Why tourism investment is Iceland’s growth engine

This week, Gamma Capital Management, an investment and advisory firm, released its first report on tourism in Iceland, examining how the industry is shaping investment in the country.

The report found that the growth in tourist arrivals has not matched the capacity of the airport, road/rail connectivity, availability of hotel rooms, and conditions of tourist sites. This presents foreign investors with both exposure and early entry to assets currently in operation and those to be developed.

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Inbound Numbers

Tourism, driven mainly by American visitors, is Iceland’s biggest generator of hard currency and export growth. Last year, each month saw double-digit year-on-year tourism growth, and the IMF expects 2018 to approach more sustainable levels. This, Gamma suggests, is advantageous for investors as it mitigates the risks of an overheated market.

Based on allotted landing slots at major airports, Isavia, the country’s national airport and air navigation service provider, expects the number of inbound tourists this year to increase 11 percent to 2.5 million. Analysts have speculated that growth might approach high single digits from 2019 onwards. Moderate growth, the report notes, is more manageable and reduces the risk of severe infrastructure lags, overcrowding at tourist sites and intolerance of tourism among the native population.

The report also suggested that the króna’s exchange rate may also help tourism adjust to capacity constraints. By fueling an appreciation of the króna, tourism may already be self-regulating the flow of tourists through relative pricing as Iceland becomes a more expensive destination. Should appreciation start deterring tourists, the demand response will, in turn, limit the potential for further appreciation and help keep tourism at a sustainable level.

Hotel Snapshot

Iceland's hotel sector has a mix of domestic hotel chains and independent hotels, with a limited number of global brands being run by domestic operators under license. The country has about 140 hotels open and operating, over 50 of which are located in the capital area of Reykjavik, with several more under construction. Although recent years have seen significant capital investment, new construction has not kept up with the increase in tourism numbers.

The hotel segment has seen strongest foreign investor appetite within the overall hospitality industry, with American investors PT Capital Advisors and JL Properties reportedly acquiring a 75-percent stake in Keahotels, Iceland‘s third-largest hotel chain, in 2017. Iceland’s first five-star hotel will open at the Blue Lagoon in 2018. Another five-star hotel is being built next to Reykjavik’s Harpa Concert Hall and Conference Centre. The hotel, funded by SIA III (Icelandic PE fund), Carpenter & Company and other domestic and international investors, will open as a Marriott Edition hotel.

Infrastructure Investment

Some segments of the tourism industry, such as transportation and accommodation, are capital-intensive. These segments, in particular, stand to benefit from the surge in tourist numbers and the overall reduction in seasonality as it leads to year-round higher occupancy rates and better capital efficiency.

“Our research shows a heightened demand for, but low supply of, Iceland’s tourism infrastructure,” Gamma CEO Valdimar Ármann said in a statement about the report. “The team identified airports, roads, hotels and tourist site infrastructure as areas that are underfunded. Correcting this imbalance will lead to sizeable opportunities for international investors seeking exposure to alternative credit, infrastructure, and real estate.”

Gamma found evidence that the country’s tourism sector has become more efficient on the back of scale economies, lifting margins. Although lending to the tourism sector has increased, loans to the industry still compose a fairly small segment of the commercial banks’ overall portfolio, underlining the limited systemic risk posed by the sector.

Financing has largely come from outside the banking system—that is to say, through alternative investment funds or limited partnerships. Currently, domestic pension funds are the primary investors, and despite ample opportunities in the sector—not just for the deployment of capital but for the transfer of networks and knowledge—foreign investors are largely absent from the stage.

This analysis, Gamma claimed, reveals an opportunity for institutional investors seeking exposure to alternative credit, private equity, and real estate. Rising tourism numbers are putting pressure on capital-intensive industries, namely hotels and transport. Yet loans and financing from commercial banks in this direction remain small and this offers an entryway for alternative funds or limited partnerships to fill the void.

Room for Growth

Despite the rapid growth in tourist numbers, large areas in the country remain completely uncrowded. Some of the most popular locations (Reykjavík, Reykjanes Peninsula and South Iceland) are approaching full capacity during high season.

At the same time, areas in West Iceland, West Fjords, North Iceland and East fjords can accommodate far more tourists. In recent years, construction has expanded hotel capacity around the country. “We believe that with a more widespread distribution of tourists, the operational environment of hotels and activity suppliers can be improved around the whole country, especially in the areas that receive fewer visitors today,” the report suggested, noting that U.S.-based Eleven Experience recently turned an old farm in North Iceland to a luxury lodge called Deplar Farm.

Most hotel supply in Iceland is concentrated in the three- and four-star segments, although recent years have seen an uptick in new upscale lifestyle and boutique hotels. Room supply has expanded since the start of the tourist boom, but the increase in supply is nowhere near enough to keep up with demand, as evidenced by the rising occupancy rates in every quarter of the country.

Currently, the capital area has more than 20 hotel projects with 2,200-2,500 additional rooms slated to open by 2020. These rooms should accommodate as many as 215,000 tourists per year at current occupancy rates and duration of stay—equal to roughly two-thirds of the projected increase in tourist arrivals in 2018 alone, the report found.

While traditional hospitality seems to be lagging, Airbnb has been filling in the gaps. In a survey, at least 30 percent of tourists said that they had stayed in privately owned residences in 2016. On average, 2,000 homes are listed on Airbnb in the Capital area, rising to as many as 2,500-3,000 during the high season. “We expect continued upward pressure on rates and occupancy, as tourist arrivals are likely to outpace increases in hotel building,” the report said.              

A Season for Everything

Seasonality in Iceland’s hotel sector has receded, rendering capital significantly more productive. The average daily rate in Reykjavik hotels rose almost 37 percent from 2013 to 2016 due to a combination of krona appreciation and market pressures. While the final numbers are not in, Gamma suggests that ADR may have increased again in 2017 due to the strengthening currency.

“Reykjavik hotels are towards the higher end of the pricing range in European cities on average,” the report claimed. “However, it should be noted that there exists significant seasonality in pricing, with ADRs approaching the highest in Europe during summer, while remaining relatively inexpensive during the shoulder season.”