The big sell-off has not happened, yet good opportunities are emerging for a more focused group of investors, says Lynn Strongin Dodds

The last two years have not been kind to the hotel sector; transactions slumped, banks reined in finance and investors reset their sights on the core commercial office and retail properties. Today, though, this segment is slowly improving. There are opportunities to buy, but investors should examine thoroughly all prospective purchases, whether luxury, mid or budget.

Graham Craggs, director, pan euro advisory hotel team at Jones Lang Salle (JLL), says: "Investing in hotels today should be on an opportunity-by-opportunity basis. Investors should adopt a more flexible approach and not be too generic. They need to assess every investment on its own merits, taking account of its location, physical condition, true operating potential and having regard to operating structure."

The reasons for investing remain the same though, says Craggs. "The classic benefits are potential higher returns than for other commercial real estate, the absence of rental voids and steady income growth long-term. The development of brand value and the prestige of ownership are other considerations."

The industry is showing signs of recovery. Ascan Kókai, director and fund manager of Invesco Real Estate's pan European hotel fund, says: "In March 2010, we saw positive growth rates in RevPAR levels (revenue per available room) on a Europe-wide average for the first time since mid 2008. This should feed through to higher hotel revenues if this trend continues. However, it is coming off a low base."

The same holds true for transactions although it could take years before they reach the lofty peaks seen in 2007. A recent report from JLL's showed that transaction volumes in the first quarter of 2010 climbed to $2.8bn, a 53% hike from the $1.8bn reached in the same quarter last year. JLL predicts that worldwide transaction levels could reach the $11bn to $13bn level. As Alan Patterson, head of European and Asian Real Estate Strategy at AXA Real Estate Investment Management says: "Hotels have not done well in the recession because, for the clients, they are often a discretionary purchase. They rely on conferences and business travellers as well as tourists. It is difficult in this phase of the economic cycle to predict what will happen next. The pain is not fully felt on the consumer side, especially with the prospect of further job cuts and tax rises. On the business front, we are seeing improvement as the private sector is emerging from the downturn."

While views may differ as to the pace of the recovery all agree that the types of deals will remain at the lower end of the risk spectrum. Gone are the days when investors could borrow money at loan-to-value (LTV) rates of 90%. Today, LTVs are more in the 50- 60% range and investors need a large chunk of equity to invest. This explains why the operating company/property company - propco/opco structures, which gained traction in the middle of the last decade have virtually disappeared. These private equity-type structures thrived when debt was cheap, although the first one was the Le Meridien takeover in 2001 by Guy Hands and eight financing partners, including Royal Bank of Scotland. They bought the company and arranged a £1.25bn (€1.5bn) sale-and-leaseback of 12 hotels at an annual rental income of £80m.

Simon Johnson, director, CBRE Hotels and CB Richard Ellis Leisure & Alternative Investment, says: "One of the problems was that the sector attracted many first-time investors. Historically they had looked at commercial real estate, such as offices and retail, not at niche areas such as hotels. However, many did not fully understand these propco/opco structures. They did not realise they were buying returns based on earnings before interest, taxes, depreciation, and amortisation because of the leverage being used, and not on the underlying investment."

Marc Socker, director of transactions for Invesco Real Estate's pan European hotel fund, agrees: "Hotels became fashionable about five to six years ago. There was a lot of liquidity in the market but there were also many unsophisticated investors who did not understand that what they were buying was highly leveraged properties with underlying business within. Today, there is a smaller pool of more experienced investors who are in the market. They want a better alignment of interests and more guarantees built into the management contracts such as letters of credit and/or guaranteed minimum returns."

As a result, the deals of the past two years, albeit thin on the ground, mark a return to more traditional lease and management contracts. For example, Invesco, which has been one of the more active participants, has bought five hotels for €154m from Accor, Europe's largest property group, which is undergoing a divestiture programme of 450 hotels up to 2013.

Four of the hotels, the Novotel Muenchen City in Munich, Novotel Roma la Rustica, Mercure Corso Trieste in Rome and Mercure Zabatova in Bratislava (which is currently under construction), were sold under a sale and variable leaseback agreement. They will continue to be operated by Accor under a 15-year variable-rent lease - corresponding to 22% of average annual revenue - which Accor can renew at its discretion. The Pullman Paris La Défense, which was sold for €80m includes a €10m renovation programme at Invesco's expense. The hotel will continue to be operated by Accor under a 12-year management contract.

A variation of the theme was the AXA REIM AB Skipper hotel transaction last year. The property fund management group bought the Barcelona-based hotel from Spanish developer Grupo Preyco 44 and signed a management agreement with Accor Hoteles Espana. Patterson says: "I expect that we will see more private owners as well as groups selling their hotels and focusing on core business. It is an ideal opportunity because the operator may be in financial distress but that doesn't mean that the hotel is suffering. The most important thing is to put in place an established brand-name owner who knows how to boost revenue."

Market participants are also hopeful that there could be more distressed sales coming onto the market. As with other types of real estate, vulture funds were established almost immediately after the real estate slump, but so far banks are maintaining a tight hold on lending and portfolios. Robert Barnard, a London-based partner, who oversees the hotel consultancy arm of PKF's Management consultancy services, says: "There have not been the distressed sales that people expected because hoteliers by and large know how to take the cost out of their business. Interest rates are low and they have been able to generate enough cash to cover their payments. Banks are still not lending, which is casting a shadow over the marketplace."

Johnson agrees: "People expected major defaults due to the highly leveraged deals of the boom years. This didn't happen because hotels were able to pay their bills and cover their interest payments. Owners have also been reluctant to sell and there is a mismatch in expectations between buyers and sellers."

Craggs expects improvements. "What we have seen is due to the lack of supply and opportunities in the market. Investors in some cases are being encouraged to pay prices that are in excess of what the investment might be worth. However, as the volume of product increases, prices could come down."