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Thu 7 Aug 2008 04:00 AM

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Hotel investment: A mixed bag

TRI Hospitality Consulting operations manager John Podaras considers the monetary implications of investing in hotels and weighs up the financial pros and cons of making such an investment.

TRI Hospitality Consulting operations manager John Podaras considers the monetary implications of investing in hotels and weighs up the financial pros and cons of making such an investment.

How can developers continue to finance hotel developments in the light of continuing spiralling construction costs and increasing development risks due to shortage of materials and resources?

Despite the well-documented growth in hotel performance over the past five years across the region, development costs have been rising at a much faster rate.

Although hotel developments still make a great deal of operational sense, the return on investment is adversely impacted and developers are facing the challenge of being able to convince financing institutions of their projects' ability to service loans.

Developers [must] convince institutions of their projects’ ability to service their loans.

Looking at financial feasibility studies carried out by TRI five years ago, typical loan tenure was five to seven years with project payback periods within five years of start of operations.

With development costs cresting AED 15,000 (US $4083) per square metre at present, many five-star hotel projects require creative financial planning, despite stretching loan tenure to ten years including two to three year's repayment moratorium.

Clearly the amount of debt leverage is a significant factor, and developers may wish to consider extending equity participation to joint venture partners - although this may not fit in with their portfolio strategy.

Another option would be to consider a more balanced portfolio as represented by a mixed-use development that is able to provide a healthy mix of long-term and short-term cash flows. To illustrate the benefits, we have compared a hypothetical development comprising a 160 room five-star hotel and 60 apartments.

The table below illustrates two scenarios: firstly considering the operation of the apartments as part of the asset, operated as a serviced apartment unit; secondly where the hotel is retained and operated, but the apartments are sold off on a freehold basis.

Both scenarios assume a debt to equity split of 70:30 and the simplistic assumption that the off-plan sales proceed from the freehold apartment will be used to pay down the loan. In reality, the project may be subject to capital retention rules or the equity investors requiring dividend share of the proceeds.

Development costs are slightly lower in the case of the freehold apartments as it is assumed that they are sold without the furniture, fittings and equipment that a typical serviced apartment facility would require; however, the major difference is the reduction in the loan and consequently the interest rate burden.

In fact, in our scenario, the amount of debt in the freehold sales scenario is 69% of the fully-owned case resulting in a 30% cut in the interest rate burden over the life of the loan.

The graph overleaf illustrates our projected investment cash flows and the free cash flows after debt service for each of the pre-opening and first 10 years of operation.As has been already explained, the level of total investment for the second scenario is reduced, while the free cash flow at the end of each operational year is increased due to the reduced interest burden. The dip in free cash flow in year two is due to the first loan repayment kicking in, after the expiration of the repayment moratorium.

After nine years of operation however, when the loan is substantially paid off, Scenario 1, which is augmented by the serviced apartment revenues, does feature a higher level of free cash flow.

The components of a large-scale mixed use development - such as retail, office, residential, hotel - all contribute to the demand and operational synergies of the project as a whole helping to create the critical mass of a successful destination project.

The inclusion of a hotel component brings with it the opportunity of introducing a high profile international operator with brand equity that can be leveraged to add a premium to the freehold component of the development.

Developments featuring premium brands claim to have benefitted from price premiums of as high as 40%, although in this highly speculative market, there are doubtless other factors at work.

The possible alternatives of this type of arrangement are quite broad and offer a number of interesting scenarios for developers, depending on the actual location and positioning and their development.

Options can vary from a straightforward branded freehold apartment block, to a sale and lease-back arrangement where the freehold units are placed in a leasing pool and the net profits shared among the owners, to fractional ownership, to condo-hotels - the list goes on and on.

However, with the exception of a small band of enthusiastic supporters, most hotel operators in the region profess to a degree of anxiety when presented with this option by owners.

Their concerns centre on the following basic issues and there are examples in this region where projects have gone horribly wrong when these simple rules have not been followed:

1. The owner-operator relationship can be fragile at the best of times and this risk is greatly exaggerated if an operator is expected to deal direct with the individual owners.

Therefore these developments must include the mandatory creation of a residents' association based on equal shareholding, and it is this association that the operator will be contracted to, not to the individual owners.Since many of these developments are speculative in nature, it is essential that the contractual obligation is carried through to subsequent owners as these properties may be 'flipped' several times before being delivered to the end user.

2. Binding rules have to be in place to ensure that the common areas and, in case of leasing pools, the unit interiors, are delivered and maintained to the brand standards of the operator in question. Experience with residents' associations points to a typical reluctance from owners to part with cash to pay for maintenance and reinvestment that they may not agree with.

Equally, many owners simply do not understand the concept of a brand standard or the need to maintain uniformity across all units. It is essential therefore that the sale contract incorporates a clear understanding of the principle and the projected amounts of continued investment into the property by the individual owners.

3. In a leasing pool arrangement, the method of leasing, revenue distribution and length of time of each lease period must be clearly understood and binding on all parties.

For example, it would be extremely damaging to the marketing of the project as a whole if individual owners were to market their own units separately - possibly at odds with the pricing and target market strategy of the operator. Equally, the operator will require control over the pool inventory to programme adequate resources for the facility.

Branded freehold or fractional ownership properties are beginning to make themselves apparent in this region, with markets such as Egypt already having five to 10 years of experience (admittedly, not all of it good). In general these projects target the high-end and leisure-oriented developments, with the industry taking particular interest in their operational profile as and when they start coming online.

In terms of future trends, we should see a diversification of this sector into the mid-market as there are doubtless investors at all levels who would prefer to pay a premium to secure a quality product, prestigious name and guaranteed service levels.

While branding freehold assets may not always be a panacea to the woes of securing and servicing project financing, with increasing market sophistication, it can certainly add value to projects that fit the required profile.

TRI Hospitality Consulting has assisted and advised on hotel management company selections for numerous hotels on behalf of independent hotel owners and institutional owners across the MENA region. For further information, contact: www.trimideast.com or +971 4 345 4241.

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