Commercial Real Estate in 2018 – Hotel Investments

A major sector in commercial real estate is hospitality – hotels, motels, resorts, and other tourist or business accommodations. Investment returns in these properties are closely tied to the underlying business of hospitality operations, so it’s important to understand the dynamics of the sector.

Hotel stocks have surged over the past year as a wave of consolidation and a strong global economy have lifted profits, according to the investment site Motley Fool. Room rates continue to rise steadily and occupancy rates are also rising, in spite of the threat from Airbnb and other home rental services.

Market Background

The look of this market has changed, but it still has community roots. Hospitality and lodging facilities were in the past typically owned by entrepreneurs managing individual properties, but the market has come to be dominated by national and international brands. These companies increasingly utilize franchise structures (localized operator ownership, but with a uniform national identity and operational guidance – “flagging” – provided by the chains), rather than owning the properties themselves.

The hotel sector can be divided into a number of segments; one categorization method is shown below, with some example brands:

  • Deluxe:  Four Seasons, Ritz Carlton, Wyndam Luxury Resorts
  • Luxury:  Sheraton, Hilton, Westin
  • Upscale: Crowne Plaza, Doubletree, Embassy Suites
  • Midscale:  Holiday Inn, Best Western, Comfort Suites
  • Economy:  Rodeway Inn, Econo Lodge, Motel 6
  • Extended Stay: Summerfield, Homewood Suites, Extended Stay America

Luxury and upscale hotels cater primarily to business travelers, while midscale hotels with food and beverage services constitute a very large segment of the overall market.  Economy hotels are more favored by seniors and others traveling on a limited budget, and extended-stay hotels have larger, apartment-style guestrooms and typically service relocated employees and professionals assigned to a project that is distant from their usual workplace.

Hotel economics depend on both occupancy rates and room revenues, so an important industry yardstick is RevPAR (Revenue Per Available Room).  This metric is calculated by multiplying a hotel’s average daily room rate by its occupancy rate, or by dividing a hotel’s total guest room revenue by the room count and number of booked days. 

Example:  $100 average room rate  x  70% occupancy rate  =  RevPAR  =  $70

The lodging industry is also closely tied to national – or even worldwide – economic conditions.  Prosperous times mean increased room and occupancy rates, but a faltering economy causes both leisure and business travelers to stay home – or at least spend less.  New construction can also be a factor – in the late 1980s, oversupply caused a period of stagnation for the industry as a whole, even though the economy was doing well.

The degree of this correlation with general economic strength is stronger than with other real estate asset classes.  Demand for tourism services is particularly sensitive to both price competition and non-predictable shocks like terrorism, political unrest and natural disasters.  At the same time, the supply side of the industry can be quite “sticky” – new hotel construction requires large-scale capital investment and a long-term investment horizon, leaving the industry sometimes slow to respond to demand increases requiring a short-term response.

The entry of Airbnb and its “hosted rooms” business model has disrupted the hotel market, but not displaced it.  According to Motley Fool, Airbnb now has approx. 4 million listed rooms, more than the top five hotel brands combined. For now, though, it seems that hotels and Airbnb can coexist.  As long as occupancy and room rates continue to rise, hotels will likely remain attractive investments.

2018 Trends

The hotel sector currently remains one of the healthiest commercial real estate sectors, and value-add remains a favored strategy. According to JLL, high quality, single assets situated in top 25 markets or strong leisure destinations comprised the lion’s share of hotels sold by volume. The majority of the top 25 markets observed RevPAR growth in the year ended August 2017.

The hospitality sector is currently stable, but as of Q3 2017 it didn’t seem poised for significant near-term growth either. Like many asset classes, the market seems near to fully priced.

High occupancy rates continue to support solid room rate growth, but with the anticipated nearing of a real estate “cycle top,” investors are trying to avoid becoming overly exuberant.  Consumers are again taking vacations, and business trips have also regained their footing – but additions to supply should be monitored (U.S. supply grew by 1.8 percent for the year through August 2017), and increased currency exchange restrictions have slowed cross-border hotel investment from mainland China.

A recent RE Journals article notes that many repositioning opportunities lie in the repurposing of older Class C business district properties that had originally been built for office usage.  Today, much of this space has been converted to either apartments or hotels. Millenials choosing to rent in the center of urban areas explain the apartment demand, and tourism demand is typically concentrated on these centralized properties. A good example of this trend is a property at 100 W. Monroe, in Chicago. That 1927 office building of 130,000 square is now a new Hyatt Centric hotel.

According to JLL, for the 12 months ended August 2017, year-to-date RevPAR growth nationally was 2.4 percent. Hotels in major U.S. markets will likely become more expensive next year as the practice of adding resort fees becomes more common.  These charges, once reserved for getaways in exotic locales, have become more and more common at urban properties—often with a nightly price tag of $25. These fees have been seen recently in New York, Los Angeles and Chicago.

Many hotels are now also selling experiences, not just rooms.  “It’s all about leveraging the power of adjacent spaces,” said Marcello Gasdia, of Deloitte LLP’s travel, hospitality, and services group.  

These hotels are attempting to fill up their itineraries with experiences and activities, an activity viewed as especially crucial for luxury hotels. Nearby nature trips, concerts, sports, and food and drink attractions are increasingly being highlighted by hotels in an effort to broaden guests’ overall travel experience.

 

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.
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