When to limit, share or take risk in hotel development
 
When to limit, share or take risk in hotel development
16 OCTOBER 2018 7:28 AM

As costs escalate and rates and revenue plateau, the risk of development, and who shoulders it, is the subject of lively debate.

MANCHESTER, England—At this point of lowering yields and heightened competition for assets and locations, the question of who is shouldering the most risk, and whether that risk is better off shared, is being raised again.

On a panel titled “Development and construction: Taking it into the next level” at the Annual Hotel Conference, moderator James Devitt, managing director of valuations and transactions advisory Herald Hotels, opened the conversation with a Devil’s advocate statement that the brand takes no risk, while the developer passes it on as quickly as possible.

He added that uncertainty in today’s climate should be converted to risk as soon as possible so it can be tracked.

The industry has processes in place to limit risk, panelists said.

“Unless a full risk process is analysed and agreed to, it is very hard to get development off the ground,” said Richard Candey, partner and head of investor and developer services for Europe, Middle East and Africa hospitality at Cushman & Wakefield.

That does not keep any side from feeling the weight of risk is unequally placed on its shoulders.

“We are taking planning risk, which in today’s environment is quite substantial, as well as site risk. Overall, it is about managing risk and the exit, which is why we like leases, as they provide value,” Andy Jansons, managing director at Jansons Property, said, while acknowledging that most of the industry does not do leases.

The brands do carry risk, or so say brand executives.

“We are very clear we are operators and franchisors, but we do have reputational risk. We are not interested in signing deals we do not value or for one-off assets, and risk also is on the upside,” said Graham Dodd, managing director of development for the United Kingdom and Ireland at Hilton.

Dodd was then asked if brands are so confident of the upside, why there are not more joint ventures. “That is not our model,” he replied.

John Bates, director of acquisitions at Village Hotels, said he might represent one of the last hotel firms to do it all—development, ownership and operations—which he enjoys for the control and flexibility it gives him, as well as a risk-reward balance.

“It allows us to make decisions quickly, and it is a legacy thing, too, but at the end of the day you reap the rewards. The key is having the right team and expertise. … If you are the owner, if trading is good, you can do extensions, which is really important,” he said.

Construction risks
There is some distance between the first spade in the ground and the first quarterly revenue report, panelists said.

How contracts are pieced together is important in ensuring risk is mitigated as much as possible and a project is more likely to bring in the expected returns.

“A guaranteed maximum price is critical so that we can fix our margins,” Jansons said. “It always is a lively conversation when contractors do not fix their costs. By having a GMP, you might be paying a little more, but there will be no surprises along the way, and if there are changes along the way, it is clear the operator can pay for those.”

Bates said rising costs necessitate a closer look at contracts.

“Costs have gone up 20% over the last years, so you need to think more carefully,” he said. “We look at having more efficiencies, making sure the meeting space pays for itself, getting economies of scale and clawing back some of that investment per key that was starting to get away from us.”

He added it’s important to pick a good partner. “Pick one that is commercial and who will meet you half way, and do not get the lawyers involved too often,” he said.

The brands can help in this process, Dodd said.

“We provide a very clear set of brand standards in traditional or modular builds, and other ways in which they are trying to mitigate that increased cost. We continue to future-proof buildings, such as bringing common sense in developing public spaces so that could be turned into rooms. Inflation in the market is a real challenge,” he said.

“Brand standards can change. It is not just a book that keeps getting bigger,” Dodd added.

Devitt said the question then is who pays for it.

“In any good appraisal, there must be taken into account cost inflation. Modular (design), in theory, should make building cheaper, but there is no company that you can order 10,000 modulars from,” Janson said, referring to economies of scale.

Bates said one way Village Hotels reduces risk is to build differently. “We do site-assembly, not site-construction, and that leads to revenue coming in earlier,” he said.

Panelists said risk might be heightened in terms of land values because it is not the hotel industry that determines that.

“Residual hotel valuations are notoriously complicated, and what falls out of the appraisal is the residual land value,” Candey said.

Supply risk
New hotel supply coming to any market generally supresses price and raises risk, although not in every case, panelists said.

“There is a lot of pipeline in the U.K.,” Devitt said, citing as an example the town of Workington in Cumbria, North England. “It has 10 hotels, but three in the pipeline with a total of 458 keys. Does Workington need 182% supply?” he asked.

Cushman & Wakefield’s Candey said his numbers show 650,000 rooms with 50 or more rooms in the U.K. The database at AM:PM, a sister company to Hotel News Now, shows a current U.K. room count of 668,911 and a pipeline, not including deferred rooms, of 159,857.

“Those numbers are driven by core markets doing very well and brands coming in seeking market share,” Candey added.

Dodd said not nearly all of that will come to development.

“There is the idea that the markets we come into have already high penetration, but we do it because we see there is system demand. Do customers want to stay there, and can our owners make a return? And then it is about land, equity debt and the team to build it,” he said.

Jansons Property’s Jansons added, regarding the supply-demand dynamic: “There no doubt are markets where guests are prepared to pay more, as opposed to the usual thinking that additional supply will see a decline in (average daily rate).”

Another trend in U.K. hotel development is a new acceptance of an old idea—ground rents. Not everyone is sure this is a good idea, though.

Candey said institutional capital is showing a real appetite for this type of deal, which he added is easy to assess compared with freeholds. “There are not too many examples of residual lease interests being sold in the market, though,” he added.

Bates said he sees value in ground rents in terms of unlocking developments.

Jansons said he did not see from an owner’s perspective why anyone would sign a ground rent.

Asset owners and operators, he added, would be “immediately stymied” by ground rents. “Changes of use and renovations can be more difficult and expensive,” he said.

The bottom line, Candey said, is that if “landlords do not do due diligence, they will fall flat on their faces,” more notably in this current period of high costs and more stagnant revenue.

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