Key statistics

Starting with the positive…

Liz Truss’s recently announced £150bn energy plan will provide some respite for hospitality. Akin to the support announced for domestic users, businesses will see their energy costs capped on a price per unit basis, pointing to an increase of approximately 27% on summer energy pricing. However, for those businesses coming off three-year fixed price contracts the increase could be in the region of 120–150%. Still a significant increase but half the 300% press reports were citing before the unveiled energy plan.

For those moving onto new energy contracts this winter, the price cap will minimise its impact on margins. Prior to the announcement, and for those exiting fixed price deals, we were modelling that utility costs as a percentage of revenues could hit 11%. Taking this increase straight off EBITDA (earnings before interest, tax, depreciation and amortisation) could mean average EBITDA as a percentage of total revenues reducing to 18% from an industry average of 25%. With the cap, utilities as a share of revenues could be closer to 6% with margins softening to a more palatable 23%.

But there are several variables tied to this model. Firstly, we’ve assumed that revenues will remain unchanged on recent summer levels, but weakening consumer sentiment may place downward pressure on demand and, in turn, revenues, as we move into Q4, albeit the slowdown in inflation that is expected to be facilitated by the domestic price cap will help mitigate this. This will also be aided by the fact that current revenues across a number of markets are significantly higher than those seen in 2019, driven by strong rate growth, helping to provide more of a cushion to rising costs.

The regional hotel markets may be more exposed to this due to their reliance on domestic visitors. London, Edinburgh and other tourist hotspots may be able to buck this trend, helped by a continued recovery in international visitors and bolstered in part by the weakening of the pound against the dollar and euro. We’ve also assumed other costs remain unchanged. Yet, with rising food and staff costs, there will be additional pressures on margins, with upscale and luxury hotels most exposed due to greater ancillary uses and staffing requirements. Notwithstanding this, trophy luxury hotels may be able to counter some of this inflationary cost pressure due to their ability to drive rates, albeit this won’t be universal across the luxury market. On the other hand, operators may look to efficiencies elsewhere to maintain margins.

Now for the negative…

This price cap for businesses will only last for six months from October after which the Government plans to offer focused support to vulnerable industries, with hospitality already cited as one such industry. Without the detail of this support, which we won’t have for at least another three months, hoteliers are not out of the woods yet. All we can hope is that wholesale energy costs in March and April 2023 will be lower than where they are today.

Irrespective of what happens six months from now, we are potentially looking at higher energy costs over the longer term, if only to cover the scale of Government borrowing required to pay for this support package. As a result, energy costs are likely to account for a larger share of revenues than that seen historically, adding to the already mounting pressure on operator margins.

Approximate utility (energy, gas, water and other services with energy accounting for the majority) costs pre-Covid (Jul 2018 to Dec 2019) averaged £5.10 per room per month. The month-on-month change in this cost averaged only 0.5%.

This corresponds to what was seen in the energy market with the CPI measure of energy reporting a total change over the same period of only 0.2% (see chart, below). While the pandemic depressed energy costs and energy usage in hotels due to closures, the reopening of the sector saw utility costs start to increase in line with rising energy costs. In addition, whilst lower occupancies, particularly during Omicron in December 2020/January 2021, meant a surge in utility costs on a per occupied room basis, which have since softened as occupancies have improved, June 2022 utility costs were 12% higher than those seen in the winter of 2019. This is notable as winter energy usage is higher than in a summer month like June.

Furthermore, June 2022 occupancy was higher than that seen in those winter months of 2019, which will have depressed costs on a per-room basis more than that seen in the winter of 2019. The upcoming increase in energy costs this winter, even with the price cap, will elevate these per-room costs even higher.

What can hoteliers do to mitigate the impact of rising energy costs?

If there has been one positive from the pandemic, it’s the fact that operators have had plenty of experience in driving efficiencies in order to reduce costs. This time will be no different. The instigation of operational and energy-saving initiatives will help mitigate the impact of rising energy costs.

There will be some obvious and easy wins, such as reducing heat and water temperature, albeit within the range that is still comfortable for guests. But monitoring and performance measurement of energy-saving initiatives will also be key to identifying other potential opportunities for efficiencies and success. Likewise, more capex-intensive measures, such as installation of ground source heat pumps, will also be beneficial albeit may be better considered as part of new developments and extensive refurbishment projects.

While the immediate focus will be on reducing energy consumption, and, in turn, costs, there is one potential silver lining: a greater focus on energy costs could be the catalyst to really drive the ESG agenda in the sector, ultimately reducing carbon emissions.

Implications for values and transactional activity

The recent rise in debt costs was, in some parts of the market, already starting to generate upward pressure on yields. A further squeeze on margins due to rising energy costs will add to this, as hotel values are, to a large extent, determined by operational profitability. The Government support that is in place over the next six months will help mitigate these pressures, as will operator initiatives to reduce energy consumption.

There are, however, parts of the market that are relatively more insulated to the upward pressure on yields that may materialise in response to higher energy costs. Leased budget hotels will be one, due to their leaner cost model and the institutional investor appetite for these types of assets. Serviced apartments may also move up the agenda helped by its typically leaner operational model, higher margins and relative resilience during economic downturns.

For those more exposed, the compression in margins could pose a challenge to loan covenants where there is a minimum EBITDA/Debt Service Coverage Ratio specified as part of the loan agreement. However, our modelling suggests that the instances of this should be limited, subject to operational performance, due to the reduced impact on margins as a result of the price cap. During the pandemic, most lenders overlooked these covenant breaches; it will be interesting to see whether lenders adopt a similar approach this time.

If intensive margin pressures do materialise, we could see more investors bring assets to the market. This should be with the benefit of more realistic vendor expectations, which had derailed several deals earlier in the year. This, alongside some pricing correction in certain parts of the market, could improve liquidity. And with the pound weakening against the dollar, we could see an increase in US private equity funds deploying capital in the sector.

The challenge to this, however, apart from higher debt costs, could be lender sentiment. Profitability challenges and the potential impact this may have on loan covenants could dampen confidence in hotels. Whilst confidence may take a knock, we don’t think this will lead lenders to reduce exposure significantly, as was seen in the aftermath of the global financial crisis. Firstly, the fundamental drivers of demand remain unchanged, with a return to pre-Covid demand and operational performance in London and the regional market forecast for 2023 and this year, respectively. In this context, it then comes down to the specific asset and operator in question, which has always been paramount in lending decisions.

What does this mean for investors and lenders?

For building owners and lenders, as with the pandemic, open and frank discussions with tenants and hotel managers will be vital to understanding the potential issues operators may be facing. And, in the case of hotel landlords, exploring joint initiatives to reduce energy usage and ultimately improve the sustainability of your asset, may also be an option. Savills Earth, our team of sustainability experts, are already working with several hotel owners and operators to explore and develop sustainability strategies that can reduce energy usage.

Now might also be a good time for portfolio owners to look at their assets more strategically and focus on those where the demand drivers are the strongest and where the opportunities to improve efficiencies exist.

The impacts of excessively high energy costs should be a short-term issue; however, working to improve efficiencies and reduce energy consumption will not only be good for long-term profit margins but will also be good for the planet.