Investing in Hotels: Advantages, Disadvantages and Unique Considerations

In this two-part series, LoopNet provides an overview of the lodging/hospitality/hotel — terms that will be applied interchangeably throughout this series — sector. This is one of the most idiosyncratic asset types in real estate, as well as (potentially) one of the most rewarding. It’s also a sector that has been particularly impacted by the coronavirus, which has produced both distress and opportunities. Part one, which centered around the current and anticipated near-term state of the market, as well as current investment opportunities, can be found here. Part two, presented below, focuses on the long-term strengths, challenges and unique characteristics of the sector.

It’s fair to say that while every commercial real estate (CRE) asset type has its idiosyncratic features, as well as distinctive attributes and challenges, hotels are particularly unique.

To begin with, there’s the duration of tenancy. Most commercial assets, whether you’re considering office, retail or industrial product, operate with long-term leases, anywhere from three- to 15-years in duration. Even multifamily properties, which have more frequent turnover than their commercial counterparts, typically offer one- to two-year leases. These lease terms provide investors with a certain degree of security, even if markets take a downward turn.

But hotels don’t offer any similar safeguards. As Jan Freitag, national director of hospitality market analytics at CoStar, pithily observed, a hotel’s “lease terms are just one night.”

Short-term tenancy can be both an advantage and a disadvantage for hotel assets, and we’ll dig more deeply into that later in this article, but it’s also just one of the unique facets that new investors need to be aware of when entering the hotel space.

Jared Kelso, executive managing director of C&W Capital Markets and one of three senior partners in the firm’s national hospitality capital markets practice group, explained that, “It’s vastly more complex [than other asset types]. There are more constituents in a hotel investment than there might be in many others, and there is no durable revenue stream, as we learned to our chagrin again in 2020. You’ve got hundreds of operating issues; you’ve got a very different debt market for hospitality assets than you do [for] other asset classes; you have to contend with the brands, you have to contend with the managers, and you have to contend with the third-party OTAs (online travel advisors) such as Expedia, TripAdvisor and Travelocity.”

In other words, the unique features of hotel assets are myriad; but don’t get overwhelmed. Because many of the elements that make hotels a sometimes challenging real estate asset are the same features that make them a compelling opportunity.

Based on conversations with various industry experts, LoopNet developed the following list of distinctive elements and important considerations for investors contemplating hotel properties:

• The brand element (to brand or not to brand).
• Influence of OTAs.
• Differences in hotel financing.
• Intensive management requirements.
• Insurance complexities and costs.

The Brand Element (To Brand or Not To Brand)

"They’ve been there and done that, right? You are not the first one. A lot of people have made mistakes [and] learned a lot, and you can participate in that learning.”

Jan Freitag, national director of hospitality market analytics, CoStar

Perhaps the single most unique (and commonplace) feature of hotels compared to other real estate assets is the presence of brands — or flags, in industry parlance. To be clear, these brands, many of which are household names —Hilton, Marriot, Choice, etc. — typically do not own the hotels that bear their names.

Kelso described it saying, “The middle market space [i.e., hotels valued at less than $15 million] is overwhelmingly a franchise model, whereby an owner would enter into a franchise agreement with Hilton, or Hyatt or Intercontinental. The brand would place their flag on the property, subject to many, many requirements on the owner in terms of the design, the quality and the level of service they provide.”

Lest you think that the brand is doing the majority of the work for you, it’s important to understand that hotel brands typically do not manage the properties under their umbrella either. Freitag described the relationship between these entities as a “triangle between the owner, the management company and the brand. In some instances, the owner and the management may be the same, but it’s very common that the brand is a third party.”

In the modern hospitality landscape, brands rule the day. According to Freitag, approximately 70% of hotels in the United States are branded. The brands offer obvious benefits in terms of their marketing reach and name recognition. They also provide access to customers via their robust loyalty programs.

In addition to these benefits, brands make it easier for investors to access financing. According to Sachin Patel, managing principal of Shiv Properties, which is a stakeholder in 11 hotel properties, banks in the last four to six years have been reluctant to finance independent properties. “They like to see the corporate or franchise model in financing these deals.”

Brands can also be critical if you’re courting the business travel market. “There will always be businesses that want or need to see Marriot, Hilton, Hyatt or Intercontinental on their expense reports,” Kelso said.

On the other hand, Patel noted that in an independent hotel, “you don’t have someone looking over your shoulder,” which offers an investor more flexibility, particularly with regard to reducing expenses; a consideration that becomes particularly critical during turbulent economic periods, such as the one the industry is currently experiencing.

According to Kelso, it’s also important to bear in mind that the franchise agreements that investors enter into with brands are usually long term (five to 15 years, typically) and “largely are not terminable.”

Nonetheless, particularly for the nascent investor, it’s difficult to overvalue the advantage of lived experience that the brands provide. As Freitag noted, “They’ve been there and done that, right? You are not the first one. A lot of people have made mistakes [and] learned a lot, and you can participate in that learning.”

Ultimately, Patel said that it all comes down to RevPAR (revenue per available room), one of the hotel industry’s key metrics. “Those flags are going to get me more revenue per room,” he said. However, that increased revenue comes with a cost. Patel said that investors should assume that at least 15% to 18% of their operating expenses will go to brand-related costs, and that percentage grows as you climb the brand ladder from economy to luxury.

Influence of OTAs

In addition to brands, one of the most potent forces influencing the hotel market are OTAs (online travel advisors), and it’s important that investors understand the impact they’ve had, and continue to have, on the industry.

According to Ford Barton, principal of Lodging Partners, a brokerage and advisory firm focused on the hospitality and lodging sector, OTAs have fostered a “commoditization of hotels.” This, in turn, “has often resulted in less pricing power for the hotels.”

Some sources also speculated that the loyalty programs, which have long been one of the primary benefits offered by the brand franchise model, are less relevant in an era where OTAs dominate. Consumers selecting hotels through those services tend to focus more on price and less on brand loyalty. While consumers may still appreciate the presumed quality and service assurances that accompany a brand, they tend to be “less brand specific,” Barton said.

Accordingly, an independent hotel that takes the money that it would have put into a brand and reallocates it toward search engine optimization (SEO) or other digital marketing efforts to attract online interest may be well-positioned in the 2021 hotel landscape.

Differences in Hotel Financing

The aforementioned brand impact isn’t the only area where hotel financing differs from other CRE asset types. Because of the potential for a significant reduction in revenue during economic downturns, all of the experts LoopNet spoke with said it was critical that investors plan to fund a substantial portion of the purchase with cash. “You must put 35% to 40% equity into any deal,” Patel said.

Freitag observed that underfunding the equity portion of a purchase is “what’s putting a lot of people into jeopardy right now … their monthly mortgage payment is just so high.”

Further, because of the unique, daily revenue stream that hotels provide, Barton advocated for the benefits of securing financing with a smaller, local institution. “I think with a smaller hotel, you may do well with a local lender in the area,” he said. “These banks often like hotel loans because they also get all the daily deposits and there’s more to their relationship than just a loan.”

Barton also noted that lenders will want to see a clear management plan in place, and will even give particular consideration to investors that choose to literally “sleep where they eat,” often showing a preference for owner-occupied hotels.

Kelso said that investors should be prepared for swift changes in financing options. “The capital markets environment for hospitality changes much more quickly than it does for other asset classes, because it more closely mirrors what’s going on in the economy,” he said.

Intensive Management Requirements

One of the differentiating aspects of hotels that every expert LoopNet spoke with agreed upon is the amount of work they require.

“It can be a very labor intensive asset class, especially towards the higher end, as you provide more services,” Freitag said.

Patel concurred with that assessment. He said that investors should “be ready to manage more employees, and be ready to understand that payroll is a big component of a hotel, and that you will have to be involved in operations to make it successful.”

Because of the time and energy required to manage facilities and staff (including the management team, should you elect to outsource that function), both Barton and Patel advised that it is beneficial to be located proximate to your investment. “Investors will want to have the hotel in a nearby location so they can visit the hotel and keep a close eye on the investment,” Barton said.

Insurance Complexities and Costs

Kelso commented on the increased complexity of the insurance policies required for hotels, particularly for resort properties in areas prone to hurricanes or other natural disasters.

According to Patel, in addition to greater complexity, insurance for hotels comes with increased costs, and those expenses are growing.

“The insurance market is very unstable,” Patel said. “We’re seeing a large increase in insurance premiums, on the general liability side and on the property side.” He estimated that general liability premiums had increased by approximately 18% to 20%, while property insurance had increased by 10% to 16%, year over year.

“On the liability side, there are insurance carriers getting out of the business, due to the pandemic,” Patel said. The remaining insurance companies are using the situation to their advantage and raising premiums.

“In general, when things get more expensive, hoteliers have always found a way to increase their rate faster than everything else.”

Jan Freitag, national director of hospitality market analytics, CoStar

Kelso neatly summed up the investment profile of hotels in a single sentence: “It’s a high-risk, high-reward asset class.”

From a CRE investment perspective, key advantages of hotels include:

• Potential for high returns.
• Pricing flexibility.
• High margins on variable costs.
• Widespread distribution.
• Abundant data.

The principal advantage of hotels is, as Kelso noted, the opportunity “to drive significantly higher leveraged returns.”

Patel said that, if everything goes according to plan, investors can expect annual returns approaching 20%, which is certainly impressive when considered in comparison to other real estate assets.

This potential for high returns is partially owed to the flexibility fostered by hotels’ unique tenancy model. According to Freitag, this enables hotel owners to rapidly increase prices in response to enhanced demand. This is perhaps why hotels have historically outperformed the consumer price index (CPI), Freitag said. While he acknowledged that the relationship between hotel costs and CPI has deviated slightly in the last two or three years, “in general, when things get more expensive, hoteliers have always found a way to increase their rate faster than everything else [in the economy].”

Barton observed that these significant returns are partially derived through margins. “There’s fixed costs and variable costs in operating a hotel. And once you cover the fixed costs, the margins on the variable costs become very attractive.” Fixed costs include taxes, insurance and financing; variable costs are items such as food, room supplies, guest amenities and labor.

Freitag said that another key advantage of hotels is their widespread distribution, which opens up opportunities for investors in almost any market in the country.

Freitag also mentioned that abundant data, including information found in the dSTAR Report produced by STR (which, like LoopNet, is owned by CoStar Group), is an industry attribute that investors can benefit from. “You don’t have to sort of wonder, ‘How is the competition doing? How am I doing compared to the competition?’ You know,” he said.

“I think it’s far more important in the hospitality sector to consider the downside scenario, because the cash flow is so much more volatile.”

Jared Kelso, executive managing director, C&W Capital Markets

Of course, high rewards rarely come to the dance unaccompanied by their less appealing chaperone, high risk. Some of the principal disadvantages of hotels include:

• Particularly susceptible to economic turbulence.
• Cash flow volatility.
• Evolving consumer preferences.

While the nightly tenancy model enables hotels to raise prices when demand is high, it also makes them uniquely vulnerable to economic downturns.

Kelso described how this differs from other real estate asset classes. “When the brakes come to a halt in the broader economy, they come to a halt in the hotel industry,” he said. “ Assets that have long-term leases might not feel the impact to cash flow for 6, 12 or 24 months after the onset of an economic event, whereas hotels feel it on day one.”

As Barton observed, “Typically this industry’s had eight- to 10-year cycles, and in the down years, it can be a tough couple of years.”

Kelso echoed this view. “I think it’s far more important in the hospitality sector to consider the downside scenario, because the cash flow is so much more volatile than [it is in] other asset classes,” he said. He added that in order to weather downturns, you “really have to ensure that your capital base is built to withstand economic turbulence.”

According to Freitag, hotels are also particularly susceptible to the whims of the consumer. “These things stand there for 30, 40, 50 years, but consumer tastes change, consumer preferences change. And there is only so much you can do with a certain physical box until it becomes economically unfeasible,” he said.

Such challenges notwithstanding, all of the experts LoopNet spoke with believe this is a particularly compelling moment for investors to consider hotel assets.

“The good news is, if you can buy today, you’re buying at the trough. Your growth rates year over year are going to look really, really strong,” Freitag said. He added that investors just need to “be very, very clear on what services you offer, how much staff you need and what your debt service looks like” in order to ride out this period of economic uncertainty.

LoopNet’s sources also noted the uniquely enjoyable and exciting nature of the hotel industry. As Barton said, “It’s a fun business; no day is ever the same.”

Kelso concurred. “It’s a great sector to play in, it’s certainly an exciting one to play in, and there’s no question there’s going to be a tremendous amount of opportunity over the next 24 months; I encourage everyone to dive in.”