Bridging the Gap - Growing evidence of sustainability's impact on hospitality transactions and business resilience

Despite growing evidence supporting the business benefits of sustainability in risk mitigation and opportunity creation, investors in the APAC region tend to undervalue its importance during hotel transactions. This raises questions about the primary factors influencing capital allocation towards sustainable real estate, the potential impact on property valuation, and the strategy that various stakeholders—including general partners, limited partners, lenders, and hotel operators—can adopt to build more resilient and sustainable hospitality investments.

Climate change is increasingly taking shape as a key downside risk to the hospitality sector and asset values globally. From a physical climate risk perspective, the increasing frequency of extreme weather events are directly affecting profitability and cashflow stability through business interruptions and higher repair costs. Globally insurance premiums have spiked over the past five to seven years, with some markets becoming uninsurable.

Moreover, on the decarbonization side of the equation, governments across the globe are implementing building performance standards and carbon pricing mechanisms to discourage high-emission practices in the real estate sector. Notable examples include New York, Germany, and Singapore, which have already enacted policies with more expected to follow suit in the coming years.

The transition to a green economy presents opportunities, not just risks, for the real estate and hospitality sector. Owners and operators focusing on energy, water, and waste savings, as well as green energy procurement. Resort markets, in particular, have benefited from investments in renewable energy generation (rooftop solar panels), energy efficiency measures (MEP recommissioning,), and water-saving technologies, often achieving attractive payback periods of three to five years.

Businesses that recognize and act upon climate-related opportunities and risks have demonstrated greater resilience in today's volatile environment. Shangri-La in Chiang Mai was protected from recent floods due to installed floodgates, while other properties suffered significant damage. We expect climate resilience measures at an asset level to have a direct impact on hotel values going forward.

As another example, numerous Maldivian resorts have realized weathered spike in utilities expenses and insurance premiums in the recent years, thanks to substantial energy savings from solar installations as global energy prices increased. An analysis of a sample of luxury Maldivian resorts revealed that properties with solar panels contributing 20%-50% of their total energy had utilities expenses Per Available Room (PAR) ranging from USD 25,000 to 40,000. This compares favorably to resorts primarily or entirely reliant on diesel, which reported utilities PAR figures between USD 60,000 and 69,000. Such climate-related risks and opportunities are expected to intensify as carbon emissions rise and current policies and practices persist.

Investors generally operate on shorter investment cycles compared to the longer-term impact of climate change. Institutional investors have a typical three- to six-year investment horizon and although high net worth owners tend to focus on generational ownership, their investment decisions tend to be similarly short term. However, climate risks may take 15 to 20 years to materialize as recurring phenomena in specific locations. Transitional risks, such as policy changes and new technologies, may materialize sooner but are less predictable. This misalignment in timing complicates effective pricing and accounting for climate-related risks and opportunities, particularly for opportunistic investors.

Furthermore, the competitive nature of transactions inhibits potential buyers to effectively consider climate-related risks as a significant tail risk. There are a growing number of hospitality investors that conduct sustainability due diligence for the purpose of compliance and post-acquisition asset management rather than a factor of commercial negotiation.

Consequently, lenders and valuers struggle to properly underwrite risks beyond qualitative assessments as "fair market values" are inherently guided by historical performance and market transaction evidence. This creates valuation deadlock - an emergent phenomenon where valuers are unable to reflect the full range and impact of ESG risks in regulated valuations. Finally, the fragmented and progressive nature of APAC jurisdictions as well as the predominantly private ownership structure, limit transparency and regulatory pressure in the business environment of APAC.

The impact of sustainability on transactions is becoming increasingly evident across various asset classes globally. In the office sector, rental premiums are clearly linked to sustainability, driven by corporate net-zero pledges. For logistics, manufacturing and data centers, energy constitutes a significant portion of operational expenses, making renewable energy investments more material. In contrast, the hotel sector sees less pronounced impact from such investments, as labor, food, and service material costs comprise the majority of expenses.

“When it comes to APAC, although the diverse regulatory environment remains a driver predominantly for disclosure and decarbonization on new builds, European LPs and other market drivers will continue to push the integration of climate related risks in fund and investment processes across the region. We expect this to continue into 2025 despite political headwinds. Sustainability remains a liquidity risk for future values and exit plans, particularly as we move closer and closer to 2030.”

- ALI INGRAM, Head of Sustainability, Capital Markets, EMEA & APAC

Geographical disparities in ESG impact on transactions are evident, with Europe and Australia showing clearer evidence across various sectors due to their more regulated and institutionalized markets. European institutions, regulated entities, and a growing number of private equity firms are integrating ESG considerations into their investment decisions, resulting in increased scrutiny of APAC fund managers, especially those with European limited partners (LPs), regarding their net zero plans and climate resilience strategies. More comprehensive investment parameters now often include ESG factors such as CRREM (Carbon Risk Real Estate Monitor) pathways, electrification, tenant/Scope 3 emissions data, EU Taxonomy and climate-related physical risks.

Investment criteria are evolving to incorporate climate resilience when defining a core investment. For instance, a Paris-based fund manager now requires office buildings to have flood-resistant basements housing critical MEP systems, in order to be considered core assets. Norges, Norway's sovereign wealth fund, will divest from high emission industries entirely to align with net-zero targets. CRREM analysis is becoming more commonly required for European funds, with stranded assets raising red flags.

These trends across sectors and regions demonstrate the growing influence of climate-related factors on investor decision-making as well as the transaction. This impact is manifesting in extended due diligence periods and the depth of buyer pool. As European and institutional investors refine their global ESG approaches, APAC property owners must be prepared with comprehensive data and information to effectively address ESG due diligence inquiries and to appeal to a wider range of potential buyers which can help enhance the competitive bidding process. In a notable case in APAC, a Singapore-based firm requested tenant data for a Sydney office building investment which impacted due diligence timeline. Increased disclosure such as the ISSB will only magnify this trend, and we expect to see this come up during transactions in the near future.

As climate change continues to impact cashflow volatility and stakeholder requirements in the hospitality sector, owners and investors should revise their asset management and investment strategies, considering:

• Medium-term climate and sustainability outlook: Evaluate potential climate scenarios affecting future buyers' asset performance assessments. While short-term impacts may be limited, the following 5-to-20-year horizon will be affected and impact the future buyers.

• Science-based climate scenario analysis: Assess specific risks and opportunities at country, state, and property levels. Examine how shifting seasonality and extreme weather events might affect demand patterns to quantify business impact and understand local climate risks to understand future capex reserve allocation.

• Intangible benefits of social and natural capital: Recognize their role in enhancing resilience and performance, especially in experience- and nature-driven hospitality. As guests seek authentic experiences, understanding the broader implication of social and natural metrics becomes vital for business resilience in tourism.

Integrating sustainability into hospitality investments is not about sacrificing returns or being overly conservative. It's about comprehensively understanding future risks and opportunities to uncover potential opportunities and build resilience in an increasingly unpredictable business environment.

Moreover, by incorporating future climate scenarios into governance structures, owners can promote forward-thinking decision-making. This will enable owners to seize wider sustainability opportunities and address potential risks that the next buyer might only uncover during due diligence, when it's too late. Ultimately, this assists assets with liquidity and value preservation if the owner decides to exit. Much like other financial and market considerations, being prepared for the future climate reality offers investors and owners a competitive advantage over those who are slow to adapt.