Behind the Scenes: Hospitality Real Estate

Hospitality real estate is a unique asset class because it includes housing (hotel and resort properties) and retail activities (e.g., food & beverage, accommodations, banquet facilities and recreational amenities) in one investment. This creates an additional layer of complexity in the investment valuation process and requires an understanding of industry and market dynamics.

Additionally, like the airline industry, pricing fluctuates frequently as the sales and revenue management functions constantly seek to optimize the occupancy to average daily rate ratio. This is known as RevPAR (revenue per available room) which is arguably the most important of all metrics in the hotel industry because it provides a snapshot of how well it is filling rooms and how much it is able to charge (for a room.) Hospitality real estate is a “people-intensive” business. How a hotel is managed can generate substantial differences in revenue and profits even if brand or geography are the same.

While these considerations are important, the attractive risk-adjusted returns have made hospitality an important segment in the real estate industry and as part of the alternatives portion of institutional and individual portfolios, particularly in the last decade.  The tax deferred income streams along with protection from attractive total return, inflation and diversification are some of the important benefits investors can enjoy.  Historically, cash flows from hotels are generated and distributed to investors early, often and largely tax deferrable (dependent upon the investor’s tax level.) Additionally, the total risk adjusted return for investors is favorable when compared with the Private Equity Index and S&P 500 Index.

Interest rates in the United States have hovered around historic lows for several years with the 10-year Treasury rate remaining below 2.5% for almost seven years. “Easy money” policies, particularly for prolonged periods, raise investor concerns about inflation and its value-eroding effect. Real estate lease contracts (or in the case of hotels, the average daily room rates) commonly include CPI (Consumer Price Index) or fixed upward lease escalators enabling hospitality real estate investments to serve as a potential inflation hedge.

Hospitality real estate has historically displayed a low correlation to stocks, bonds and even other real estate investments. That low correlation supports maximizing risk-adjusted returns and leads to a higher Sharpe ratio in an investor’s portfolio. It’s also worth noting that real estate performs well in times of high volatility (e.g. government debt worries, geopolitical concerns, etc.) give the predictable cash flows and diversification benefits.

The method and types of hospitality real estate investments are also important to consider. There are a wide range of options with public real estate investment trusts (REITs) and private markets. Private real estate generally provides greater tax benefits and returns relative to REITs, along with better downside protection and lower volatility. Not all hospitality real estate is created equal. Hotels in the Midwest and southern regions are increasingly attractive due to a fragmented ownership base, less competition and fewer sources of investor capital. And while many investors are drawn to the beauty and excitement of “high profile” luxury resorts, history has proven that while such properties may be physically attractive, they rarely live up to financial expectations. Ultimately, investors benefit when the hospitality real estate firm has negotiation leverage to purchase properties at attractive rates and harvest the gains at the right time.

In summary, hospitality real estate, as with any asset class, should be measured against long-term historical averages and not just recent performance. History demonstrates it can serve as a valuable component of a diversified investment portfolio. While illiquidity is an important consideration for any investor, the returns generated from quarterly tax-advantaged cash flows helps to return capital to investors much more quickly than a fund’s life may imply or other investments can promise.