Big Four CRE investors pivot to hotel investments for many reasons. Higher cap. rates lead the initial attraction. However, other reasons start to dominate once they get to know the asset class.
Jumping into a new asset class is always challenging. Hotels add a few layers of complexity that are worth understanding before going too deep.
This guide will bring you through a series of the high-level considerations.
How Hotels are Different than Big Four CRE | The Absolute Basics to Establish Your Strategy and Team | How to Pivot Your Pipeline to Hotel Investments | The Best Sponsors Start with a Sound Business Plan | Getting to Know USALI
Hotel investments are an operating business with a real estate component. This may be the biggest differentiator from the Big Four CRE assets that focus more on asset management than operations.
Hotels also have voracious appetites for ongoing capital improvements, as a result.
Alignment with a strong operational team and a sound business plan mitigate many of the associated risks. Still, anyone venturing into this world should prepare wisely and always stand ready to capture and implement good advice.
Hotels measure their inventory by available room nights. A simple estimate for total available room nights in a year is equal to the number of rooms times the number of days open. For example, a 100-room hotel typically has 36,500 total available room nights in a normal year.
Consequently, occupancy is a measure of… wait for it… occupied divided by available room nights.
Rooms sales adjust seasonally based on the demand profile in the market. Nevertheless, strategies for selling out the inventory apply year-round. Your approach only changes based on which business segments are trending for that booking window.
Business segments follow different patterns throughout the year. Group travel has a longer booking window than transient guests, while contract business is reliable throughout the year. A sound revenue strategy accounts for each of these according to their individual needs and desires.
Contract and group business form the base. This reliable revenue gets booked weeks and months in advance. Rates may not shock and awe, but they allow the revenue manager to shrink the available inventory to raise prices.
Supply and demand dynamics take effect as the booking window closes.
A hotel that covers its overhead weeks in advance has greater flexibility to refuse a low rate than one without solid base revenue. This compression drives rates up at the hotel, and market rates adjust similarly when all hotels are well-booked.
Your revenue manager will target channels that bring the guests that you need when and how you need them.
Brands, online travel agents, and direct sales comprise the largest revenue contribution. Distribution among the various channels will flex throughout the year to get the optimal business mix.
Operational and Contract Positioning
An operating hotel relies on a diverse set of vendors for its daily operation and maintenance. In many cases, they provide goods and services under long-term agreements that adjust slowly compared to the revenue cycle. As a result, they are prime candidates for repositioning with an intensive asset management approach.
Brand and management contracts and big-ticket leases are the low-hanging fruit.
Contract terms are open to negotiation at various stages throughout the investment lifecycle. However, an acquisition presents your strongest position, as you have the urgency of a sale and a seller that could play another negotiating angle if cooperative.
Seek to gain alignment with your vendors early in the relationship.
Too often, sponsors focus only on reducing cost and lose sight of other aspects in the deal. I always revert to the old engineering principle that allows you trade between cost, quality, and timing. Accordingly, cost may not be your most important driver in positioning the hotel for optimal profitability.
A holistic approach considers the strengths and weaknesses of your internal and external stakeholders.
For example, you may find that two vendors with complementary capabilities could be more expensive. Yet, you may be able to justify the cost with greater incremental revenue opportunities if they provide higher quality or implementation speed.
These principles apply to every aspect of the business plan from capital structure to operations and beyond. Therefore, regular and comprehensive asset management reviews should highlight areas to enhance revenue along with potential savings. Don’t lose yourself in cost cutting without considering that revenue drives this business.
Hotel Investments are All Core Plus or Riskier
Every experienced real estate investor understands risk-adjusted return.
Your risk level for hotel investments is very high at best when you first get the idea to pivot to hotel investments. Risk comes down as you gain education and start building out the infrastructure. However, the investment never really drops to a true core investment.
As previously mentioned, hotels are operational- and capital-intensive assets. They always come with a brand mandated property improvement plan (PIP) and operational enhancement opportunities upon change of ownership.
I can count on one hand the number of core investment opportunities I underwrote in the past decade.
Strong hotel investment sponsors reduce risk by aligning with a strong team and implementing strategies that hedge against the most common threats. Risks come in many forms throughout the investment lifecycle, and usually, experience is your best guide.
Execution of any construction or renovation project tops the list for most. This risk arises from two areas – minimizing guest disruption and actual completion. Ongoing operational risk follows closely and remains throughout your investment period.
All the traditional risk factors that plague other CRE investments still apply to hotels. These may include loan maturity, sale liquidity, and a variety of macroeconomic risks. A proven strategy and solid team are the first lines of defense to mitigate the various investment risks.
Successful investments in any real estate asset class starts with a sound strategy implemented by a strong team. These combine to be your north star as you pivot to hotel investments.
Attention to the finer details of your investment strategy will pay dividends when building up your team. Further, each stakeholder can be loads more productive when they clearly know how to act in any situation.
Essential Points of a Good Hotel Investment Strategy
This is a street corner business.
Start with greater macro trends that you already know from your Big Four CRE investments. Secular trends, like population growth and employment, will guide you to markets that may make sense for a hotel investment.
Next, get to know the demand drivers in each market.
Proximity to major demand drivers can generate significant revenue, and consequently, value. This finer targeting will help quickly eliminate opportunities that come across your desk.
Your prospective guests’ needs and desires will be revealed as part of a general picture of demand in a market.
For example, a geographic focus that comprises mostly leisure travel would benefit from a resort strategy. However, a business transient profile may be more tuned to full or select service hotels.
Chain scale and service level combine as the second consideration after geography. These are like looking at the building class, but they are more aligned with revenue production than objective quality.
Smith Travel Research slots brands into a peer group based on global average daily rates every year to determine where they sit in the chain scales.
That knowledge allows you to further narrow down your focus to particular brands.
Location, service level, chain scale, and brand form the foundation of a sound hotel investment strategy. Finally, consider your risk appetite.
We briefly covered hotel investment risks in the previous section. Now, it’s time to determine what risks you want to play on.
Light value-add may be a good entry point for most. This could include a simple brand-mandated PIP comprised of paint, carpet, and FF&E. Most operators can manage that execution internally. More intensive value-add strategies require an expanded team that may include a general contractor to manage the work.
Identify Your Major Stakeholders
Hotel investments bring together three major stakeholders – brand, operator, and owner. Industry players combine these in a variety of combinations. The most common are brand-operator and owner-operator, where the respective third is a separate entity.
Brands form the sales and marketing arm of your team. They provide distribution through centralized sales, an online booking engine, loyalty programs, and much more. Additionally, they provide support for the front- and back-of-house in the form of systems and processes for effective execution.
Operators perform the daily tasks of keeping the hotel optimally occupied and maintained. A management company hires and manages employees, and the mothership provides additional systems and processes to enhance the execution.
Finally, the owner is responsible for overall asset management and strategy. She brings all stakeholders together and approves major decisions at the property level, such as annual operating budget and major capital expenditures.
Each of these stakeholders relies on a variety of additional contributors depending on their internal capabilities.
Larger real estate investment groups may have internal legal or construction management personnel, for example. Still, a good understanding of their experience executing your strategy is critical to fill in any gaps with third parties.
I like to approach team formation with a SWOT analysis that reveals the most pressing needs.
- Strengths – internal attributes with a potentially positive impact
- Weaknesses – internal attributes with a potentially negative impact
- Opportunities – external attributes with a potentially positive impact
- Threats – external attributes with a potentially negative impact
This information gives you a clear picture of areas to exploit and enhance the positive and provide support or mitigation for the negative impacts.
Internal and External Contributor Alignment
Management companies earn 3% of gross operating revenue, and brands take as much as 15% for all their fees. The temptation to recapture these fees is real and extremely enticing. Resist that urge.
Pivoting to hotel investments is challenging enough. Establishing an operating and brand platform at the same time just compounds that stress.
A better approach is to build alignment with your internal and external stakeholders.
Investment partners and employees respond well to incentives. The same is true for your vendors. Accordingly, you can usually structure mutually beneficial contracts by offering incentives to achieve the results you seek.
For example, a management company is responsible for bringing enough revenue to cover operating expenses. Simultaneously, they should operate the hotel efficiently to ensure you bring as much of that revenue to the bottom line as possible. A financial bonus for passing a profitability threshold could motivate the hotel leadership to focus on top- and bottom-line performance.
You must rely on intensive asset management, to be sure. However, this is a lot like giving your key employees a piece of the sponsor promote.
Incentive fees also help with retention and engagement. Those two factors combine with other areas of your culture to establish a loyal and productive working ecosystem.
Pay for Experience
We all want to achieve our five-year vision by next week. That’s the nature of the human experience, and it’s compounded by the instant gratification culture we created in the past few decades.
That said, you can realize a tremendous amount of value – tangible and intangible – by aligning with experienced partners. It can have a high opportunity cost in the short run, but it’s well worth it in the long run.
Asset-based lenders will be happy to make a loan to an inexperienced hotel sponsor with a high coupon because they know the intrinsic value of the asset. An astute asset manager can replace you in the event of default and continue along until maturity. That’s an expensive proposition.
The alternative is to bring on a partner for your first few deals.
You will probably split the promote in an initially unfavorable division. However, that will adjust as you bring in more business and prove your value. Along the way, you will get better financing terms with an experienced co-sponsor, and you’ll pick up loads of best practices.
Credibility will also help you build your pipeline.
Deal sources that know you aligned with an experienced team will have confidence to show you the opportunities that you may not see by yourself. Leverage their track record to make yourself look bigger than you are.
Of course, co-sponsorship is not essential when you make the pivot to hotel investments. However, it has perks that make it a worthwhile consideration.
A robust pipeline is the best way to get the attention you seek in all areas of your business.
As any business developer knows, your biggest challenge will be keeping it full once you land the first deal.
Real estate investing is a lot like panning for gold. You fill the pan with everything and shake it around until you’re left with only the sparkly stuff. The winners in CRE are those that can quickly and efficiently fill and clear their inbox.
You know this from your Big Four CRE experience. Hopefully, you’ll pick up something here that will complement what you know and prepare your hotel pipeline.
Active Hotel Deal Sources
All business development relies on three deal sources – direct, intermediaries, and centers of influence.
Direct sources are those that control the inventory. They are the existing property owners and financial partners in a deal.
Intermediaries don’t own the asset, but the owner empowers them with information and incentivizes them with a fee to sell their asset. The most effective process gives the intermediary an exclusive right to market and sell the property. However, you may find non-exclusive sources to be beneficial, as well.
Finally, centers of influence are those people that can introduce you to an opportunity, and they don’t expect direct compensation in return. These are attorneys, architects, and others in the trade that are interested in building a relationship of trust and mutual benefit.
A consistent pipeline relies on maintaining strong, value-oriented relationships with these players.
Too often we think in transactional terms – give and take. Unfortunately, this limited perspective only opens you to what each of you can gain from a one-to-one relationship.
Relationships based on giving value are more likely to yield opportunities.
You open yourself up to a greater universe of receiving when you understand and fill the needs of each person in your network. This is because your contacts perceive you as a central actor within their own opportunity pipeline.
Start by considering what you have that is low value for you but potentially high value for someone else. This may be property-level operating intelligence for a broker, for example. That is ammunition to help inform her conversations and maybe even win a deal.
Track and Manage Leads
A reliable pipeline results from decent follow-up. However, great follow-up enhances your pipeline exponentially.
Great follow-up starts with tracking and managing leads effectively.
You want your pipeline to be informative, organized, efficient, and clear. Its value drops rapidly when you find yourself scrambling to get what you need in a pinch.
Pipeline tracking tools vary from simple Excel worksheets to complex, Salesforce-based systems and everywhere in between. I use a Google Sheets document that is sharable among my team. You can also consider the pipeline tracking tool that I built in Excel.
Regardless of how you track the pipeline, you must build a system around how you fill and manage it.
Lots of activities must come together before you get to an offer on a deal. In fact, even before you get to underwriting, you need to receive the lead, sign a confidentiality agreement, download the data, fill in your underwriting template, and then understand where and how you can extract value.
These processes are time consuming and monotonous, which is why most pipelines move in waves. A high level of attention produces some opportunities, then you get bogged down in reviewing them. Along the way, you may close on one, but 15 great leads pass you by while that one consumes you.
Build a system that lets you take a weekly snapshot of each lead and the next step to move it forward.
Friday and Monday reviews work best because those days tend to be more focused on planning and review. Understand where the opportunity lies and engage the lead source if needed. Like any effective meeting, a clear objective must drive your activity and accountability in your follow-up is essential.
Focus to Enhance Production
Owners hire brokers for two important reasons:
- Brokers have the time and network to shop your property to the widest audience
- Brokers know the most effective tactics to get a buyer’s attention
We’re all vulnerable to “shiny object syndrome.”
Anything that looks like it could be an interesting opportunity jumps onto the gameboard and sits there until someone does something with it. This is especially seductive when the pipeline is drying up. We just want to see SOMETHING on there.
Resist the urge to go after leads that don’t fit your investment strategy.
You built a strategy and team around a clear view of the market and your ability to extract value from deals that fit. Further, every lead you chase builds your brand in that direction.
A pipeline review is not the time to be figuring out if you can adjust your strategy or team to go after an opportunistic lead. That is a good mental exercise for another time.
You and your team benefit greatly from a laser focus on the vision and strategy.
The team that can clear off the garbage faster than anyone else is the winner. This takes discipline, but the rewards are incredible.
All deal sources, especially brokers, appreciate a “quick no” over a “long maybe” every day of the week. You build credibility around your strategy and save them wasted time.
Internal rewards are even more pronounced.
It’s difficult to find a lead. Hundreds of calls may turn up very few results. Therefore, any level of interest in an opportunity is a huge dopamine rush for the person that found it. However, that rush quickly turns to animosity when you go down the road and realize that you could have terminated the lead at stage one.
Just food for thought.
Business plans are a pain to write. I don’t know many people who actually enjoy this part of making the deal. Still, it’s a critical step in formalizing the objective and aligning your team.
A solid business plan is a living document that you can spin off in many directions.
It forms the base for your marketing materials when financing the deal. You can pull out sections on revenue and expense strategy for the operations team to understand your objective. And it helps your asset management team to track exactly where you expect to be at any point in time.
I’m a huge fan of a modular business plan, but you need a solid concept before you can get your hands dirty.
Revenue First… Always
Revenue drives all business.
That’s a fact. And, in my hotel investments, it’s gospel.
We talked earlier about the complexities of putting “heads in beds,” and what that means for your investment strategy. You’ll notice that I didn’t elaborate too much on expense management. We’ll get to that in a minute. Still, I can’t move on without overemphasizing the importance of your revenue strategy to the point of annoyance.
Every hotel has a room and amenity mix that defines it from the competition. In most cases, that mix was determined when the original developer built the hotel. In many cases, it’s still relevant. This is where strategy comes in.
You beat the competition when you can effectively match the hotel configuration with the needs and desires of your prospective guest.
For example, a hotel in a family-oriented market, like Orlando or Anaheim, may perform better with an abundance of double-occupancy rooms. However, a business transient guest prefers more single-occupancy rooms.
The same goes for public space and meeting amenities.
Hotel investors unlock value by looking outside the mainstream. They take risks based on a growing knowledge of how to align with the most optimal guest for that hotel.
Your approach can be based on service or physical improvements. Regardless of how you get there, a creative strategy on business mix optimization will lead you to the promised land.
Identify and Neutralize Seasonality
Seasonality is the biggest adjustment many have in making the pivot to hotel investments.
No doubt, your Big Four CRE tenants deal with seasonality in their business or employment. Those seasons could impact percentage rent or leasing velocity. However, your seasonal exposure is likely minimal.
Hotel seasonality is market specific.
The business seasons follow weather seasons in many cases. However, they also closely follow social and business seasons, like school and federal holidays. These are the drivers behind major events that fill your rooms.
Follow these three steps to identify and neutralize seasonality in your business plan.
- Look for multi-year trends
- Connect demand spikes to events in the market
- Use a monthly financial model to capture cash flow challenges
One year of STAR data is not enough to get a good idea of when and how a market fluctuates. Major one-time events, like a sports championship or a traveling convention, can give false hope for revenue growth in the market.
At least three years of data are essential for a good sense of the ebb and flow.
Demand spikes appear in the STAR data as outliers in percent change for the month. A simple search for what happened that month in that year will reveal whether it’s something you can rely on going forward.
You don’t want to find out from your partners or lenders that you missed the Superbowl bump in your underwriting.
A simple annual cash flow model is fine for an initial feasibility review. However, a solid model of how revenue seasonality impacts month-to-month cash flows is most effective when you get serious about an opportunity.
A monthly model helps you understand how much to keep in operating reserves and how equity distributions may fluctuate from quarter-to-quarter.
Many Forms of Cost Containment
A standard hotel profit and loss summary statement has four lines for operating revenue and 14 expense lines and one non-operating income line.
Each expense line has fixed and variable components. Variability decreases as you move down from departmental expenses through undistributed expenses to fixed expenses.
You are a price taker in some cases.
For example, unskilled labor makes up a big portion of your expense load. Long-term stability depends on you meeting the market wages, even though you may have some flexibility in benefits. The same goes for most commodity products and services in the operation.
That said, you can influence chunky pieces in your expense management with the right approach.
Creativity and flexibility are essential for an optimal asset management strategy. A holistic view of whether and how your team is maximizing each vendor and playing them off each other will yield the greatest outcomes.
From a financial modeling perspective, it’s easy to chop $50,000 here and $10,000 there. However, an astute investor or lender will expect a comprehensive strategy for that kind of wholesale cut.
Of course, wholesale cuts can dominate a first-pass desktop review. Spend the time refining and defending that pro forma in the due diligence stage, once you control the deal.
I’m a big fan of zero-based budgeting, where you build your expenses up from zero with a one-by-one review of each expense line. This takes a lot more work, but it provides a clear picture on what’s working and what you can replace or eliminate.
Take a Position and Own It
Nobody wants to be wrong.
It’s a bad feeling to go to an investor or lender, present your opportunity, and they find every hole you missed.
You have two choices in this position – own it and make the necessary improvements or move on from the opportunity.
If you’ve come this far, you’re probably a successful investor with plenty of experience with this scenario. You know that resilience is a pre-requisite for getting deals done. Still, it’s demoralizing when you’re working hard to pivot to hotel investments, and you’re called out as an imposter.
I use a two-pronged approach when marketing a deal.
I start with a list of conservative banks and investors. They see my track record, so they want to spend time looking at opportunities, but they are not likely to pull the trigger. This is my external investment committee – my circuit breaker to make sure I’m putting my best foot forward for everyone else.
My most likely financiers come next – after I incorporated or reasonably rejected comments from the first round.
You must own your strategy and assumptions regardless of how you define and then refine your business plan.
That level of fortitude is essential for building alignment among your stakeholders – internal and external. Note, it also means taking ownership of when you got it wrong and adjusting accordingly.
The Hotel Association of New York City published the first version of what has become the Uniform System of Accounts for the Lodging Industry (USALI) in 1926. It evolved over the years and, today, forms the basis for most accounting systems at institutional-grade hotel operations.
HFTP and AHLA released USALI 11th Edition in 2014, which is available for purchase at the HFTP website for about $90. It is well worth the investment.
Standard operating statements make financial analysis much more efficient and logical.
You’ll discover this as you get cash flow statements printed from QuickBooks that don’t break out labor between departments, for example. These make it difficult to find where there may be room for improvement.
Four Operating Revenue Categories
The standard summary operating statement breaks operating revenue into four broad categories.
- Food and Beverage
- Other Operated Departments
- Miscellaneous Income
Room revenue includes all segments of revenue – transient, group, and contract – along with income related to rooms sold. The related revenue may include cancelation fees and attrition revenue, which is a fee paid for not filling all the rooms in your group block.
Food and beverage revenue contains all income from outlets, like restaurants and bars. It also covers revenue associated with banquets and catering, including equipment rental and service fees.
Revenue from other operated departments comes from amenities that a hotel operates directly and usually has a related expense. These may include a gift/sundry shop, golf course, or parking, for example.
Miscellaneous income is revenue that comes from leases and services rendered by third-parties or fees that do not have directly associated expenses. Common lease and service examples include cell phone antennas, ATMs, vending machines, and timeshare desks. Resort fees are the most common large fees that appear in this line.
The first two categories have very clear rules about what goes where. However, the latter two allow a bit more flexibility.
As an example, a parking agreement with a third party may appear with revenue in other operated departments and an associated expense. However, depending on the contract, it could instead appear as net revenue to the hotel under miscellaneous income.
Your categorization here is important because there are expenses down the P&L directly tied to total operating revenue, like management fees and capex reserves at 3% and 4%, respectively.
Three Major Expense Clusters
Expenses come in three flavors, and their variability declines as you go down the P&L.
- Departmental Expenses
- Undistributed Operating Expenses
- Non-operating Income and Expenses
Departmental expenses are exactly as the name suggests – costs directly tied to operating the associated departments. Here, you have a corresponding line for each of the revenue lines, except miscellaneous income.
Think of departmental expenses in terms of, “if we eliminated the department, we could eliminate 100% of these related costs.”
Undistributed operating expenses, on the other hand, are your overhead costs. These are the costs associated with keeping the operation going regardless of where and how the revenue comes in.
These expenses include utilities and maintenance, but they also have a softer side in general management, accounting, human resources, and marketing. These are direct costs associated with operating the hotel over which the property management company has complete control.
USALI 11th Edition places property management fees below and outside undistributed expenses. These may include an incentive management fee, which is usually tied to surpassing a gross operating profit (GOP) hurdle.
Finally, non-operating income and expenses includes those fixed costs that you would incur whether you had an operating hotel or not. Property and other taxes plus insurance make up the bulk of this expenses cluster. While these may fluctuate based on the operation, they’re generally out of the control of the property management company and negotiated by ownership.
EBITDA – earnings before interest, taxes, depreciation, and amortization – is the result of total operating revenue minus all these expenses. However, the replacement reserve is your last expense before you get to net operating income (NOI).
Industry standard replacement reserve is 4%, but it is ultimately determined by your brand license agreement and/or loan agreement.
Rules of Thumb Based on Descriptive Statistics
The standard summary operating statement includes a variety of descriptive statistics. Many investors expand on these in their analysis to get a better picture of past and pro forma operations.
Standard descriptive statistics include:
- 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 statistics include:
- % 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 statistics, whether at the top of the operating statement or within, offer a normalized perspective on performance. For example, it’s much easier to compare year-over-year performance with a percentage or per occupied room dollar amount as opposed to nominal dollar amount.
I often tell anyone planning to pivot into hotel investments to underwrite everything that comes across your desk. This exposure is the best way to get a solid understanding of the financial impact of different operating models.
You will discover profit margin differences among different property types and other rules of thumb along the way. These will give you a faster read on anything that fits a similar profile down the line.
More advanced underwriting may include flow-through analysis, which shows you how effective the operator is at bringing incremental revenue to the bottom line. However, I think it’s best to get your bearings on the basics before jumping into this territory.