Portfolio construction is a very personal task, but diversification is one of the universally accepted principles to provide long-term sustainability. Passive hotel investments provide a variety of benefits as part of that well-balanced diet.
Hotel investing presents challenges that you don’t see in Big Four CRE assets.
Those challenges make it unattractive for many investors. However, they provide tremendous opportunity for those investors that align with a high-quality team.
I don’t plan to go into the fine details on building a CRE investment strategy. Many of the principles outlined here apply to many other CRE asset classes, though, particularly other specialty assets.
Why Passive Hotel Investments? | How to Maximize Risk-Adjusted Returns | How to Build Your Opportunity Pipeline | What to Look for in a Hotel Sponsor | The Absolute Basics of Evaluating an Investment Opportunity
I love investing in hotels (in case you couldn’t tell ?).
Deal-level economics are attractive, they function more like an operating business than traditional real estate, and it’s an asset that you can actually experience.
Each investor chooses from many reasons to invest in hotels. I’ll highlight a couple from investors I know that like passive hotel investments.
On its face, the concept of a nightly lease sounds very risky. However, it presents a terrific opportunity, even considering the risk.
Great hotel revenue managers adjust pricing daily.
These revenue ninjas scope out the market, assess the opportunities, and flex rates based on perceived demand and availability. A proactive approach like this allows hotel owners to capture the benefits from inflation long before operational fixed costs can adjust.
Laying a solid base lies at the core of a great revenue management strategy.
Full service hotels benefit from function space, restaurants, and other amenities that attract high-spending corporate groups or social events. Select and limited service hotels can build a similar base with local negotiated rates (LNRs) and airline or training contracts.
A solid base allows revenue managers to shrink the hotel. They can then focus on picking up higher rates later in the booking window when most of the house is full. As you know, low supply and high demand yields high prices.
This strategy is difficult to accomplish in Big Four CRE asset classes.
Multifamily relies on one-year leases, and industrial, office, and retail properties typically host tenants for two to 10 years or more. While many Big Four CRE leases have inflation escalators, they don’t allow for rapid repricing in good times.
Loath are the landlords that sign tenant-favored deals in a recession.
Of course, the greatest risk emerges when demand softens. However, a strong property and asset management team can execute on strategies to capture more of the demand that exists than their competitors.
Constant supervision of market dynamics allows a high-quality deal sponsor to pivot quickly in the face of danger.
Real estate investments benefit from a very favorable tax code in the United States.
Most stock market investors are familiar with the public REITs that don’t pay corporate taxes on profits distributed to investors. These companies employ an army of attorneys, accountants, and compliance personnel to meet their legal requirements (both tax laws and SOX compliance). As a result, REITs are expensive to operate, but that’s not the biggest reason private placement investors avoid them.
REITs don’t pass on depreciation for your personal use.
Depreciation is an accounting method that decreases the value of an asset on your balance sheet by a prescribed percentage based on its estimated useful life. The United States tax code allows you to take this as a loss to reduce your taxable income.
Depreciation is one of the most compelling reasons to invest directly in real estate. You collect cash from the operations, but only a portion of that cash is taxable.
Hotel assets comprise of a diverse set of real and personal property. We can treat the land, building, furniture, fixtures, equipment, and intangibles separately for depreciation purposes. This is a process called cost segregation.
The most basic real estate building depreciation expense falls on a straight-line 39-year schedule. Separating all the components allows us to accelerate their respective depreciation schedule to 10, five, or even one year.
Strategic cost segregation is available for all real estate asset classes. However, the capital-intensive nature of hotel real estate makes it an especially strong candidate.
Hotels are So Cool
The last reason to consider a passive hotel investment is more personal.
Hotels are a cool experiential investment.
I love that you can actually experience this asset with family and friends.
Real estate is unique among alternative investments because of its tangible value. You can touch and feel the asset. That said, what are the odds that you hang out in a warehouse, office, or apartment community.
Hospitality assets allow you to enjoy the investment. You can feel the energy, engage with the staff, spend the night, taste the food, and unwind.
We all love to receive the financial return from a job well done. You can get that anywhere, and we’ll talk about the financial considerations in the next section.
I always strive to deliver to the perks of ownership in the form of discounts and special treatment, and I know many other sponsors try to do the same.
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We already established that hotel investing is risky, even as a passive investor. However, we expect higher returns from operating cash flow and value appreciation than a similar Big Four CRE investment as a result.
Unlike public securities, risk-return benchmarks are difficult to come by for most passive real estate investments. They tend to trade in low-volume, highly illiquid, and opaque markets.
That said, we can look at subjective risk measurements to get a good understanding of how to measure and mitigate risk.
In my mind, it starts with the location, then the manager, and finally, the strategy.
Hospitality is a street-corner business.
Your ability to invite the right guest for the right price at the right time is directly tied to your physical position in the market. The old real estate cliché, “location, location, location,” doesn’t even begin to explain how important this is.
Hotels are rarely a destination in themselves. They rely on one or many demand drivers to put heads in beds. As you can expect, more demand drivers equals more revenue opportunities. However, the diversity of that demand is also a critical consideration.
Many markets are one-trick ponies. They have a major demand driver, like oil & gas drilling sites, parks, state capitals, etc. Beyond that, you fill in with marginally related business that may come at a lower rate.
In good times, sparse demand drivers are fine. They provide stability so long as new supply is muted.
In bad times, a lack of diversity leaves you scrambling to fill a hotel with only a handful of options.
Note: some markets with less diversity may still be good candidates because they have a stable demand profile or countercyclical characteristics. Major universities and large medical campuses, like the Mayo Clinic or Houston Medical Center, are favorites among the hedging crowd.
I look for locations with a diversity of industries, consistent population growth, favorable business climate, and robust transportation access.
Vibrant communities perform better than their sleepy counterparts in any economy. Yet, they are also more competitive among investors. This makes buying more of a challenge, but it also means there’s more liquidity when it’s time to sell.
Great investment managers are made, not born. They emerge from the trials and tribulations of working in the weeds for many years.
Hotel investment sponsors come in two varieties – hotel operations and hotel asset management.
Operations executives rise through the ranks on the property-level through revenue or operational disciplines. Revenue-minded executives have a good perspective on filling rooms, managing guest needs, and working with prospective guests. Operational-minded executives are best at implementing preventative maintenance, coordinating property improvements, and managing staff.
Asset managers come from a financial perspective. They rise through analytics or originations disciplines.
Analytical-minded asset managers focus on the nuts and bolts – the technical aspects of the opportunity. Originations-minded asset managers focus on the relationships that will yield more opportunities.
At a certain level of abstraction, you find many similarities among the all these personalities. Of course, this is an oversimplification. I just notice that most people are stronger in one area than another.
Great passive hotel investments begin with a sponsor that understands her strength, plays to that strength, and brings together the right team to support her weaknesses.
It’s difficult to objectively measure the strength of an investment manager.
Track record helps, but as you know, past performance is no indication of future performance. Therefore, you need to rely on interviews, communication, and a general gut feeling from all your interactions.
If you don’t get a good feeling about someone – there’s something that just doesn’t fit – it’s probably best to avoid that sponsor.
Multiple Levers for Value Enhancement
I love investing in hotels because they have so many levers for enhancing value.
A hotel repositioning plan may include all the same value enhancements you would find in a Big Four CRE asset. For example, you can improve the look and feel to attract a better tenant or reposition some non-revenue space. However, hotels have various additional components on the operational side to further enhance cash flow.
Very few hotels follow a core investment strategy.
I can count on one hand the number of opportunities I reviewed in the past decade that need little to no property or operational enhancement. Most are core plus or riskier.
Your focus should be on the scope of the risk and how the sponsor can handle it.
Branded hotels have some limitations compared to independent properties. However, they also have tremendous advantages. This is particularly the case for hotels and locations that favor a larger distribution system – usually those with a narrower demand profile.
Brand-mandated property improvement plans (PIPs) focus on the areas that bring a hotel up to the modern brand standard. Every hotel acquisition comes with a change of ownership PIP. The scope of that investment varies depending on the size and age of the asset. Still, remember that the PIP is just a subset of improvements that will elevate the property and its performance.
Creative sponsors look beyond the PIP to find areas for enhancement.
Additional improvements may be physical or operational in nature with a front-of-house (guest facing) or back-of-house (employees only) focus. Performance enhancements may even present themselves in the form of a simple renegotiation of service contracts.
The point is, don’t get too hung up on the PIP. A holistic approach is far more effective.
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Let’s be clear.
There’s nothing passive about building a portfolio of direct real estate investments using private placements. It takes a lot of time and energy to screen sponsors and track to the right asset mix.
You spend time vetting investment opportunities, sponsors, and just sorting through the noise of daily deal flow. Add a full-time job as a working professional, and it’s a wonder how anyone manages to get these things done.
My general business development framework revolves around three sources for opportunities – direct, intermediary, and centers of influence. This applies to anyone involved in real estate.
As the name implies, a direct opportunity that comes straight from the source. Deal sponsors are the direct contacts for passive hotel investments.
Intermediaries are people that match capital with opportunities. They receive compensation for making the introduction, which could take the form of a one-time transactional fee. I also include registered investment advisors (RIAs) that don’t have full discretion in this mix.
Finally, centers of influence are those people that introduce you to opportunities sporadically and don’t receive compensation for the introduction. These are usually influential third-parties, like attorneys, accountants, friends, family, etc. They want what’s best for you, and in their opinion, the opportunity on offer fits that description.
The world of private placement investments is opaque and inefficient, which translates to, “it’s really hard to find good deals.”
Most sponsors start with the intention to build a database of hundreds of investors. Along the way, they land a whale that agrees to fund all their deals. After that, you’re not likely to see many of their opportunities.
Smart networking is essential.
Build a database that categorizes each person according to one of the three designations above. Reach out to each person at least once per quarter to check in.
You’ll want to tap them often in the beginning and back off after that. The goal is to build name recognition right from the start, and then maintain the relationship over time.
Define Your Investment Criteria and Manage Leads
Finding opportunities is only the first step, and it may be the easiest. The hard part begins when you have to make an investment decision.
Real estate investing is a numbers game.
You kiss a lot of frogs before you find your prince.
Organization and systemization are the keys to managing this effectively, whether you’re a deal sponsor or passive investor. Your ability to load up and clear your desk faster than anyone will set you apart from the competition.
A clear investment criterion is the first step in this process. Define your investment box by considering the following.
- Asset type
- Execution strategy
- Risk-and-return profile
All of these have sub-categories, sub-sub-categories, etc. that allow you to quickly discard opportunities that don’t fit as soon as they hit your inbox. Building that discipline is a different issue entirely, as every investor easily falls victim to shiny-object-syndrome.
Assuming you find and evaluate a bunch of interesting opportunities, the next step is to keep track of them.
Many passive hotel investment opportunities track closely to a brokered acquisition marketing process and standard contract terms. Therefore, sponsors will have a similar structure for when they release information and collect investments.
An Excel or Google Sheets file is a good place to start for tracking these opportunities.
At a minimum, you should track the name, location, source, contact information, critical dates, and relevant notes. Beyond that, many investors also like to keep tabs on the projected returns and valuation.
Review your pipeline weekly to ensure you don’t miss an offer date.
I mentioned the importance of smart networking above, and I can’t emphasize this enough.
Most people – investors, sponsors, brokers, anyone else – make an introduction and leave the rest to chance. Follow-up is confined to a desperate email whenever there’s the “oh sh*t my pipeline is about to run dry” moment.
Don’t let that be you.
There’s an old marketing principle called the Rule of Seven, where a prospect needs to encounter your brand seven times before she buys. In today’s noisy, crowded world, many experts believe that is now the rule of 14 or 21.
Regardless of the magnitude, the principle holds that you need more than an introductory phone call to stay relevant.
People do business with people, especially those they know, like, and trust. This is most important when entering a marriage in the form of an equity partnership.
Reading this, you may be thinking that this sounds like a lot of work.
It can be a lot of work, or you can create systems to do the work for you.
A basic digital marketing funnel has two phases – introduction and relationship maintenance. The introduction phase presents the prospect with relevant information that helps them get to know you. The relationship maintenance phase comes in the form of periodic messages to stay relevant.
You can set up a complex automated solution, or simply prepare a series of emails to send manually. Below are five to get you started. I encourage you to expand and modify this list to fit your strategy and voice.
- Introduction – request a phone call
- Thank you – follow-up from phone call with brief recap on your strategy
- ICYMI – in case you missed it – resource they might find useful
- Just invested – deal you recently put money into
- What’s new – quick check-in on their progress
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Deal sponsors are the operating partner (aka general partner or GP). They manage the investment’s day-to-day operation, aside from certain major decision rights that a money partner may have. Consequently, you should be comfortable with the way they work.
Private placements give you more operational influence than you would find in public securities. They allow you to interact one-on-one and build a relationship with the management team.
This access lets you directly ask questions and request information regarding the sponsor and the opportunity.
First and foremost, past performance is not an indication of future performance.
Still, a sponsor’s track record is a good indicator of what you can expect in the next deal.
Investment returns are good to review, but the real value lies beyond the numbers. Each deal has a story that will tell you more about how the sponsor operates than just the numbers.
Each deal in a sponsor’s track record has three broad areas that you should understand – sourcing, execution, and return of capital.
A sponsor’s deal sources will give you an indication of the types of opportunities to expect. You’ll see whether she pursues off-market or marketed opportunities. There may even be a trend in buying either distressed or performing assets.
On the operational side, ask questions related to how the sponsor mitigated risk and overcame adversity. Every deal eventually comes off the rails of a well-conceived business plan. The best sponsors pivot proactively rather than waiting for the problem to escalate.
Finally, return of capital comes in the form of distributions from operational cash flow and capital events. The capital events reflect a return from value appreciation.
Distribution frequency and amount are good to know for past deals, but it may be more beneficial to understand how a sponsor approaches refinance and sale.
A sponsor that keeps her finger on the pulse of the market will be proactive. She will aggressively seek opportunities to pivot a business plan and/or recycle capital. Track record presented along with thorough case studies will give you an idea about whether your strategy aligns with the sponsor.
Platform & Team
Companies don’t execute business plans, people do.
A company is a collection of people striving for a common vision and mission. They unite behind a shared set of values that drives the daily task list.
Sponsor teams do not have to be big. In fact, there’s a benefit to aligning behind a small, nimble team that can work efficiently to address the needs of the investment. However, you should learn what the sponsor performs in-house as opposed to outsourced.
Hotel investments have three major stakeholders – owner, operator, and brand. Sponsors may combine these in a variety of ways. For example, brand-operator, owner-operator, and so on.
Similarly, a sponsor may perform a variety of other services in-house, like construction management, procurement, financing, legal, etc. The asset management fee may include these services or it could be billed to the investment separately depending on how they’re structured.
Team experience is also critical to evaluate.
Like the track record, a deeper knowledge of successes and failures gives you a clear view on how each opportunity benefits from the team behind the deal.
It’s too easy to just give a number of years’ experience and pedigree. This may serve as a good proxy for the executives’ capabilities, but it doesn’t tell the story of how they overcame adversity to create a great result.
You don’t have to formally interview the sponsor, but spend some time getting to know the key people involved in managing the deal. You’ll quickly get a sense of alignment within the team and with your investment objectives.
Again, if something just doesn’t jive, walk away from the opportunity. No harm, no foul.
After you sign the subscription agreement and wire your money, the deal sponsor owes you nothing more than a check every time there’s a distribution and a K-1 every year.
Of course, that would be the worst-case scenario.
Great deal sponsors are transparent and proactive. They communicate the good with the bad in a way that delivers a clear picture of the investment with a reasonable view of the future.
Frequency of reporting may be monthly, quarterly, or semi-annually depending on the intensity of the operation. Many hotel sponsors report quarterly results with a month or two lag. These reports include a financial snapshot along with progress on any major projects.
The reporting lag is related to timing of internal and external inputs. Hotels commonly close the books for the prior month somewhere between the 15th to the 20th. Additionally, competitive set tracking data from STR comes out on or around the 17th of the following month.
As a passive investor, you can’t do too much with the data on a monthly basis beyond questioning what happened and what was the response. That said, you should expect to be informed – and sometimes even consulted – for major events and decisions.
Obviously, nobody has a crystal ball, but you invested with this team for their expertise. You expect to get a bit of their thought leadership from time to time.
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Everything leading to this point was preparing you to make an investment.
A user-friendly sponsor will prepare you well for this offering stage by providing ample diligence material on them and their investment strategy. Front-loading this evaluation will give you a leg up when it’s time to decide on the opportunity in hand.
Private placements move quickly, especially for high-quality deals and sponsors. Therefore, you may miss out on the first one or two as you get comfortable with the sponsor’s offering process.
Active sponsors will present many more. Just make a point to stay in touch and relevant.
Demand and Supply Dynamics
A great business plan starts with revenue.
Revenue is the lifeblood of every business. Demand and supply are the two market factors that influence how much revenue you can capture.
As mentioned, this is a street-corner business. Hotels rely more on specific placement within a submarket than most real estate. Your proximity to demand drivers can dramatically impact your ability to drive occupancy and rates.
For example, a hotel located on the beach side of Collins Avenue in Miami Beach can have a $150 rate premium over a similar room located directly across the street. Aside from specific amenities, the guest is paying for premium placement and accessibility.
With that in mind, let’s talk demand.
Hotels are rarely a destination by themselves. They draw demand from attractions in the market. These may be corporations, convention centers, theme parks, or even major construction projects. Depending on the type of hotel, it could even accept demand for social banquets, like weddings and bar mitzvahs.
Aggregate occupancy in a market provided a STR Trend or Destination report makes demand easy to measure. However, this is inherently misleading because it only shows historical demand.
An aggregate level of historical demand is also misleading because it doesn’t provide insights into what product type is performing best in the market. Still, it’s a good indicator of what demand available in the market.
Supply is a similar story.
Building a hotel is like a quarterback throwing a long pass. He must know the route of his intended receiver along with good timing and strength to get the ball where it belongs and when. Similarly, real estate developers need to understand where a market is heading and place the right product in the right location.
Existing supply reflects historical demand in that market, as a result.
Market dynamics work through supply and demand on two trend patterns – cyclical and secular.
Cyclical trends are those that we all know and love in the form of a business cycle. In this case, we have macroeconomic factors that drive economic activity upward and economic shocks that pull it back down. These are the cycles where investors look to time a buy at the bottom and a sale at the top.
Business cycles are difficult to predict, and most often, you miss the opportunity if you are purely speculative.
Secular trends are more interesting. These are major demand movements inspired by demographic, technological, and social changes. They are the undercurrents that keep moving even while a market cycles up and down.
Both trends are important to consider, but they are each more important at different points in the business cycle.
Get a sense of new demand entering the market in all asset types. Seek to understand what is driving their migration. Business climate, weather, and generational shifts are good places to start. Some markets may even benefit from the introduction of a major demand driver, like a convention center, that fundamentally changes who is visiting.
A market with good fundamentals and a strong secular direction will weather well through business cycles. Still, a focus on basis and cash flow are essential to ensure consistent performance and sustainable capital structure in downcycles.
We define property improvements as defensive or accretive.
Defensive improvements are capital investments required to maintain the hotel’s position within the market and brand system. They aim to liven up the asset and improve guest satisfaction scores.
A defensive investment has some return, but mostly, you’re making the improvements to stay relevant.
Accretive improvements are those that fundamentally alter the revenue potential of a property. These improvements often go beyond the brand-mandated PIP, such as repositioning non-revenue space. However, it could also be within the PIP scope, as in the case of a tub-to-shower conversion.
Significant renovation can positively impact the property’s market position, but it also comes with considerable risk.
The scientific method is my favorite mental model for evaluating a risky business plan. Think back to high school science, where you learned about forming and testing a hypothesis.
Good business plans are basically experiment designs.
A sponsor proposes a hypothesis that if we make certain improvements, then we’ll see a better result. The supporting data and research get you comfortable with the likelihood of reaching the proposed result.
The deal sponsor should be an expert in this type of renovation, which is why she believes in the opportunity. Your investment is a validation of that plan. Therefore, you may have the influence to suggest changes that improve the business plan for all investors involved.
First, understand the market dynamics to determine if the improvements make sense. This will give you the perspective to determine whether adding those investment dollars to your all-in basis is worthwhile.
Every hotel operation starts with revenue. A good plan for getting heads in beds is fundamental before you even start worrying about operational matters, like productivity.
It’s easy to lose yourself in the numbers when we talk about revenue.
Remember, each room night reflects a live human staying in your hotel for a specific reason. We’re interested in understanding those reasons, finding the 20% that bring 80% of profits, and iterating to increasingly more lucrative bookings.
Sustainable hotel revenue strategies focus on building solid base business.
This may come from group sales, airline and training contracts, or consistent corporate demand. Regardless, you’ll want to know who books and when. That intelligence empowers you to charge more for the supply that remains closer to the date in question.
For example, consider a peak period two weeks out in a situation where we booked 80% of the hotel three months in advance. This is a great position to be in, especially if your competitors are in a similar situation.
Your objective is to reach break-even revenue with as little occupancy as possible so that every incremental reservation is pure profit. This is the revenue management team’s game.
All physical and operational improvements should answer that question. Namely, “how do we plan to build that base and attract the transient demand that will fill in the difference to 100%?”
Operational strategy comes after revenue.
You want to get a good sense from the sponsor about her plans to lean out operations.
Expense reduction is a fine balance, as you must consider its impact on guest and employee satisfaction. Contract renegotiation is often the low-hanging fruit, especially for acquisitions off a long hold period. You may even find ROI on the planned capital improvements.
Every execution is different by sponsor and property. A broad generalization about expense improvements is difficult, as a result. Scrutinize the business plan to be sure reasonable assumptions form the basis for the sponsor’s hypothesis.
I hope this guide provided some perspective on how to build your passive hotel investment platform. It is not comprehensive by any means, but we covered some major ground. Here’s wishing you all the best on your quest for more exposure to passive hotel investments!
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