Diversify Your Portfolio With Passive Hotel Investments

Big Four CRE investors use hotels for several reasons. Higher cap rates entice investors. Once people grasp the asset class, other motivations prevail. Changing asset classes is difficult. Hotels bring complexity that's worth knowing.

This guide covers high-level issues.

 

How Hotels Differ from the Big Four CRE

Hotel investments are a kind of running company that has a real estate component. This might be the most significant divergence between the Big Four CRE assets, which are more concerned with asset management than with operations. As a consequence, hotels have insatiable appetites for continual capital investments. Many of the risks are mitigated by alignment with a strong operational team and a solid business strategy. Still, anybody stepping into this environment should plan well and be ready to capture and use sound advise.

Nightly Rentals

Hotel inventory is measured in terms of available hotel nights. A rough estimate for total available room nights in a year is the number of rooms multiplied by the number of days open. In a typical year, a 100-room hotel will have 36,500 total available room nights. As a result, occupancy is defined as... wait for it... occupied divided by available room nights. Room sales vary seasonally dependent on the market's demand profile. Nonetheless, tactics for selling out goods are applicable all year.

Your strategy will simply differ depending on which business categories are trending for that booking window. Throughout the year, business sectors exhibit varying trends. Group travel has a wider booking window than transitory visitors, although contract business is consistent all year. A good revenue plan accounts for each of them in accordance with their specific demands and preferences. Contract and group business are the foundation. This dependable income is reserved weeks and months in advance.

Rates may not be shocking, but they do enable the revenue manager to reduce available inventory in order to boost prices. As the booking window closes, supply and demand dynamics take effect. A hotel that pays its overhead weeks in advance has more leeway to decline a cheap rate than one that does not have a stable base income. When all hotels are fully occupied, this compression raises hotel prices, and market rates follow suit. Your revenue manager will identify avenues that will deliver you the visitors you need when and how you require them. The greatest income contributors are brands, online travel agencies, and direct sales.

Throughout the year, distribution across the different channels will bend to achieve the best business mix.

Positioning for Operations and Contracts

For everyday operation and upkeep, an operational hotel depends on a broad group of providers. They often deliver products and services under long-term contracts that change slowly in comparison to the revenue cycle. As a consequence, they are ideal candidates for repositioning via rigorous asset management. The low-hanging fruit include brand and management contracts, as well as large-ticket leases. Contract conditions are negotiable at different points of the investment lifecycle.

However, an acquisition puts you in the greatest position since you have the urgency of a sale and a seller who, if cooperative, may play another negotiation angle. Early in the engagement, seek alignment with your suppliers. Too frequently, sponsors are just concerned with cutting costs and overlook other parts of the transaction. I always go back to the classic engineering approach of allowing you to trade between cost, quality, and time. As a result, cost may not be the most essential factor in placing the hotel for maximum profitability. A comprehensive strategy takes into account the internal and external stakeholders' strengths and shortcomings.

For instance, you may discover that two providers with comparable skills are more costly. However, if they deliver superior quality or faster execution, you may be able to justify the expense with increased additional income prospects. These ideas apply to all aspects of the company strategy, from capital structure to operations and all in between. As a result, frequent and thorough asset management assessments should identify possibilities for increased income as well as possible savings. Don't get caught up in cost-cutting without realizing that income is what drives this firm.

All Hotel Investments Are Either Core Plus or Riskier

Every seasoned real estate investor knows the concept of risk-adjusted return. When you initially have the notion to pivot to hotel investing, your risk level is pretty high at best. Risk decreases when you acquire knowledge and begin to build up the infrastructure. However, the investment never really becomes a primary investment. Hotels, as previously said, are both operational and capital-intensive enterprises. Upon change of ownership, they always include a brand-mandated property improvement plan (PIP) and operational enhancement possibilities.

I can count the number of core investment opportunities I have underwritten on one hand in the last decade. Strong hotel investment sponsors mitigate risk by collaborating with a strong team and adopting tactics that mitigate the most frequent dangers. Throughout the financial lifespan, risks take numerous shapes, and experience is typically your greatest guide. Most people prioritize the completion of any building or repair project. This risk stems from two areas: limiting guest interruption and completing the task. Ongoing operational risk follows closely after and stays throughout the duration of your investment.

Hotels are nevertheless subject to all of the classic risk considerations that affect other CRE ventures. Loan maturity, selling liquidity, and a range of macroeconomic hazards are examples. The first lines of defense in mitigating the numerous investment risks are an established strategy and a good team.

The Fundamentals of Establishing Your Strategy and Team

A solid plan followed by a competent team is the foundation for successful investments in every real estate asset class. These will serve as your compass when you pivot to hotel investing.

When it comes to creating your team, paying attention to the finer points of your investment plan can pay benefits. Furthermore, when each stakeholder knows exactly how to respond in every scenario, they may be much more productive.

The Key Elements of a Successful Hotel Investment Strategy

This is a street corner shop.

Begin with larger macrotrends that you are already familiar with from your Big Four CRE investments. Secular factors, such as population growth and employment, will direct you to areas where a hotel investment may make sense. Then, learn about the demand drivers in each market. Proximity to key demand generators may produce considerable income and, as a result, value. This tighter targeting will aid in the rapid elimination of opportunities that come across your desk. Your potential visitors' demands and wishes will be presented as part of a market's overall picture of demand.

A resort approach, for example, would benefit a regional emphasis that consists mostly of leisure tourism. A business transitory profile, on the other hand, may be better suited to full or select service hotels. After location, the second factor is chain size and service level. These are similar to the construction class, but they are more concerned with money generation than with objective quality. Every year, Smith Travel Research assigns businesses to a peer group based on worldwide average daily prices to establish where they fall on the chain scales. This information helps you to concentrate your attention even more to certain brands.

A solid hotel investment plan is built on location, service quality, chain size, and brand. Finally, think about your risk tolerance. In the last part, we discussed hotel investing concerns briefly. It's now time to decide which chances you wish to take. For most, a light value-add may be a decent starting point. This might be as basic as a brand-mandated PIP consisting of paint, carpet, and FF&E.

Most operators are capable of managing that execution internally. More intense value-add tactics need a larger team, which may include a general contractor to oversee the operation.

Determine Your Key Stakeholders

Hotel investments include three primary stakeholders: the brand, the operator, and the owner. These are combined in a number of ways by industry participants. The two most popular are brand-operator and owner-operator, with the third being a distinct business. Brands serve as your team's sales and marketing arm. They provide distribution through centralized sales, an online booking engine, reward programs, and many more services. They also offer front- and back-of-house support in the form of systems and procedures for successful implementation.

Operators are in charge of keeping the hotel occupied and maintained on a daily basis. Employees are hired and managed by a management business, while the mothership offers extra systems and procedures to improve execution. Finally, the owner is in charge of asset management and strategy. She gathers all stakeholders and approves significant property decisions such as the yearly operating budget and large construction expenditures. Depending on their own capacities, each of these stakeholders depends on a range of extra contributors. Larger real estate investment organizations, for example, may employ internal legal or construction management professionals.

Nonetheless, a thorough grasp of their expertise implementing your plan is essential for filling any gaps with third parties.

I prefer to start team building with a SWOT analysis to identify the most critical demands.

• Strengths are internal characteristics that may have a beneficial influence.
• Weaknesses are intrinsic characteristics that may have a detrimental consequence.
• Opportunities are external characteristics that may have a favorable influence.
• Threats are external characteristics that may have a detrimental influence.

This data provides a clear picture of places to exploit and develop the good while providing assistance or mitigation for the bad.

Alignment of Internal and External Contributors

Management firms get 3% of overall operational income, whereas brands may charge up to 15% for all fees. The desire to recoup these payments is genuine and quite appealing. Resist the temptation. Making the switch to hotel investing is difficult enough. Concurrently establishing an operational and brand platform adds to the burden. Building alignment with your internal and external stakeholders is a superior way.

Incentives are highly received by investment partners and staff. The same goes for your suppliers. As a consequence, you can generally establish mutually beneficial contracts by providing incentives to attain the desired goals. A management business, for example, is responsible for generating enough money to pay operational expenditures. Simultaneously, they should run the hotel effectively to guarantee that as much of the income as possible makes it to the bottom line. A monetary incentive for exceeding a profit threshold might encourage hotel management to prioritize top- and bottom-line performance.

To be sure, extensive asset management is required. However, this is analogous to giving your important staff a stake in the sponsor promotion. Incentive payments can aid in retention and engagement. These two criteria work together with other aspects of your culture to create a loyal and productive working environment.

Experience Is Money

We're all hoping to finish our five-year plan by next week. That is the essence of the human experience, and it is exacerbated by the immediate gratification society we have built in recent decades. That being said, partnering with skilled partners may help you achieve a significant amount of value, both physical and intangible. In the short term, it may have a significant opportunity cost, but it is well worth it in the long run. Because they understand the inherent worth of the asset, asset-based lenders would gladly provide a loan with a high coupon to an unskilled hotel sponsor. In the case of default, an adept asset manager may take over and continue till maturity.

That is a costly proposition. The option is to hire a partner for your first few transactions. You will most likely divide the promotion in an initially disadvantageous division. That will change when you bring in more business and demonstrate your worth. You'll receive better financing conditions with an experienced co-sponsor along the road, and you'll learn a ton of best practices. Credibility will also aid in the development of your pipeline.

Deal sources that know you're working with an experienced team will be more confident in showing you chances you may not notice on your own. Use their track record to make yourself seem larger than you are. Of course, co-sponsorship is not required when making the switch to hotel investments. However, it offers advantages that make it worth considering.

How to Diversify Your Investment Portfolio to Include Hotel Investments

A strong pipeline is the most effective technique to get attention in all aspects of your organization. Your greatest issue, as every company developer knows, will be keeping it filled after you get your first transaction. Real estate investment is similar to gold panning. Fill the pan with everything and shake it around until only the glittery stuff remains. CRE winners are those who can fill and clean their inboxes rapidly and effectively. This is something you know from your Big Four CRE experience.

Hopefully, you'll learn something here that will supplement what you already know and help you plan your hotel pipeline.

Sources of Active Hotel Deals

All company growth is based on three types of transaction sources: direct, intermediates, and centers of influence. Direct sources are those who have complete control over the inventory. They are the current property owners and financial partners in a transaction. Intermediaries do not own the item, but the owner provides them with information and compensates them for selling it. The most efficient method provides the intermediary the exclusive authority to promote and sell the property. Non-exclusive sources, on the other hand, may be useful as well.

Finally, centers of influence are those who can expose you to an opportunity without expecting direct reward. These include lawyers, architects, and other professionals who want to develop a partnership based on trust and mutual profit. Sustaining solid, value-oriented relationships with these players is critical to maintaining a continuous pipeline. We think in terms of give and take much too frequently. Unfortunately, this restricted viewpoint only allows you to see what each of you can get from a one-on-one connection. Relationships founded on providing value are more likely to provide opportunities.

When you comprehend and meet the needs of everyone in your network, you open yourself up to a larger world of receiving. This is because your contacts see you as a key player in their opportunity pipeline. Begin by contemplating what you have that is of little worth to you but may be of great use to someone else. For a broker, this may represent property-level operational information. That is ammo to enhance her negotiations and maybe clinch a deal.

Leads Must Be Tracked and Managed

A dependable pipeline is the consequence of good follow-up. However, excellent follow-up tremendously improves your pipeline. Great follow-up begins with good lead monitoring and management. You want your pipeline to be informative, well-organized, efficient, and easy to understand. When you're in a hurry and need to grab something, its worth plummets quickly. Pipeline monitoring software ranges from basic Excel spreadsheets to large Salesforce-based systems and everything in between.

I utilize a Google Sheets document that my team may access. Consider the pipeline tracking tool that I created in Excel. Regardless matter how you monitor the pipeline, you must create a mechanism for filling and managing it. Before you may make an offer on a transaction, a number of events must occur. Even before you begin underwriting, you must first acquire the lead, sign a confidentiality agreement, download the data, fill out your underwriting form, and then determine where and how you may extract value. Because these operations are time-consuming and boring, most pipelines proceed in waves.

A high degree of focus generates some possibilities, but then you get mired down in examining them. You may close on one along the road, but 15 wonderful leads will pass you by while that one consumes you. Create a system that allows you to take a weekly snapshot of each lead and the next action to advance it. Friday and Monday reviews are the most effective since those days are more focused on preparing and reviewing. Recognize the opportunity and, if necessary, contact the primary source. A clear aim must drive your activity, as it does in every productive meeting, and accountability in your follow-up is crucial.

Concentrate on Increasing Production

Brokers are hired by owners for two primary reasons:

1. Brokers have the time and network to market your property to the broadest possible audience.
2. Brokers understand the most efficient methods for attracting a buyer's attention.

"Shiny object syndrome" affects everyone. Anything that seems to be a promising opportunity is added to the game-board and remains there until someone takes action. This is particularly appealing when the pipeline is running dry. We just want to see SOMETHING there.

Resist the impulse to pursue leads that do not align with your investing plan. You established a strategy and team based on your understanding of the market and your ability to extract value from transactions that fit. Furthermore, each lead you pursue helps to strengthen your brand in that area. A pipeline assessment is not the time to consider if you can change your strategy or team to pursue an opportunistic lead. That's a terrific brain workout for another day. A laser focus on the vision and plan benefits you and your team significantly.

The squad that can clean the waste quicker than everyone else wins. This requires discipline, but the benefits are enormous. Every deal source, particularly brokers, prefers a "fast no" over a "long maybe" every time. You establish credibility for your plan while saving them time. Internal rewards are even more noticeable. Finding a lead is tricky.

Hundreds of phone calls may yield relatively few results. As a result, any amount of interest in an opportunity is a massive dopamine boost for the individual who discovered it. However, as you go farther down the road and realize you might have ended the lead at stage one, the excitement rapidly turns to rage. Simply fodder for thinking.

The Most Valuable Sponsors Begin With A Solid Business Plan

Business plans are difficult to create. I don't know many folks that appreciate this phase of the transaction. Nonetheless, it is an important step in formalizing the goal and uniting your team. A good business plan is a live document from which you may branch out in numerous ways. When funding the purchase, it serves as the foundation for your marketing materials. You may extract portions on revenue and spending strategies so that the operations staff understands your goal.

It also assists your asset management staff in tracking where you intend to be at any given moment. I'm a big admirer of modular company plans, but you need to have a strong idea before you get your hands dirty. First and foremost, revenue... All businesses are always driven by revenue. That is a proven truth. And it's gospel in my hotel investments.

We discussed the complexity of placing "heads in beds" and what that implies for your investing plan previously. You'll note that I didn't go into great detail on budgeting. We'll be there in a second. Still, I can't go on without exaggerating the significance of your income approach to the point of irritation. Every hotel has a unique room and amenity combination that distinguishes it from the competitors. In most instances, the mix was set when the hotel was established by the original developer.

It is still relevant in many circumstances. Here is when strategy comes into play. When you can properly match the hotel arrangement with the wants and aspirations of your potential guests, you trump the competition. A hotel in a family-friendly area, such as Orlando or Anaheim, may do better with an abundance of double-occupancy rooms. A business transitory visitor, on the other hand, desires more single-occupancy rooms. The same is true for public spaces and meeting facilities.

Hotel investors may uncover wealth by exploring outside the box. They take chances based on their expanding understanding of how to match with the most ideal visitor for that hotel. Your strategy might be focused on either service or physical upgrades. Regardless matter how you get there, a creative business mix optimization plan will get you there.

Seasonality Must Be Identified and Neutralized

Seasonality is the most difficult adjustment for many people when transitioning to hotel investing. Your Big Four CRE tenants, without a doubt, contend with seasonality in their company or occupation. These seasons may have an effect on percentage rent or leasing velocity. Your seasonal exposure, on the other hand, is most certainly modest. Hotel seasonality varies by market. In many situations, business seasons coincide with weather seasons.

They do, however, closely follow social and business seasons, such as school and government vacations. These are the driving forces behind the large events that fill your rooms. To detect and counteract seasonality in your company strategy, follow these three actions.

Look for long-term patterns.

Connect market demand spikes to market events

To capture cash flow issues, use a monthly financial model.

One year of STAR data is insufficient to have a clear understanding of when and how a market moves. Major one-time events, such as a sports championship or a traveling conference, might provide false promise for market revenue growth.

A minimum of three years of data is required to have a solid feel of the ebb and flow.

Demand surges emerge as outliers in percent change for the month in the STAR data. A simple search for what occurred that month in that year will tell if you can depend on it in the future.

You don't want your partners or lenders to find out that you missed the Super Bowl bump in your underwriting.

For an initial feasibility evaluation, a basic yearly cash flow model is sufficient. When you are serious about an opportunity, though, a good model of how revenue seasonality affects month-to-month cash flows is most effective.

A monthly model explains how much you should preserve in operational reserves and how equity payouts may vary from quarter to quarter.

There are several methods of cost containment.

A typical hotel profit and loss summary statement has four lines for operational revenue, 14 lines for expenses, and one line for non-operating income.

Every expenditure line has both fixed and variable components. Variability reduces as you go from departmental spending to undistributed expenses and finally to fixed expenses.

In certain circumstances, you are a price taker.

Unskilled labor, for example, accounts for a significant amount of your expenditure burden. Long-term stability is dependent on you achieving market salaries, even if you have some benefit flexibility. The same is true for the majority of the operation's commodity items and services.

However, with the appropriate strategy, you may control large chunks of your spending management.

A successful asset management approach requires both creativity and adaptability. A comprehensive perspective of if and how your team is optimizing each vendor and playing them off each other will provide the best results.

From a financial modeling standpoint, it's simple to cut $50,000 here and $10,000 there. However, a smart investor or lender will anticipate a thorough plan for such a large-scale reduction.

Of course, a first-pass desktop review may be dominated by massive cutbacks. Spend effort improving and defending the pro forma throughout the due diligence stage, after you have control of the transaction.

I'm a huge admirer of zero-based budgeting, which involves starting with zero and working your way up with a one-by-one evaluation of each spending line. This requires far more effort, but it offers a clear picture of what is functioning and what can be replaced or eliminated.

Take A Stand and Own It

Nobody likes to be incorrect. It's a dreadful feeling to go to an investor or lender and pitch your idea, only to have them point out every flaw you overlooked. In this situation, you have two options: own it and make the required modifications, or pass on the chance. If you've made it this far, you're most likely a successful investor with lots of expertise in this situation. You are aware that perseverance is required to close agreements. Still, it's disheartening to be labelled an impostor when working hard to switch to hotel investing.

When it comes to promoting a transaction, I use a two-pronged strategy. I begin by compiling a list of conservative banks and investors. They are interested in prospects because of my track record, but they are unlikely to take action. This is my external investing committee - my safety net to ensure I'm putting my best foot forward for everyone else. My most probable funders will be contacted when I have integrated or fairly rejected feedback from the first round. Regardless of how you design and subsequently improve your business plan, you must own your approach and assumptions.

That kind of tenacity is critical for achieving alignment among your stakeholders, both internal and external. It is also important to recognize when you have made a mistake and modify appropriately.

Learning About USALI

In 1926, the Hotel Association of New York City issued the first version of what is now known as the Uniform System of Accounts for the Lodging Industry (USALI). It developed over time and now serves as the foundation for the majority of accounting systems in institutional-grade hotel operations. In 2014, HFTP and AHLA issued the USALI 11th Edition, which is available for purchase on the HFTP website for about $90. It is well worth the money. Financial analysis is substantially more efficient and rational using standard operating statements. You'll notice this when you obtain cash flow figures from QuickBooks that don't break down labor by department, for example.

This makes it harder to identify areas for improvement. There are four operating revenue categories. Operating revenue is divided into four major areas in the typical summary operating statement.

• Rooms
• Food and Beverage
• Other Operated Departments
• Miscellaneous Income

Room revenue covers all revenue categories - transitory, group, and contract - as well as profits from rooms sold. Cancellation fees and attrition income, which is a price paid for not occupying all of the rooms in your group block, are examples of related revenue. Food and beverage revenue includes all revenue from outlets such as restaurants and bars. It also includes earnings from banquets and catering, such as equipment rental and service fees. Other operated departments generate revenue from facilities that a hotel directly runs and frequently incurs an associated expenditure. These might include a gift/sundry shop, a golf course, or parking.

Miscellaneous income is money derived from leases and services provided by other parties, as well as fees with no directly linked expenditures. Common lease and service examples include mobile phone antennae, ATMs, vending machines, and timeshare desks. The most typical significant costs in this category are resort fees. The first two groups have extremely specific guidelines for what belongs there. The later two, on the other hand, provide a little more leeway. A parking arrangement with a third party, for example, may show alongside income in other operating departments and an accompanying expenditure.

Depending on the contract, it may show as net revenue to the hotel under miscellaneous income. Your classification here is critical since there are costs on the P&L that are directly related to total operating revenue, such as management fees and capex reserves at 3% and 4%, respectively.

Three Major Expense Groups

Expenses exist in three varieties, and their unpredictability decreases as you go down the profit and loss statement.

• Expenses for Departments
• Operating Expenses Not Distributed
• Non-operational Revenue and Expenses

Departmental expenditures are, as the name implies, costs directly related to the operation of the connected departments. Except for miscellaneous income, each revenue line has a matching line here. Consider departmental expenditures in terms of "if we removed the department, we would be able to cut 100% of these connected costs." Your overhead costs are your undistributed operational expenditures. These are the expenses of running the business regardless of where or how the money comes in. Utility and maintenance costs are included, but they also have a softer side in general administration, accounting, human resources, and marketing.

These are the direct expenses of running the hotel, over which the property management firm has entire control. Property management costs are shown below and outside of undistributed expenditures in the USALI 11th Edition. These might include an incentive management fee, which is often linked to exceeding a gross operating profit (GOP) threshold. Finally, non-operating revenue and expenditures comprise fixed costs that would be incurred whether the hotel was open or not. The majority of this spending cluster is made up of property and other taxes, as well as insurance. While they may vary depending on the business, they are normally outside the property management company's control and are negotiated by ownership.

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is the result of total operational revenue less all of these expenditures. The replacement reserve, on the other hand, is your last expenditure before reaching net operating income (NOI). The industry standard replacement reserve is 4%, but your trademark licensing agreement and/or loan arrangement will ultimately set it.

Rules of Thumb Based on Descriptive Statistics

A number of descriptive data are included in the standard summary operating statement. Many investors elaborate on these in their study to get a more complete understanding of previous and projected operations.

Standard descriptive data includes:

• Occupancy = Rooms Occupied / Rooms Available
• Average Daily Rate (ADR) = Rooms Revenue / Rooms Sold
• Revenue per Available Room (RevPAR) = Rooms Revenue / Rooms Available
• Total RevPAR = Total Operating Revenue / Rooms Available

Common line-level descriptive data includes:

• % Total Operating Revenue = Line Item Total / Total Operating Revenue
• % Departmental Revenue (used for departmental expense lines) = Line Item Total / Associated Departmental Revenue
• $ PAR = Line Item Total / Rooms Available OR Line Item Total / # Rooms
• $ POR = Line Item Total / Rooms Occupied

These descriptive data, whether at the top or inside the operating statement, provide a normalized view of performance. For example, comparing year-over-year success with a percentage or per occupied room dollar amount is considerably simpler than with a nominal dollar amount. I often advise anybody considering a hotel venture to underwrite anything that comes across their desk. This exposure is the greatest method to get a thorough grasp of the financial implications of various operating strategies. Along the process, you'll learn about profit margin variances across property kinds and other general rules of thumb. These can help you get a better handle on anything that matches a similar profile later on.

Flow-through analysis, which illustrates how successful the operator is at getting new revenue to the bottom line, may be included in more sophisticated underwriting. However, I believe it is essential to first learn the fundamentals before venturing into this region.