According to industry research, 2015 was the second highest year for hotel transactions posting a growth of 50% vs 2014. Investment activity in 2016 was forecasted to be positive if not the same volume as in 2015. Hotels, either stand-alone properties or as part of chains are being seen as a worthy investments by individual investors or private equity funds. Investing in hotel differs from other real estate asset classes such as commercial or residential due to the different income generating variables and cost drivers.
Hotel business dynamics
Hotels are a lot more sensitive to global economics, are capital intensive and carry a higher risk of failure that investors need to take into account. The operating model of hotels means they are more at risk to the general economic conditions. Most of the investment & capital borrowing decision hinge on the net cash flow produced by the hotel.
A big chunk of hotel’s revenue is derived from a combination of room occupancy and room rate. Both of these factors are highly affected by spending power of consumers, general condition of the economy (during hard economic times, leisure is one of the first items to be cancelled, corporations keep business travel to the strict minimum) and availability of alternatives (competing hotels and nowadays, Airbnb).
When the economic engine is running full steam, consumers and businesses spend but this also fuels new investments and introduction of new hotels in the market. More rooms in the market gives more bargaining power to the consumers, hence some hotels are forced to drop the room rates to keep up the occupancy level. However, this often leads to decrease in revenues, with occupancy sometimes not rising. If by this time in the hotel’s life cycle, the economic pace has slowed down, there is even more downward pressure on the room rates in order to attract customers in a slowing economy. Newer hotels in the market also prompt existing hotels to up their investment in facilities and services.
For investors what matters most is the net cash available (after paying for all the expenses) to be able to pay back the debt. Despite lower occupancy level, lower room rate or poor operating performance, the cost of debt does not change. This is where investors are hit with the hotel business reality. It is very important for investors to understand the challenges of hotel investment and adjust their expectations & finances accordingly.
Location, Location, Location
Location can be a winning or losing proposition for a hotel. Visibility, ease of access, parking, and proximity to various entertainment venues, amount of competitors, or presence or collaboration with local corporate businesses can all contribute to a hotel’s strong performance. The local market also needs to be monitored for changing dynamics. E.g. new demand generators opening or closing (businesses or leisure venues), demographic and social changes etc. These factors are not only important for the hotel operating performance but also affect the valuation of the property. If the market where the hotel is located has high barriers to entry (lack of land for sale, government restrictions or red tape, lower market occupancy & room rate etc.) it discourages new supply in the market. Therefore, the hotel’s location exerts great influences on revenues, cash flows and its value.
People, People, People
Despite investing in a physical asset, investors often forget that hotels are still in the service industry, driven by people and experiences. No matter how good your location is, no matter how shining the new infrastructure is, it is the staff & management that can make or break the hotel. Poor service leads to unsatisfied customers which leads to fewer repeat guests and the spiral continues. If guests are happy but management cannot manage their costs then the profitability declines. Hence a hotel’s performance is primarily dependent on the team that operates it. There are numerous instances where a hotel investment was made based on great market conditions and positive ROI but due to poor management, the hotel never realized its potential, which affected its exit value.
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