Are There Opportunities in Hotel Investing Post-COVID?

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In every economic crisis, the pain that is caused also creates opportunities. This is the silver lining of any recession. Far from “taking advantage” of the situation, investors who are able to stomach the higher risk level and put money to work in riskier environments can actually help pull us out of the recession. Putting capital at risk creates jobs and stabilizes falling prices.

In real estate, one potential area where opportunities may arise is the hotel space.

As you can see from the charts above (or as anyone with a pulse already knows), hotel occupancies took a major nosedive when COVID-19 arrived on the scene. After a slight rebound over the summer, occupancy started trending back down.

Expert forecasts point to a slow and painful recovery as opposed to a quick snapback to pre-COVID-19 levels. This will mean a lot of stress for current hotel owners and potentially some downward pricing pressure on hotel assets in the market.

Basics of hotel investing

Investing in hotels is an entirely different animal from what most real estate investors are used to. Hotel operations are highly complex and, in many ways, more closely resemble a business operation than a real estate investment. Operating a hotel requires hiring and managing many employees, dealing with franchise agreements through one of several “flags” (Hilton, Marriott, IHG, etc.), booking events and conferences, and more.

Hotels also come in many forms. There is a spectrum of service levels associated with hotels that ranges from limited-service hotels (revenue is based largely on room fees and there is very little in the way of food and drink or other amenities) to full-service hotels that can accommodate large events and typically have large food and beverage operations.

Within these categories you’ll also see differentiation through pricing and services. A mid-price hotel will still differ drastically from a luxury hotel.

The key factors to understand hotel investing and how it differs from, say, apartment investing are operating leverage, financing, demand drivers, and revenue dynamics.

Operating leverage

Operating leverage can be explained as the percentage of costs that are fixed (don’t change in response to changes in revenue) vs. variable (do change based on changes in revenue). Hotels, and especially limited-service hotels, are known to have high operating leverage. Most of a hotel’s expenses don’t change much whether the property is 95% occupied or 50% occupied. The mortgage payment, insurance, taxes, cable/internet, and some staff salaries (someone needs to be at the front desk) are generally fixed and represent the lion’s share of expenses. 

While there are some expenses, like the cost of turning rooms and hiring additional maids, utilities for empty rooms, and food and beverage inventory (if any) that will go down if occupancy drops, these expenses make up a smaller portion of the total.

This has the effect of creating massive profits when occupancy and rates are stronger than normal, but it also creates huge losses if occupancy drops. Once a hotel has generated enough revenue to cover fixed costs, a very high percentage of each additional dollar of revenue goes straight to profit. Conversely, once revenue drops to around the point where only fixed costs are being covered, each additional dollar in revenue lost cannot be offset with lower expenses and puts the hotel at risk of defaulting on debt.

Financing

Speaking of debt, financing is another key area that differs drastically from apartments. Apartments have very deep pools of very aggressive lenders, including agencies that can offer artificially low rates due to the backing of the federal government. Local banks, regional banks, and insurance companies also love lending on apartments.

While there are financing options for hotels, these lenders understand the higher risks inherent in the space and will price their loans accordingly. Expect to see higher interest rates and lower loan-to-value (LTV) ratios in the space.

Today, lending hasn’t completely dried up in the hotel space but interest rates are extremely high and lenders are extremely picky and cautious. Any investing strategy needs to prioritize this issue.

Demand drivers

Demand drivers in the hotel space are also unique. Whereas apartment demand comes from areas with job growth, development, entertainment, and convenience, hotels, while sharing some of those drivers, are also driven by things like sporting/concert events, conventions, airports, business travel, leisure travel, and proximity to major transportation hubs. Understanding these drivers, and which drivers impact the hotel you’re considering investing in, is crucial.

For example, a hotel that generates most of its demand from leisure travel and tourism will be affected much differently than one generating demand from conventions.

Revenue dynamics

Lastly, revenue dynamics are critical to understand and look nothing like an investment in apartments, retail, office, industrial, or self-storage.

In those other asset classes, you may have between one month and 20 years of revenue contractually locked in from your tenant. In hotels, you have a day! That means that your revenue can vary wildly with moves in the market. In a business with high operating leverage, this creates additional risk.

In hotels you’ll also likely be dealing with your franchisor in matters of revenue management. All of the major flags have their own rewards and bookings systems that you’ll be plugged into. This introduces additional complexity into managing revenue.

The terminology you’ll run into when looking at hotels will also sound different. On the revenue side, you’ll hear the term RevPAR. This stands for Revenue per Available Room. This is a simple calculation that simply multiplies the ADR (Average Daily Rate) by the occupancy (there can be some adjustments, but we’ll keep it simple). If your ADR is $200 per night, and your occupancy is 75%, the RevPAR for that time period is $150.

The opportunity

Given what we know about the high operating leverage of hotels and the drastic declines in RevPAR that have taken place and are forecast to continue for several years, it seems inevitable that many hotels will have a hard time staying solvent. 

While there are currently some forbearance programs in place, and banks have shown a willingness to work with borrowers, there will come a time when full loan payments are expected and the cash flow simply won’t be available. While we may see further bailouts and deferments that soften the blow, there will likely be many distressed properties hitting the market nonetheless.

The right investors with the right time frame and capital requirements stand to benefit from this trend.

How to execute 

For new investors thinking of putting money to work in the space, I’d highly recommend partnering with some high-quality managers who know the industry well. I would gladly pay a management fee for the experience and expertise good hotel management companies bring to the table. You may also consider acting in a limited partnership capacity and providing equity to a highly experienced sponsor who has the skills and experience to execute on a distressed hotel opportunity.

Focusing on limited-service hotels would also be wise. By limiting the number of variables and taking food/beverage/banquet/event revenue out of the equation, you’ll be left with deals that are easier to understand and carry less risk.

Look carefully at demand drivers. Hotels catering to tourists and casual travelers may rebound sooner. The business travel situation is still in flux. It is unclear when and to what degree we’ll start to see massive conventions and a resumption of general business travel. However, your typical family is itching to get out and see a new part of the country, enjoying a vacation and a return to normalcy. The most affordable hotels may see the earliest pickup in activity, as consumers will likely be looking for great deals to entice them to travel.

Currently many hotels have been able to stay afloat by tapping reserves or working out arrangements with lenders. The longer time drags on without a strong rebound in RevPAR, the harder it will be for hotels to stay above water. Patience will be key, and we may well see another wave of delinquencies when banks start to demand payment more vigorously.

Conclusion

For the right investors with the right risk profile, hotels may provide an opportunity to make higher returns than many other asset classes. In doing so, it is critical to understand the unique risks and operating differences that hotels present. There is no such thing as a free lunch, and these potentially higher returns come with the trade-off of higher risk. If you do decide to enter the space, consider partnering with highly experienced investors and property managers to give yourself the best chance at success.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.