Economic stability and low interest rates have led to a high availability of capital looking for stable and risk-adjusted returns in Europe’s real estate sector. The touristic upturn has reached almost every country in Europe, boosting strong hotel market performances. 2017 was another record year in which guest arrivals grew 8 percent, revenue per available room rose 5 percent and transaction volume set an all-time record.
As a consequence, hotels have become a sought-after and established asset class. Institutional players are intensively looking to this sector to diversify their real estate investments and achieve a long-term, stable income.
But the lack of products, yield compressions and increasing diversity of buyers have created a competitive investment landscape. Capital is chasing opportunities away from “plain vanilla” and is attempting more granular business cases.
Still, especially during economic peak periods, hotel operators and investors must critically challenge their investments. Rushed or pressured decisions can have immediate effects on hotel profitability and returns in times of a market slowdown.
Which trends will shape the next 12 months? What fundamentals are driving decisions and what tools help me identify risks? At the recent International Hotel Investment Forum in Berlin, the industry came together to answer such questions. “Together with the organizers, we decided to host a panel at this year’s event called ‘State of the Art Underwriting’ to take a closer look at today’s due-diligence criteria and how to increase analytical depth in order to make sustainable decisions,” said Andreas Ewald, founding partner of Engel & Völkers Hotel Consulting. “With Keith Evans (Starwood Capital Europe), Erik Jacobs (HORECA Investment Partners), Hayo Nadler (Highstreet Design) and Boris Schran (Peakside Capital), we were able to gather some of the most experienced industry leaders who gave insights into their investment metrics and expectations.”
Here were some of their findings:
1. Get the fundamentals right
One must still get the fundamentals right. Location, size, market, real estate, operator and contract are the driving aspects that determine the attractiveness of an investment—often with equal importance. At the same time, cost of capital, yield and timing decide whether it is a good deal at that point. While strong demand figures drive investors into certain markets, investors are well-advised not to ignore the supply side of the equation and to evaluate quality and additions to room stock.
2. Technology drives data availability—but not the use of it
While data harvesting and processing technology is evolving fast, panelists united in the warning about “analysis paralysis” and not to overload the decision table. While Europe is still behind on market transparency, classic databases and reports from market participants remain the cornerstone of market research.
Operational tools such as the intranet of online travel agencies or customer feedback portals are valuable, real-life information sources to identify positioning and upside potential in investment targets. Regardless of individual risk profiles, one should incorporate a range of stress tests into their model to see how changing lending rates and cap rates may influence the business plan.
3. The plateau is here, with a balanced outlook for 2018
The consensus of the panel about the future could be summarized as balanced optimism. While political uncertainty is not to be underestimated, the operational performance of hotel markets is expected to remain strong. Investment cases in [second- and third-tier] locations can work well if one can take advantage of current yields and is positive about future exit scenarios. The substantial increase in construction costs, however, is seen as a risk in the coming months. As property prices rise, margins diminish and force developers to contract crafts directly, which binds more resources.
According to the panel, the transaction activity has reached a plateau in the key European markets, and more records are not to be expected in coming years. This can be attributed to the fact that many hotels traded today are being bought by long-term holders who bind product for future transaction cycles.
One could expect investments to shift toward more pipeline deals and to coin the trend “forward is the new normal.” Overall, the risk of rising cost of capital is hanging over all real estate investments and might expose buyers who acted too aggressively in times like these.
4. Sustainable investment cases include downturn scenarios
To sum up, hotel investments are attractive but have a certain degree of volatility. Specialized investors with many international capital sources create competition and compress yields. A due-diligence process should always be customized to the individual investment strategy and should minimize uncertainty.
In uncertain times, underwriting should include several stress tests to reflect a potential downturn or the impact of investment parameters such as cost of capital. The improved access to data through technology does not exempt investors from properly analyzing and using them. Sustainability means resisting the pressure to invest when numbers do not add up.
Robin von Bothmer is a senior consultant at Engel & Völkers Hotel Consulting, a firm that advises owners, developers and operators along the lifecycle of hotel real estate and operations.