Hotel development was once a licence to live dangerously but the recession has created a more sensible environment that could still yield dividends, says Eric Jafari
The performance of a hotel is closely linked to broader economic conditions. Its two main income streams - tourism and business travel - are driven by the disposable incomes of consumers and the vibrancy of local economies respectively. It’s perhaps unsurprising, then, that hotels were among the first property asset classes to be hit by the recession, as consumers felt the squeeze and business traffic nosedived. Non-city centre hotels and those in poor regional locations were particularly vulnerable.
Although the recession took its toll on the hotel market and effectively put hotel development on hold, its impact hasn’t all been bad. It helped expose some inherent flaws in the hotel funding and operating system that are now being addressed.
During the boom years, many banks were willing to lend at high loan-to-value ratios. With the high debt, the owner would develop the hotel and allow it to be operated for at least three years, providing evidence of a track record of profitability before selling or refinancing it at a premium. With funding readily available, all this could be done solely on the basis of a management agreement with an operator such as Hilton, Accor or IHG.
This meant that 100% of an owner’s revenue, profitability and asset value was derived from the performance of the operator, who, if they didn’t perform in a particular location, had nothing to lose. The operator dictated the net worth of the asset and yet was not willing to provide any form of financial reassurances on performance. For this reason, a number of operators promised the world and then failed to deliver, leaving a high number of unsuccessful hotels and upset investors and lenders.
A number of operators promised the world and then failed to deliver, leaving a high number of unsuccessful hotels and upset investors and lenders
Now, aside from luxury central London projects, hotels are a four-letter word to most credit committees. As a result, credit and consequently sites are drying up, despite strong demand for affordable hotel accommodation in many regional city centres. Banks and investors won’t touch a project unless you’ve got a lease backed by a strong covenant, and the hotel operators who have performed best in recent years (the likes of Premier Inn) are those who have offered leases to help unlock development of new sites.
Many of the investors and lenders that were burned when the boom ended are now seeking certainty of income, making it far more difficult for projects with management agreements, rather than leases, to attract equity or debt. When you approach an operator and ask them to put their balance sheet on the line, the level of analysis they will carry out on a particular location goes up significantly, reducing the risk for all involved.
Most operators don’t want to encumber their balance sheets with leases if they can avoid it. The onus is therefore still on developers to convince them of the merits of a particular project and location.
The obvious focus for operators and investors is central London, but with everyone chasing the same transactions it is increasingly difficult to find projects that stack up financially. But there are opportunities to be found for savvy developers - York, Aberdeen, Edinburgh, Cambridge, Oxford, Bristol and Bath, for example, enjoy strong business throughout the week.
The only real competitors to operators providing leases are owner operators - individuals or companies with the capital and the expertise to operate their own hotels. These are few and far between and the vast majority are focusing on the London market.
All this means conditions are now right for developers to start looking at new hotel projects, so long as they avoid the pitfalls of the past. Provided developers don’t build anything without a lease, make sure the demand is there and pick the right locations, there are real opportunities to be found in the hotels sector.
Eric Jafari is the chief executive of boutique property investment firm BridgePoint Ventures