Time to check-in?
For many institutional investors, hotels are seen as a volatile, non-core asset class. But is this a fair assessment? Christine Senior investigates
There has been a measureable increase in institutional investment in the hotel sector over the past two years, following a dearth of activity immediately after the financial crisis. Transactions for the first nine months of 2011 in EMEA were valued at €6.3bn, compared with €4.2bn for the same period last year, according to Jones Lang LaSalle Hotels. So far this year the UK has been the most active market, with deals worth €2.4bn concluded, compared with €743m in the second most popular market, France.
Nontheless, for many institutional investors the hotel sector is outside their scope. For some, this is simply because hotels are a non-mainstream real estate asset class. For others, there is the perception of the hotel sector as ‘risky', subject to higher volatility and sensitive to the state of the global economy.
Jochen Schaefer-Suren, partner and head of the hotel and leisure division at Internos Real Investors, admits that hotels suffer from a lack of understanding from some investors. "It's a bit like retirement homes, self-storage and student housing," he says. "It's outside the typical office building on a 20-year lease. Pension funds recognise the benefit but also see the risks. They recognise that they don't really understand the assets. Even if you convince the managing director in charge of real estate, it doesn't mean you can convince the investment committee."
Douglas Crawshaw, senior investment consultant at Towers Watson, has reservations about pension funds investing in such a specialist area. For one thing it requires a certain amount governance resources. "In the main, a very specialised product wouldn't really fit," he says. "When you gross up the number of products and managers you would have, and the percentage of capital allocation to the asset class and other asset classes, pension funds can end up with too many managers to properly monitor. If you want to go global with diversification argument you have to be careful what you do."
Still, there are investors becoming wise to the merits of European hotels as a real estate investment. As the search for returns takes institutional investors outside mainstream real estate sectors, hotels fit the profile of investments that can provide regular inflation-linked liability-matching cash flows.
"Pension funds and life insurers want to match their investments with their long-term liabilities," Schaefer-Suren says. "They need to look at assets in the hotel space that offer long-term recurring income streams where volatility is smoothed out through the right operating agreements, fixed or variable leases as opposed to management contracts."
The notion of hotels as being a stable, incoming-producing asset class is perhaps counter-intuitive to some investors' preconceptions. Marc Socker, director of the hotel fund management team at Invesco Real Estate, believes this was compounded by the experience of recent years, when highly leveraged, non-hotel specialists entered the sector. During 2006 and 2007, a number of major hotel operators sold their real estate assets, attracting a flood of leveraged buyers who were new to the market and, arguably, did not understand the sector. Values were over-inflated and unsustainable, and the crisis pricked the bubble.
"Some investors were 90% leveraged, values were huge and not really sustainable," says Socker. "As soon as the crisis came, these investors didn't have the right teams and the right specialist asset managers in place. The value of their holdings was greatly reduced.
"In 2009, in particular, hotel transaction volumes across the globe, but especially in Europe, fell to minimal amounts. There was quite a strong rebound in 2010 and it looks like 2011 will be strong again. It looks like there have been some pretty strong hotel deals this year and quite a few portfolios are on market now."
One step that will go some way to making hotels more mainstream is the launch in September of the Investment Property Databank (IPD) European Hotels Index, which will enable investors to compare hotel performance against other sectors. The index, which includes 373 hotels from nine countries, shows that last year hotels returned 6.9% in local currencies, while UK hotels returned 14.9%. The index also shows how the hotel sector has outperformed over the past 10 years relative to IPD's all-property index, and with a lower standard deviation.
JLL Hotels, Invesco Real Estate and HVS are all sponsors of the index. Mark Wynne-Smith, CEO EMEA at JLL Hotels, says the index is a significant improvement for the sector.
"While various consultants track the performance of hotels in isolation, previously there wasn't a trustworthy index that most institutional investors use for benchmarking," Wynne-Smith says. "There are a number of [investors] that can't look at property types that aren't tracked by IPD. Now we have a benchmark that will be regularly updated and which gives a comparison with other property types."
Crawshaw feels this is a welcome development but will take time to be really useful.
"You want to see the performance of the sector," he says. "Thus far, there hasn't been a lot of visibility of that. The index should provide that but it's going to take some time for it to be robust. Once you see how the sectors have performed at different points of the market cycle, that can help you develop a view as to whether you want to get an exposure at different times."
Sticking to budget
Budget and mid-market hotels are in the section of the market that is of most interest to institutional investors, and which holds up better in a recession than five-star luxury hotels. Upmarket hotels are more dependent on the event and conference trade, which suffers more in tight economic conditions, making revenue more volatile.
The budget end of the hotel spectrum has been popular with large UK pension funds that invest directly in their domestic market. The BP Pension Fund owns Travelodge hotels in Manchester and Liverpool as well as the Nottingham Belfry hotel. Travelodges have found favour with Derbyshire County Council, Leicestershire CC, and Staffordshire CC pension funds.
Elsewhere, Dutch pension fund asset manager APG has been active in the asset class: this year its joint venture alongside the Singapore sovereign wealth fund GIC, with Host Hotels and Resorts, bought the Pullman Bercy in Paris for €105m, following the joint venture's acquisition of six hotels in Paris, Amsterdam and Dusseldorf in 2008.
An important consideration is that hotels are a capital-intensive asset, according to Wynne-Smith. "Hotels have to be kept competitive and that means spending money," he says. "In the budget market, it's easier to predict what your capital requirements will be. If you are involved in hotels with conference and banqueting space, it then becomes harder to predict because the market isn't so linear. The location of the asset and its facilities, have a very strong bearing on the rent it can afford to pay. You need to drill harder into the asset than with a budget hotel."
By contrast, budget hotels have more predictable revenue streams. With centralised marketing and reservations, the budget chains have the flexibility to price their rooms competitively to keep up occupancy levels in a downturn. Budget hotels can also benefit from travellers who downgrade in hard times.
Gael Le Lay, head of hotel investment at AXA Real Estate, says: "When you invest in budget hotels it depends on the time in the cycle, but the performance of hotels in good locations will always be satisfactory. You have limited competition. When you have a crisis, some clients who would have gone to a three-star or four-star hotel will downgrade, so you benefit from that."
The ideal investment is a hotel that has seven-day business - weekdays drawing business travellers and weekends attracting the leisure trade. City centre hotels in major cities are particularly well placed. Socker favours Frankfurt, Munich, Vienna, Brussels, Amsterdam and Barcelona, and London, although these assets are fully priced.
While in the US branded hotels are well established, the same cannot be said in Europe where family-owned establishments have been the norm. But the UK and France have led Europe in the development of branded hotels, the likes of Travelodge and Premier Inns in the UK and Novotel or Mercure in France, introducing more professionally managed, streamlined operations with performance track records. In much the same way as supermarkets, hotels are taking the sale and leaseback route for their real estate holdings, to free up capital for business development while opening up opportunities for real estate investors to take on the assets.
On a macro level, growth in the travel industry is linked to growth in GDP. While GDP growth is limited in Europe, the buoyant Asian and other emerging markets are stoking demand for hotel beds, both domestically and in Europe; long-term travel industry growth projections are good.
"We believe this isn't just investment into real estate, you are investing into a growth industry as well," says Marc Socker, director of the hotel fund management team at Invesco. "There is economic volatility now and there has been over the previous few decades, but hotels consistently outperform inflation, consistently outperform GDP. Tourism is growing."
The fact that hotels typically offer investors long-term contracts, which could be 20-25 years, is also a plus for investors. Coupled with that, hotels are a specialist area offering a yield premium to other more mainstream real estate sectors like office or retail. "We call it a double-whammy," says Socker. "You have a yield premium to other real estate classes, given it's a specialist asset class, given it's not fully understood yet, but at the same time you get long-term contracts."
Covenant strength of the operator is also an issue. That is why having a tenant with the backing of a FTSE100 company like Whitbread's Premier Inns is highly prized.
Andrew Ferguson, fund manager of Legal & General Property's Leisure Fund says: "Part of the risk from smaller operations is the covenant strength. If a company goes into receivership, you have to ask the question whether it would be easy to attract new tenants to the unit. Location is key. You don't want to buy in a poor location where you can't re-let the property."
Hybrid lease structures
Exposure to the travel industry brings its own risks. Although the industry may be a source of long-term growth, short-term demand for travel and hotel accommodation can be adversely affected by global recession, war or terrorism.
A further burden on the industry is the constant demand for capital expenditure on upgrading and refurbishment. "Hotel ownership has to be seen as a partnership with the operator," says Socker. "If you don't renovate hotels you will struggle. We ensure in the operating agreement every year there is proper renovation of the hotel, to keep it in the right position."
Investors have a number of different ways to invest, according to the type of lease or link to the operator. At one extreme it can be the simple lease structure, at the other extreme full exposure to the operational performance of the business. Lease terms and lengths also vary in different jurisdictions. The most straightforward and popular option is a simple lease on a long term of 20 or 25 years with rent increases linked to inflation.
Other options popular with operators are hybrid leases linked to turnover - for a budget hotel investors might earn 15-25% of turnover, depending on the location and the business margin.
"With that type of lease structure, as the owner you are closely tied to the performance of the asset," says Wynne-Smith.
"If you are in budget or mid-market [hotels] you can look back over many years and see the close correlation between the performance of these hotels from a revenue perspective and GDP. They are far more predictable than where leases are linked to profits."
A hybrid lease is the format favoured by Invesco. Socker says: "Our preferred style is a hybrid lease structure where we have a guaranteed income from tenants. We have a long lease, a minimum guaranteed amount which will be indexed and fully guaranteed by the parent company of the tenants. We want to take a share of the upside as well. Therefore, we would take the higher amount of a turnover percentage and that minimum guaranteed rent. You have the floor, so you are protected in the downside scenario, so investors have the comfort of a certain income return and exposure to the upside as well."
A simple 25-year lease linked to the retail price index (RPI) is the format that the BP Pension Fund has adopted for its hotel portfolio.
"In all cases it's pure rent, no stake in the turnover," says Tim Hayne, the fund's head of property. "Although it's the hotel sector it's pretty diluted. We are just paid quarterly rent."