BIS), discuss in their paper that measures such as capital add-ons on specific exposures may threaten financial stability and will frustrate the green transition itself.
For those who are not acquainted with the BIS, it is the Bank of International Settlements, known in the popular press as the central bank of the central banks. It is an international financial institution offering banking services for national central banks. In other words, the BIS is the place where monetary policymakers meet, discuss and coordinate monetary and financial sector policies.
Concerning the role of EU ESG (Environmental, Social, and Governance) policies within this context, several policy measures have been taken to ensure that the environmental targets for 2030 (Fit for 55) and 2050 (Paris Climate Agreement) will be met. While this mainly focuses on the “E” of ESG, the EU has deployed other measures that will force companies to also pay attention to the “S” and “G.”
Within the ESG context, the EU has made an EU Taxonomy (with a focus on the environment) and is in the process of making a taxonomy focussing on social and governance, which can be used by companies to see how much of their business activities can be deemed environmentally and socially sustainable. Furthermore, the EU has passed certain legislation that will mandate the disclosure of non-financial (i.e. ESG) information.
For the financial institutions, the EU has created the SFDR (Sustainable Finance Disclosure Regulation), which ”lays down harmonized rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products.” In other words, this means that banks, for example, will need to report the sustainability risks in their loan books.
For this, financial institutions need the necessary ESG information from the companies in which they invest and/or lend to. Enter the NFRD (Non Financial Reporting Directive) and its 2.0 version the CSRD (Corporate Sustainability Reporting Directive). These directives ultimately will make it mandatory for most companies (estimated to apply to at least 49,000 EU companies) to report on key ESG factors. This will provide the necessary input for, amongst others, financial market participants (banks, pension funds, insurance companies, institutional investors, etcetera) falling under de SFDR.
The idea of the EU Taxonomy, SFDR, NFRD and CSRD is not just to make sure that companies and financial institutions disclose ESG factors, but to use this info to start steering capital toward ESG-compliant businesses and away from those that do not. And, by extension, these kind of measures can lead to unintended consequences, according to the BIS paper.
STEERING CAPITAL FLOWS AND UNINTENDED CONSEQUENCES
For example, according to the FSI authors, measures like capital add-ons could have unintended and serious consequences. For banks, capital add-ons are nothing new. Certain types of loan exposure carry more risk and therefore require banks to hold more “buffer” capital against such a position on the balance sheet. This could mean that banks with loans to companies with below-par ESG scores will be forced to hold more capital. This buffer capital is expensive, thus reducing the profitability of such loans for the bank. Furthermore, if a financial institution has a high exposure to companies with below-par ESG scores, it itself might find it harder and more expensive to attract capital.
Banks and other financial market participants, are not blind to this and seem to already have taken action by reducing exposure to certain companies or sectors. This increases the cost of capital for those subpar ESG companies and reduces the value of their assets accordingly (the cash flow generated by these companies assets will be discounted at a higher WACC rate, thus leading to lower asset values). The lower asset values means that the debt providers are in for a possible hard landing, as the loan to value, or LTV, might shoot up, as the loan stays unchanged but the value of the assets against which the loan was given are plummeting.
Given this prospect, it is not unreasonable to expect capital providers to pull their capital away proactively. This can create a credit crunch for these companies and means that financial institutions that do not or cannot move out quickly enough (i.e. they provided long term debt), will possibly face solvability problems themselves due to declining asset values, further exacerbating the problem.
Looking at the sheer amount of loans and equity capital at companies with subpar ESG scores, it is not hard to see that this could lead to bank runs, a credit crunch, solvability crises and wreak economic havoc, further exacerbating the aforementioned negative effects. This vicious circle would clearly undermine the financial stability (systemic risk) and is basically what the authors of the FSI paper warn against.
Furthermore, ironically, subpar ESG companies need capital to make the change happen to ensure a smooth green transition, but these ESG measures could actually prevent this from happening. In other words, a lot of these companies with below-par ESG scores have an important role to play in the green transition by making the transition themselves, but ESG regulations might starve them of the necessary capital to make said switch.
What about the link to hospitality real estate valuation? As can already be seen with the mandated energy labels for commercial real estate in some countries (again, driven by Fit for 55 and the Paris Agreement), availability of capital effects are already noticeable. For example, in the Dutch market, ING bank is no longer funding commercial real estate with a label lower than C and ABN Amro is providing 100% LTV financing for green transition projects. Logically, this will widen the valuation gap between commercial real estate with label A-C and versus label D-G.
While hospitality real estate is exempt for now from the energy label C or better requirement, the EU’s 2030 and 2050 environmental targets are encased in law, so to think that this exemption will last would be unwise, especially since hospitality is the biggest emitter of Co2 within the commercial real estate sector.
THE WAY FORWARD
The energy label requirements are a showcase for the way in which ESG (so much wider in scope than just energy or Co2 emissions) will be implemented in the EU. Hospitality real estate should pro-actively implement ESG in their strategy; a failure to do so could lead to the real estate assets becoming stranded assets, due to lack of capital and/or excessively expensive financing.
Further complicating matters is the plethora of business models within the hospitality sector, which often entails that the rental income for the real estate owner is in part variable, meaning that the commercial success of the tenant is a key determinant of the value of the hospitality real estate object. Many tenants could face similar problems in relation to capital availability and capital costs if the aforementioned CSRD comes in full effect, thus hurting total rental income and valuations. This means that measures to improve the ESG profile of a real estate object need to approached holistically by including all the relevant parties in the making, executing and financing of transition plans. This is not easily done as not all interests align perfectly (who is responsible for what, who pays for what and when, how to deal with contracts that need to be altered and so forth).
ESG regulations, combined with the current significant rise in interest rates, seem to form a perfect storm for the hospitality real estate market. But storms also eliminate the unfit from the system. So those hospitality real estate owners that can execute the ESG transition properly and swiftly will face sunnier times after this storm has run its course.
This perspective contributed by Alexander Sassen, a lecturer in finance and ESG at Hotelschool The Hague and owner of financial research company Sassen Research and ESG consultancy company Conifer Advisory Services. Parts of this article are based on a publication made for Conifer Advisory Services.