5 Things Investors Should Know About Hotel Real Estate
Hotels offer investors the opportunity to further diversify their real estate portfolios while generating potentially attractive returns. With hotel fundamentals projected to remain strong through 2019, new investors may be considering how best to gain exposure to the hospitality market.1
Hotels differ from some of the more familiar commercial real estate sectors, like multifamily and office. To navigate this property type successfully, investors should take the time to understand how hotels function as investments. Here are five things every investor should know to confidently begin investing in hotel real estate.
1. How hotel real estate differs from other property types
Hotels have a heavy operational aspect compared to most real estate, and are uniquely dynamic because they do not rely on lease agreements. While office, retail and multifamily tenants generally sign leases ranging from one year for an apartment to up to 20 years for an office, hotels depend on guests who make their “leasing” decision nightly.
This means hotels are able to respond to changes in the market almost instantly. Hotels can flex rates on a daily basis to quickly capture the benefits of a tight market or mitigate the risks of a soft day, month or year. This flexibility allows hotel investments to benefit from capital improvements and operational enhancements much faster than other sectors. The inherent volatility and operational intensity also means that hotels typically generate outsized cash yield relative to other asset classes.
On the other hand, hotels can be among the first to suffer from disruptions in the market. When a local economy weakens or new supply is introduced, hotel operators may find that they need to immediately lower rates or increase the quality of their product offering to remain competitive. While no sector is immune to market changes, hotels usually feel both the good and the bad before others. Whether or not that’s a positive attribute largely depends on your personal investment philosophy, appetite for risk, and the dynamics surrounding each specific hotel investment opportunity.
2. The five types of hotel assets
As an asset class, hotels fall into five major categories: Full-Service, Select-Service, Limited-Service, Extended Stay and Budget. These categories are largely defined by the amenities and services they offer, although the brand may also play a defining role. Here’s an overview of each category:
- Full-Service: Ranging from luxury brands such as Four Seasons, St. Regis and Aman to upscale and midscale brands including Marriotts, Hiltons and Wyndhams, these hotels offer guests a variety of services and amenities. From on-site retail to spas, meeting rooms and restaurants, Full-Service hotels rely on a large staff and depend heavily on the competitive positioning of their amenities and service.
- Select-Service: As the name suggests, these hotels adhere to the same core principles of Limited-Service properties, though they have a subset of the services and amenities characteristic of a Full-Service property. Generally, this entails a scaled-back restaurant offering and banquet facilities. The Select-Service category was created to bridge the widening gap between full and limited service hotel offerings. Examples of Select-Service hotels can include Aloft, Hilton Garden Inn, Hotel Indigo and Courtyard by Marriott.
- Limited-Service: These hotels are most easily defined as those without a restaurant or banquet facilities, though they may still provide certain services and amenities. Expect hotels in this category to offer swimming pools, limited meeting space and fitness centers — along with a smaller staff due to fewer service offerings. Example brands include Hampton Inn, Fairfield Inn and Comfort Inn.
- Extended Stay: These hotels provide guests with temporary housing and cater largely to families undergoing relocations and business travelers on long assignments. Most of these hotels offer larger suite-style rooms with at-home features such as kitchens and access to laundry. Typically, they offer discounted rates on longer stays. Extended stay hotels serve every segment of the market, although the majority specialize in mid-range and budget offerings. Brands include Extended Stay America and Hilton’s Homewood Suites and Embassy Suites.
- Budget: Budget hotels focus purely on keeping costs down, and therefore offer fewer amenities and services. Days Inn, Travelodge and Super 8 are examples of budget hotels.
3. Key metrics to understand
Hotel real estate utilizes a few sector-specific metrics to track performance — the two chief calculations being Average Daily Rate (ADR) and Revenue Per Available Room (RevPar).
ADR is the measure of the average nightly rate paid for rooms at a hotel, and is calculated by dividing room revenue by rooms sold over a particular period of time.
ADR = Room Revenue / Rooms Sold
RevPar is calculated by multiplying the ADR by the occupancy rate. Investors can also think of it as the total room revenue divided by the total number of available rooms. RevPar complements ADR because while ADR only considers the average rate of rooms sold, RevPar takes into consideration the number of rooms that were actually occupied at that rate over a given period.
RevPar = ADR x Occupancy Rate
Example 1: Find the ADR and RevPar based on the following assumptions:
- Assume the total room revenue for the month of September is $179,800
- Assume the hotel has 85 rooms
- Assume the hotel sold 1,675 room nights in September
The ADR in this example is $107.34 because we divided $179,800 by 1,675. Now that we know the ADR, we can begin to calculate the RevPar by first determining the September occupancy rate:
Occupancy Rate = Rooms Sold / Total Possible Rooms Sold
We know that 1,675 rooms were sold over the month, that September has 30 days, and that the hotel has 85 rooms. Therefore, the occupancy rate is 1,675 divided by 2,550 (30 days x 85 rooms), or 65%.
Now we can calculate the hotel’s RevPar:
RevPar = $107.34 x 65% = $69.77
Hotel owners and operators use daily, weekly, monthly and annual RevPAR trends to gain insight into factors impacting the hotel’s performance. Even better, comparing a hotel’s RevPar over the last year to the RevPar of competitor hotels can provide a powerful metric for judging the performance and competitiveness of any hotel over a given period.
Relative to other property types, hotels focus heavily on the performance of their “competitive set.” This is because guests tend to make lodging decisions in real-time and weigh factors such as cleanliness, service, amenities and location relative to certain moving demand drivers (e.g., events, stadiums, offices, restaurants and shops).
4. What drives hotel real estate success
Two main groups of consumers drive the majority of hotel demand — business travelers and tourists. Business travel tends to boost demand from Sunday through Thursday, while tourists drive demand on the weekends and during peak holiday seasons. On a more localized level, many hotels depend on particular demand drivers unique to their market, which could include anything from waterparks to universities. Demand is also seasonal, with ski resorts experiencing peak occupancies during the winter, while hotels near convention centers can expect high demand during key events.
While a hotel is somewhat susceptible to the ebbs and flows of the local economy, its ability to capture an outsized share of a certain type of business can make or break its success. This is especially important during periods of particular strength or weakness in a market.
Ensuring that a hotel investment is handled by quality operating partners helps to drive top-line revenues and create the optimal mix of business in any particular submarket. Equally important is a hotel’s ability to convert top line rooms and food and beverage revenues into bottom line net operating income.
5. How to get started
Given that hotels run the gambit from five-star luxury destination spas to spartan roadside motels, there is no one-size-fits-all recipe to hotel success. While it can be a useful starting point to consider which hotels are enticing from a personal perspective, investors should resist the urge to make investment decisions based solely on what hotel experiences they find attractive. It’s not uncommon for modest hotels with limited-service offerings and efficiently run staffs to generate returns that outperform some of the most opulent downtown hotels.
To identify the strongest investments, conduct a comparative analysis using the ADR and RevPar metrics among a group of similar hotels in the same market. Then, layer on an assessment of operating efficiency (profit margin), which can vary significantly depending on the property. Finally, as with all real estate investments, price matters. A budget hotel at a great price may be a far more successful investment than paying top dollar for a world-class hotel.
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- National Real Estate Investor, “Hotel Occupancies, Rent Growth Remain Strong, with a Positive Outlook for 2019,” November 18, 2019