Pension fund real estate investors stand to gain much from successful investment in the hotel sector, but they must be clear about how involved they want to be in the operation, as Keegan Viscius reports

Hotel assets are emerging as an essential part of a diversified real estate portfolio. Global transaction volume for hotel assets reached nearly US$70bn (€52bn) in 2006, with deal volume expected to surpass US$100bn in 2007.

Driven partly by institutional investors such as pension funds which are facing limited investment opportunities in their domestic markets, as well as private equity investors who see the value in aggressive asset management, hotels continue to offer a unique investment opportunity for those seeking to unlock higher returns.

Investor confidence is being bolstered by a number of recent transactions in the past year, such as the Blackstone acquisition of Hilton Hotels (US$26bn), Colony Capital LLC along with Saudi Arabia's Kingdom Hotels International's acquisition of Fairmont Hotels & Resorts (US$3.3bn), and the consortium led by Quinlan Private's acquisition of 47 Marriott hotels in the United Kingdom for US$2.2bn, as well as the increase in liquidity and transparency of hotel transactions.

Historically purchasers of hotel assets have been owner-operators, though largely starting in 2001, hotel groups began selling off real estate assets in order to focus on the operational side of their business, or ‘OpCo-PropCo' splits, separating the operating company (‘brains') from the property company (‘bricks').

This shift was pioneered by the InterContinental Hotels Group and Accor's sale of a large part of their property, with many other groups following suit. This structural shift and focus of priorities by the hotel groups has allowed traditional property investors to allocate both debt and equity capital into hotel real estate, offering either a fixed income stream or variable income stream depending on the type of operational agreement.

As interest and investment in the hotel sector continues to increase through 2007, it is important that the investor is aware and understands the dynamic value drivers and the fundamental differences between a lease and a management agreement with a hotel operator, and how the inherent risk is appropriated.

Sale and leasebacks have traditionally been used as a method to unlock value from owner occupied real estate investments. In this case the most obvious benefits to the hotel group gained by selling the property would be that it frees up a substantial portion of capital which can then be used to fund further operational expansion, be returned to shareholders, and/or used to improve the return on capital employed.

Benefits to the investor are a fixed income stream regardless of hotel occupancy, performance, or profitability, at a contracted annual amount for a set period of time and generally with the benefit of annual indexation. Not all is favourable with lease agreements though. By limiting themselves to a fixed annual lease payment, investors neglect any upside potential which could be gained from positive shifts in the market and any increases in the profitability of hotel operations, these returns will go solely to the operator/tenant. At the end of the lease the owner has a property which may need major refurbishment, though there are various hedging mechanisms which can mitigate this exposure. The operator also faces risks, for instance if profitability drops (even for a short period) there might be a chance that rent obligations can no longer be fulfilled by the business, though again this can be mitigated by parent or group guarantees set out in the lease.

Management agreements on the other hand offer a variable income stream to the investor based on hotel performance and profitability. In the case of a management agreement, hotel operators act as operating partners to the owners, operating the hotel as a fiduciary representative on their behalf for a management fee. Usually under a management agreement the fee is comprised of two parts: (1) a percentage of all hotel revenue, and (2) an incentive fee which is usually based on some measure of profitability or cash flow. The first part of the fee is aimed at rewarding the hotel operator for volume generation, while the second part rewards them for efficient operations and resulting profitability.

While management agreements offer the possibility to access the upside potential not offered in a fixed rate lease agreement, contracts will usually have an initial term of around 20 to 25 years with a rolling extension, though this can also leave investors exposed if there is an economic downturn in the market.

In today's market the majority of internationally branded hotel operators work exclusively under a management agreement.

Under a lease agreement the owner effectively gives up all involvement in the operation of the hotel and property. With a management agreement the owner retains some influence in the running of the hotel business in order to achieve optimal performance from their investment. Historically there has also been a yield gap of 2.5% between variable income and fixed income streams, though this margin has compressed greatly in recent times to between 75 and 125 basis points, indicating investors' confidence with management agreements.

Especially for institutional investors, investing in hotel real estate assets offers the opportunity to diversify and spread risk into an asset class which is not highly correlated with equity or fixed income markets. The added element of cross-border investment offers diversification opportunities from domestic markets.

Hotel assets, especially those under management agreements, have a high correlation with economic performance, though in the instance of an economic downturn recover much quicker than traditional property assets. This strong positive correlation between hotel performance and GDP growth makes investments in hotel real estate in rapidly developing economies, such as the Central and Eastern European countries which have recently joined the European Union, all the more desirable.

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