The Strategies Behind Hotel Deal Making
There is a tendency to think that in a real estate transaction the acquiring party is optimistic about the future and the other one is not or wants to play it safe. In CRE, and most specifically hotel deals, this is not likely the case. Hotels transactions are much more than the conversion of real estate assets into cash, they are the realization of a value creation strategy, that by definition has to “end” with the disposition of the asset.
Professor Jan A. de Roos, from Cornell University School of Hotel Administration (SHA) delves into the five fundamental Hotel Real Estate strategies for value creation:
- Create value via development or redevelopment. This is achieved when the total cost is less than the replacement cost, or even better, less than the market value of the improved property. Sometimes this is achieved by major enhancements, additional amenities, or traditional construction projects, sometimes it means converting the building use, and it tends to be the preferred approach for developers with a background in construction and project execution.
- Use superior operating skills to enhance revenues and operate more efficiently to generate superior NOIs. This is the approach skilled hotel operating companies take, looking for properties that are performing below its potential that they can improve with better management.
- Take advantage of lower capital costs, this allows well financed companies such as public REITs to leverage their access to capital and realize a significant improvement in the IRR compared to undercapitalized or poorly structured companies that are not leveraging their assets efficiently for whatever reason (such as a family owned unencumbered asset)
- Time the market, meaning that you see something the other party is not, whether by superior skills or the use of big data and analytics. If you can see or interpret macro trends in an area before or better anyone else, you become a contrarian and timing the market becomes possible. Some of the most famous and successful investors have become extremely wealthy by playing well this contrarian game, but do consider that a market timing strategy, “buy low and sell high”, by definition is not consistent with long holding periods, as cycles averaged between 5-10 years from trough to peak.
- Embrace risk, such as adding debt to leverage equity returns.
To determine the strategy to follow you should ask yourself:
- How long do I intend to hold the property? The holding periods using operating skills and a low cost of capital tend to be long, as a lot of the value is generated during the operation and not upon the sale; the market timing and leverage driven strategies are aligned with shorter holding periods, as IRRs are maximized upon a sale. Therefore, only get into the long term operational space if you have the expertise or can partner with someone with skin in the game that does, otherwise you are better off “flipping” it and moving on to the next one.
- Who are my brand and management partners? Some developers prefer to retain their own management and purchase a franchise, as they expect to hold the property for many years, while others simply make a development profit, selling assets upon completion and realizing a shorter-term gain, in which case you are better off leaving the buyer the flexibility to decide and negotiate the franchise of his choosing.
- What is the right levels of debt and equity capital in the deal? Developers can embrace debt capital to maximize their equity returns as the build and sell strategy has a short holding period conducive to high IRRs, but long-term operators can and do function with a 50%-70% debt to equity ratio. Obviously the higher the debt the higher the potential return, but the higher the risk and the less room to maneuver in a downturn.
- When I sell, who are the likely buyers? One must understand who the potential buyers might be, so as to structure and position the deal appropriately; REITs are looking for high yield and may be willing to trade some “upside potential” for stable cash flows, so if you are running a very profitable operation a REIT is your ideal buyer. Opportunistic investors are willing to trade lower cash flow for significant “upside potential”, so a property in need of a major renovation, or even a newly renovated one, would be ideal to an operating company looking to generate value at the disposition of the asset.
At the end of the day the true “art of the deal” in real estate investing is being able to make good, risk adjusted decisions based on a certain expectation of the future. Investors must guess right more often than not, or eventually they are quickly “exited from the playing field”. It is important to keep in mind the many externalities outside of our control, and how they can become great opportunities or force us into loosing situations. A most relevant one is when you are forced to sell, such as when the fund life is nearing its end, here timing is everything, begin the deposition process to close to the exit deadline and you might be forced into a less than optimal deal for your investors.