The first steps in safe and long-term investments.
A hotel is an operating business with a real estate component. It derives much of its value from its proven ability to generate and the potential to increase income. In fact, the hotel’s operational nature is one of the primary reasons to invest in hotels.
Hotel investment is different than the Big Four CRE asset classes in a few ways. The operational component adds risk and uncertainty, but it also provides a wealth of additional benefits that make hotel investing such an attractive business.
The following reasons to invest in hotels are just a starting point. Any hotel investor could easily expand this list by another 10 or more.
1. Nightly Leases
Hotels sell their rooms by the night. Each night represents another opportunity to increase revenue. The challenge comes in optimizing the net income from each additional room night sold. Sales and marketing make a hotel successful from a technical perspective. It’s straight forward to sell to the right audience or place advertisements in all the right places. However, the intangibles, like loyalty and property culture, are most important when building up a reliable revenue stream. The spirit of the property spreads by word-of-mouth, and that is where you can extract the greatest value from a nightly lease. This asset class recovers quickly from a downturn, but it is the first to suffer when the economy moves in the opposite direction. A deal based on sound economic fundamentals ensures that the hotel can weather a decline in business and come out swinging.
2. Sticky Expenses
The USALI standard hotel financial statement separates expenses into three categories – Departmental, Undistributed, and Fixed. The profit lines that follow each of these represent varying levels of control over these expenses. Departmental expenses are cost of goods sold. This is what it takes to service the rooms, food & beverage, and other departmental sales. Much of these expenses are related to labor and a good portion is goods and services. Undistributed expenses are related to the cost of operating the hotel. Management, maintenance, and sales-related expenses fall in to this category. These expenses relate to outside goods and services more than labor. Fixed expenses are exactly as the name implies. The hotel incurs these charges regardless of occupancy and revenue. As you can probably tell, these expenses become more fixed as you move down the financial statement. Some expenses are very sticky and set by outside market forces, like wages and utilities, but most are open for negotiation. This is one of the greatest reasons to invest in hotels. You can negotiate a great deal with suppliers that keeps expenses at one price level, while revenue increases on a separate track. As revenue improves, the cost to service the hotel doesn’t increase dramatically. This provides for a healthy increasing profit.
3. High Risk-Adjusted Return
High yield is one of the biggest reasons to invest in hotels for experienced real estate investors. The statistics are clear that hotels trade at higher cap rates than the Big Four CRE asset classes across the board. However, they are associated with more risk to manage. A high-alpha investment manager understands the risks and constantly seeks to protect the downside while optimizing the upside. The best hotel investment managers either have experience in hotel operations or hotel asset management. They understand the needs of the real estate and the operations.
4. Tax Benefits
Direct real estate ownership is among the most tax efficient investments in your portfolio. Depreciation, equity growth, and tax-free exchange are the three biggest benefits that come from real estate investment. This applies to all direct real estate investment, but hotels take each of these to another level. Real estate loses value over time through wear and tear and functional obsolescence. United States tax law allows you to reduce your taxable income by applying a depreciation expense schedule over a defined timeframe. Hotel investments have a variety of real, personal, and intangible property. Therefore, they benefit from more tax laws that may accelerate the depreciation. Equity growth is important for a variety of reasons, but the most significant tax benefit comes in recapitalizing your investment. Cash equity pulled out from a debt refinance is not subject to federal income tax. Small tweaks to a hotel’s operations can boost cash flow and add tremendous value, which is accessible tax-free in this way. Finally, the tax-free exchange is the hallmark of all great real estate empires. Flip four green houses to build a red hotel on your lot. This amplifies your income potential while consolidating operations into a single, large-scale property.
5. Cost Segregation
Hotel investments are comprised of three major tax categories – building, FF&E, and goodwill. The first two – building and FF&E – are physical assets. Goodwill is the intangible value ascribed to customer loyalty, employee relations, and other intangible factors that make the hotel successful. Each of the physical assets have different depreciation schedules. Some sub-categories even have their own depreciation schedules depending on government policy aimed at increasing specific investments. A hotel’s operational and capital-intensive nature allow them to take advantage of many bonus depreciation policies not available to other Big Four CRE assets. Cost segregation is an important aspect of increasing after-tax income. However, it can also have an important impact on transfer and property taxes. Many states require real estate investors to pay a doc stamp tax based on the value of the real estate sold. In many cases, you can separate the value of the land and intangible assets from the real and personal property.
Note 1: Be sure the purchase price allocation and cost segregation values align in your overall tax strategy. A single, clean balance sheet will avoid potential problems among taxing entities.
Note 2: Don’t try to wing it. Go to a professional for purchase price allocation and cost segregation. This is an advanced asset management technique that requires professional certification.
6. Many Levers for Adding Value
Hotels derive a big portion of their value from operations. This flexibility is one of the great reasons to invest in hotels. However, so many other areas come into play when impacting the ultimate investment value.
The four areas of value enhancement in a hotel are:
- Capitalization – You make money when you buy, but you also need to structure the capital stack appropriately to efficiently deliver the value to your bank account.
- Renovation – Guest expectations for the built environment are constantly changing. In many cases, these are stylistic changes, but staying current will ensure a healthy revenue stream for the duration of your ownership.
- Operations – Hotel operations is a people business. Customer loyalty and employee engagement has a tremendous impact on your ability to optimize revenue and minimize expenses. Many of these improvements are free or very affordable.
- Contract Positioning – Hotels operate with a variety of sales and service contracts. Terms of the brand licensing agreement and certain major maintenance agreements can have a material impact on revenue and profitability.
A high-alpha investment manager balances her impact among each of these and recognizes where each hotel needs the most love. Cash flow multiples amplify even the smallest income improvements, so it helps to have multiple areas to increase income.
7. Community Impact
Almost half of all hotel operating expenses are related to labor. It takes a lot of hands to operate a hotel. This still has a tremendous impact on jobs within the community. Hotels provide an important service for the community beyond just a place to work. As a temporary housing solution, they provide shelter for family, business associates, and residents in need. Full service hotels even provide an event venue for social and business events. They are a place to unwind and reconnect with those that you love. The most successful hoteliers extend their hospitality beyond the walls of their real estate. They are actively engaged in building the community that aligns with their company values and those of their guests.
8. You Can Experience It
The financial benefits of owning a hotel are clear, but the ability to experience it is unmatched in any other real estate investment. Even the simplest limited service hotel provides a space for you to move around with very few impediments. You can get into rooms, public spaces, and back of the house with ease. Add a restaurant, meeting space, or a gym to that, and you’re in a new category of experience. Financial investments, like stocks, bonds, and even commodities, have very little tangible value. Even many real estate investments are hollow beyond their ability to deliver cash flow and tax benefits. A hotel, though, is unique in its nature as a public environment for your enjoyment.
9. It’s Challenging
Money is not the biggest reason for investing in real estate. There are so many easier and less risky ways to make money than investing in real estate. Most investors do it for the love of the game. Hotels represent one of the most challenging asset classes for a real estate investor. Every level of investment in hotels – passive to active – requires tremendous deal diligence and understanding of the industry. Investors must scrutinize and scrub all factors that impact the operation, especially external, market-related factors. As big as the hotel investment industry is, it still represents less than three percent of the total CRE square footage in the United States. The major players all know and respect each other because they understand how difficult it is to consistently perform at the top of their game.
10. It’s Cool
The best reason to do anything is because you love it. But if you can look good while doing it, that’s just a big bonus. Plainly stated, investing in hotels is cool. This is mostly for all the reasons explained here. It’s a high-profile investment that takes more energy to break into and execute at a high level. Big Four CRE investors have respect for hotel investors that continually pump out great investment returns. The ability to welcome your family and friends into a hospitality environment is also very rewarding. You spend so much time and money making a special place, and you want to share it with the people you love. That is difficult in many investments, but a hotel is a public space built for just that – sharing.
Repost from Hotel Investor Thoolbox, written by John Wijtenburg
