Europe

A view to a killing

When it comes to alternative assets, investors could do a lot worse than hotels in the UK generally and London specifically. The market has seen steady growth and transaction levels in 2015 were back to the 2006 high point.

Much of that growth in the past year has been in the regions,§ but there have been key investor deals in London too, such as the sales of St Ermin’s Hotel for £185m, Holiday Inn London Kensington for £350m, the Bulgari Hotel for £270m, the Ace Hotel in Shoreditch for £149m and the portfolio sale of the three Maybourne hotels (Berkeley, Connaught and Claridges) for £1.6bn. The price per room for prime London luxury hotels has exceeded £1m per room, reaching £3.2m per room for the Bulgari and Maybourne portfolio.

The UK institutions have so far not invested heavily in the hotel sector and investors are more likely to come from the private equity world or from private wealth. Why are institutions not looking at hotels?

Management contracts

First, there is the way hotel operators structure their interest. Big operators, particularly those at the luxury end, have an “asset light” strategy, which means they want to operate the hotels in their portfolio on a management contract basis and do not want the encumbrance of a lease and the responsibilities that go with it.

This reverses the risk profile for the investor. Under a lease arrangement the operator would be obliged to pay rent however well the underlying hotel business is performing. The rent might be linked to turnover, but there would normally be a base rent, so the investor could expect at least a minimum return. Under a management agreement all costs associated with running the hotel are for the owner and the operator takes its fees before any residual profit is passed to the owner. Some of those fees may be performance related but the operator will still get its base fee and other fees for royalties, marketing, reservations and licencing of the brand. All the risks therefore lie with the owner, and it is the one who has to absorb any losses.

Most luxury hotels are held on management contracts, while typically budget hotels are held on leases, so institutional investment in the UK has usually been in the budget market.

Operator as employer

Also, under a management agreement the operator expects the owner to be the employer of all the hotel staff with the exception of key individuals such as the general manager and the restaurant manager. Many investors either do not want that responsibility or, for tax or regulatory reasons, cannot take it on, as they can only invest and are not able to trade.

Hotels are also very capex-intensive, so management agreements will require that a certain level of profit (possibly up to 7%) is retained to be recycled back into maintaining the hotel. Ultimately, though, if profits are insufficient to cover the cost of maintenance, the owner will be required to make funds available. Compare that with a lease structure, where the tenant (the operator) would be the one who is obliged to retain or provide funds for maintenance. If the tenant does not keep the hotel in the required state of repair, at the end of the lease it could be liable for dilapidations.

Having said all that, well-run hotels can produce good returns for investors, but like other asset classes they are subject to wider market forces. No assessment of the market at the moment can avoid a reference to the possibility of Brexit. It may be a cliché, but the markets don’t like uncertainty and that is depressing the value of the pound.

Some argue that a cheaper pound makes London hotels more affordable and the city more attractive as a tourist destination and may therefore be good for the hotel industry. It may also make investment into London for international investors more affordable. Others are worried that a Brexit will cause a prolonged period of uncertainty that will be detrimental to the overall economy and that the hotel industry will not be immune from that.

Beware the distruptors

Other factors affecting hotels include the new national living wage, which will affect a significant proportion of hotel staff; the potential limits on immigration that may result from a Brexit vote, as hotels are reliant on an itinerant workforce; and the disruptors in the market such as Airbnb and One Fine Stay, which challenge the traditional approach to finding travel accommodation, and the online travel agencies that challenge the hotel operators’ ability to control their pricing.

Jackie Newstead is global head of real estate at Hogan Lovells

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