(The following is an exerpt of
Admiral's Field Notes: REITs and Rental Real Estate)
Hotels
Hotels are similar to retail in that value is derived from end-user demand. This means that a hotel operator is involved in many of the same marketing strategies as a mall operator. The hotel operator needs to decide the clientele and the resulting service and amenities levels.
Because of the varied services expected for different levels of hotels (3-star versus 4-star versus 5-star), revenue per square foot, profit margin, and ultimately return on investment can be very different. For example, a three star hotel has a lower revenue per room compared to a 5 star hotel, but its profit margin is typically 15 to 20 percentage points higher. Thus, analysts should keep in mind that the cost structure is very different between different hotels.
In higher end hotels, often revenue from non-room sources (food & beverages, for example) will be as high as room revenue. However, the profit margin differs widely. In fact, some hotels target to only have their food and beverage business break even, and they drive overall profitability through maximizing profit from room revenue. When calculating profit margins, analysts are cautioned to separate room from non-room revenue when they calculate the cost structure of hotels.
Hotels, furthermore, have several unique aspects. First, hotel contracts are much shorter than leases of other property types. Hotel leases are daily, and prices can be managed dynamically. In fact, in most well run systems, computers are used to calculate latest offering prices, at 30-minute intervals, based on the latest occupancy rates and time away from the lease date. This is the reason why a hotel website sometimes gives different rates within a fairly short period of time.
Ultimately, a hotel sees its room-nights as a perishable resource. For every night that a hotel room does not have guest, the company receives zero revenue for that particular room night. In the short term, a hotel can increase its attractiveness by lowering room rates. Thus, on the one hand, a hotel would want to fill up its hotel as much as possible. On the other hand, however, the hotel also does not want to decrease room rates too much. Multiplying occupancy and average daily rates generates Revenue Per Available Room, or RevPAR for short, which captures the overall profitability of the hotel. RevPAR multiplied by the number of hotel rooms is the room revenue. Computer programs and human management specifically are managing room rates to generate as high of a RevPAR as possible.
Second, while a mall has its tenant relationships with the retailers, a hotel signs most of its contracts with customers directly. This allows hotels to have a more targeted approach in bringing customers to their hotels. Many hotels seek longer term contracts with airlines or travel companies to reduce the volatility of daily occupancy. These contracts, usually at a lower rate, keep occupancy up. Since many of the hotel costs are fixed, keeping a reasonable level of occupancy from contracted guests covers operating expenses. From there, the hotel can be more proactive in filling in the rest of the hotel with higher rate contracts with individual customers.
Owner versus Operator
Source: Admiral Investment
Third, hotels have increasingly segregated its ownership from operations. In this case, a hotel is typically owned by an investor without the network or brand strength to run the hotel. The operation will be contracted out to an operator, who owns the brand and the systems for hotel management. See the above illustration for the difference between the two models.
The operating risk can stay with the landlord, shared between the landlord and the operator, or transferred completely to the operator. On one end of the spectrum, the operator collects a fixed fee for the operating services, and the landlord keeps all the upside and downside of the operation. On the other end, the landlord master --leases the building to the operator, collects a fixed rent, and all operating upside stays with the operator.
Most contracts, however, will have a profit sharing element where the landlord and the operator share the risks and the profit. If the landlord retains control, then the operator will provide the service, with profit sharing potentials if profit is above a certain level. Increasingly, however, the landlord will lease out the building to the operator, but keep a percentage-rent clause, similar to a retail mall, so that the landlord shares some of the upside.
The latter structure is becoming popular because of an IFRS rule. If a hotel is operated by the owner, it cannot be classified as an investment property. The asset will have to be depreciated as a fixed asset. If the hotel is leased out, however, the asset may be classified as an investment property and it may be revalued like other commercial buildings. Thus, when analyzing a hotel landlord, it is important to focus on the economic substance, and not merely the legal relationship between the landlord and the tenant.
Hotel supply and demand are based on tourist arrivals. Most countries report tourist arrivals transparently, and most have Tourism Boards to advocate tourism. The tourism boards often have operational targets on tourist growth, which tend to be relatively realistic. For example, the Hong Kong Tourism Board has a medium term target of 5% growth per year until 2017.
In addition, the tourism boards also report the number of nights per overnight tourist. Nights per tourist often stay constant in the short term, and thus the current year number can be used to forecast future growth. The number of tourists arriving multiplied by the average number of nights per overnight tourist gives realistic data for demand.
Supply response is similar to other asset classes, as it takes several years to build a high-rise hotel. Furthermore, hotels typically have a lower per-square foot value than offices or malls, especially in city center where hotels are in higher demand. If hotels do not form their own planning zone, often they will be crowded out. Developers may acquire a fully functioning hotel and redevelop the site into an office tower. The Ritz Carlton Hotel in Hong Kong was redeveloped into the China Construction Bank Building in the last cycle, for example. This is the reason why some Asia Pacific economies have implemented a hotel-only planning zone to maintain a certain level of hotel rooms in the city center.
