The United Kingdom still has hotel investment opportunities, but they are riskier plays than investments in mainland Europe.
LONDON—To succeed in the United Kingdom, investors are moving further up the risk curve to deploy capital, according to sources.
At a session titled “A focus on private equity” at the recent Hotel Investment in Europe Conference, Camil Yazbeck, partner and investment director at Patron Capital, said the right deals exist if investors look closely.
“There are lots of deals you can find in key cities in the U.K. and Europe, but you just have to work harder to find them,” he said. “Returns for lower-risk hotel investments are very low, hence to achieve good results, you have to move up the risk curve. In order to do this, underwriting deals is even more challenging, and you have to be more granular every step of the way. What it boils down to is finding good real estate in good locations with strong business-demand generators, having a clear business plan and the right management.”
Some amount of risk comes with the territory, said Stéphane Obadia, managing director of Schroders, which on 31 July bought Algonquin.
“Good, cash-flow assets are no longer risk free,” Obadia said.
Neville de Melo, SVP of acquisitions at Realstar Group, said it’s time for patient capital on the buyers’ side.
“It is a consequence of where we are in the cycle. It is not the time just for purchasing anything, despite there being a lot of existing capital on the (private equity) side,” de Melo said.
That money looking for placement is despite a lot of private equity reaching its natural lifespan and exiting from hotels, panelists said.
“The rise in consolidation and platform sales has derived from private equity, such as ourselves, having exited most of the hotels purchased back in the 2011-to-2013 period,” Yazbeck said. “Now we are seeing a lot of opportunities with bigger platforms at lower yields with nearly stabilized profits with good cash on cash. The new buyers are long-term buyers and institutional.”
Yazbeck added Patron has already invested around €700 million* ($808 million) of its almost €1-billion* ($1.15 billion) fund, which closed in summer 2016.
Obadia said the investment community views hotels as a stable investment class, but more owners are content to hold than sell.
“Hotels are becoming more attractive to investors who want solid assets, thus real estate values are high, and that is the risk,” Obadia said. “The question is how many sellers will we see in the next three years? It is drier out there.”
The pace of transactions could quicken at any moment, de Melo said.
“And the biggest buyers will only be determined by what will be sold, and who are the sellers,” he said.
It is not only buyers who need to be patient, panelists said.
“If the price is right, they’ll sell. Also patient are the sellers,” de Melo said.
More and more institutional investors are expected to scoop up assets across Europe, Obadia said.
“Everyone knows the same numbers in the U.K., but in Europe it is more fragmented, where exposure to hotels from institutional investors remains quite low,” he said. “That is likely to rise, though, and brands and their stories will increase.”
It’s a wonder institutional hotel investment across Europe hasn’t picked up already, sources said.*
“Why the European hotel industry is not more institutionalized is an interesting concept,” he said. “The cycle starts with assets that are not performing or could perform better, where private equity firms such as us acquire them to improve the asset condition, introduce better systems and processes with improved management and increase the hotels’ bottom line to get them to a stabilized income situation, to then sell them to institutional-type capital who are seeking lower but safer returns. … Depending on which markets and cycle you are in, you will see more or less of institutionally owned-type assets.
“Looking at how many branded hotels are in the market is also an indication of a more mature market and what stage that particular market is in the cycle.”
In some markets—notably Germany, Europe’s largest economy—it might be the business model that is to blame, panelists said.
“The attitude needs to change to get away from the lease structure, as leases make it difficult for institutions to employ capital. Institutions want to see other institutions investing and benefiting before they follow,” de Melo said.
Obadia advocated for the owner-operator structure.
“With leases you do not always get the upside,” he said. “I believe the owner-operator (model) is the best model, but it comes with risk. You can still do better deals with leases of 3% yields than you would in other asset classes.”
Panelists said the debt market across Europe is pretty positive.
“At the moment, the current market is driven by strong optimism and belief in the future and tolerance to higher risk, so debt continues to be readily available,” Yazbeck said. “There is increased competition in the debt markets from non-traditional lenders and the creation of credit funds. And there is much wider availability of finance to fund customized, innovative investment deals suited for variety of investors.”
Debt is not for everyone.
“The closest we got was looking at mezzanine debt, but when we saw it would cost 8%, we decided we’d rather invest our own equity. What amazes me is that people in the U.K. are still securing debt on ground rent,” Obadia said.
The U.K. market is further complicated by Brexit, panelists said.
“If you have a short-term strategy (in the U.K.) it might be pretty difficult to navigate,” Realstar Group’s de Melo said. “Every day (Brexit) changes. It moves everywhere, and it might run up to March, and then someone might work it all out, or extend (the leaving date).”
Yazbeck said Brexit creates plenty of uncertainty for investors.
“Would you invest in the U.K. knowing Brexit is looming?” he said. “There are numerous variables to consider. More granular homework is needed for each and every hotel in its micro-market. For example, you have to ask yourself what is the top-line revenue segmentation of your hotel and what type of impact there might be with, say, less corporate business in that particular market or if there will be more revenue generated due to the value of the pound decreasing and getting more leisure stays.”
Labor costs are also expected to increase once Brexit is complete, Yazbeck added.
“Costs are up and will continue to rise, putting pressure on the bottom line, but the pound (sterling) is weak, so will you get sufficient average daily rate to cover your increased costs?” Yazbeck said. “The U.K. hotel regional market is more reliant on European employees, and we are in danger of a chronic shortage of skills if an immigration system is put in place prioritizing high-skilled workers. Considering these key facts, I believe the market could be pricing the Brexit risk incorrectly currently.”
Schroders’ Obadia said markets in the U.K. still were on the side of risk he’s happy with.
“It is not a bad time to buy into the U.K.,” he said. “It is not as dramatic as it could be. I do not see a decline in occupancy, and I do not see a hit in revenue in London, although pockets of the regions might be hurt.”
De Melo said he has one overriding issue.
“If you underwrite the U.K., what does that underwriting look like going forwards? How do you make that business plan work?” he said.
So where else?
Panelists said there are several attractive markets for hotel investment throughout Europe, including Lisbon, Portugal.
“If you are happy to invest in resorts, Spain is very interesting, and so is France if you get your head around the specific market challenges,” Yazbeck said. “Some key cities in eastern and central Europe are interesting, too, but it is all about whether there is sufficient liquidity and if the asset would be attractive to institutional capital down the line when we exit.
“Demand is continuing to outgrow supply in many key cities, but you have to understand what the increasingly sophisticated customer wants.”
Yazbeck said it’s interesting that companies such as AccorHotels are going back to a verticalization model and trying to be present at every step of the customer journey.
“(AccorHotels wants) to capture their customers of all age groups, trying to keep them loyal within the family using their various brands and providing products that appeal to them and to their ever changing choices at several stages of their lives,” Yazbeck said.
“Any individual guest does not want the same type of hotel three times in a row, but there is an attachment to brand, an attachment to loyalty and an attachment to ease of booking,” Obadia said.
*Correction: 18 October 2018: A previous version of this article included incorrect valuations.
*Clarification: 23 October 2018: This story has been updated to specify the pace of institutional hotel investment across Europe.