Cash-strapped inns are a cheap way to expand into China's hospitality sector, but buyers should look at the hazards Distressed state-owned hotels in China are providing investors an opportunity to expand in the mainland hotel sector at a low cost, yet with unpredictable risks concerning regulatory issues and policies. With a higher internal rate of return, the sector has lured institutional investors, developers and international hotel chains to a treasure hunt in one of the world's biggest hospitality markets. 'Among all the state-owned hotels in the market, four-star and five-star hotels and budget hotels are doing the best,' said William Zhao Xianglong, a senior representative in China of global consulting company HVS International. 'Many of the two-star and three-star hotels are losing money and even on the edge of bankruptcy,' said Mr Zhao, whose company has been conducting research on China's state-owned hotels in 25 cities. 'The most attractive point in investing in distressed state-owned hotels is that they have very good locations,' he said. 'The price of the land where they stand will keep rising.' State-owned hotels usually occupy a large land area. This gives investors a chance to own a big piece of land in a good location by buying a relatively cheap two-star or three-star hotel. 'Land costs on average account for more than 30 per cent of the overall costs of a new four-star or five-star hotel in China,' Mr Zhao said. 'But by buying a three-star state-owned hotel and then building a new high-end hotel on the land will lower the land cost percentage to 5 per cent to 6 per cent.' Goodwin Gaw, the chairman of Gateway Capital, a property fund management company with a Greater China focus, said the fund definitely is interested in the sector. 'Repackaging distressed assets by adding value could be creative,' he said. 'We are definitely interested in [acquiring distressed hotels] mainly due to their low prices. By adding value, you can be creative, for instance, by converting an office into a hotel.' The internal rate of return is higher than in normal asset acquisitions, Mr Gaw said, adding that the return varied deal by deal. 'But normally, real estate funds target projects with [returns] in the mid-20 per cent,' he said. A year ago, Gateway looked at 63-storey office-hotel-residential development Guangdong International Building in Guangzhou, once the city's landmark, he said. But the fund gave up due to complications in the property's title, Mr Gaw said. 'You have to spend time and effort to improve returns on assets such as this.' He said there are also many opportunities in Shanghai. 'There are many half-built developments foreclosed by the banks and courts,' he said. Recently, the fund bought an office building which suffered from a poor occupancy rate due to mismanagement in Beijing. 'We plan to upgrade it into a serviced apartment [block],' he said. Far East Consortium International is also seeking opportunities in the sector to build up its mainland hotel portfolio. 'The company is looking at seven to 10 distressed hotels in different cities,' said deputy chairman David Chiu Tat-cheong. In contrast to its three-star and four-star hotel portfolio in Hong Kong, Far East Consortium's investment in the mainland will concentrate on four-star to five-star hotels. Mr Chiu hopes to finalise a deal shortly. Starwood Hotels and Resorts has foreshadowed an aggressive acquisition spree in the mainland including exploring opportunities in investing in distressed hotels. 'We will go for it if we find their financial structure is right,' said Stephen Ho, Starwood vice-president for acquisition and development in Asia-Pacific. The chain plans to double its rooms over the next three years from 23,000, he said. Investing in distressed assets requires extreme caution and a doubling of efforts to uncover the hidden risk. Mr Zhao said the highest risks in state-owned hotels come from usage of land on which the hotels are built. 'The government can easily forbid the buyer of a hotel from redeveloping the land or building a new hotel,' he said. Many risks require investors to tread carefully, he said. 'Take hotels of China Post for example. It is very difficult to figure out who actually paid the money to build the hotels.' In cases like this, China Post usually owned the hotels indirectly through a state-owned holding company. 'Investors have to figure out the ownership between the hotels and the holding company, as well as that between the holding company and China Post.' Sellers of state-owned hotels range from owners of an individual hotel to those who own a group of hotels. The sellers mostly suffer from financial problems and bad management or entered the hotel business blindly in the early days. Mr Chiu said bankers once presented a package of 300 distressed hotels owned by a state-owned enterprise to his company. 'If each hotel took a day for due diligence, [all 300] took us a year. But it is an interesting area,' he said. Li Ying, a partner at Heller Ehrman who has been helping clients on mergers and acquisitions in China, said it is not easy to find buyers for owners of domestic hotels who have run into financial difficulties. 'It's hard for them to sell, they can hardly repay loans from the bank.' One of the biggest owners of distressed hotels is China Post. 'Definitely we are going to sell part of the hotels we have,' said Ren Yongxin, an executive at the State Postal Bureau, the office in charge of separating the main postal business from other businesses of China Post. However, the exact number and asset valuations of the hotels under China Post are still unknown. There could be hundreds worth about 10 billion yuan in total, Shanghai Securities News reported in September. China Post is still evaluating its own hotel assets. The State Postal Bureau has sent out staff to help people from the consulting firm to check each of China Post's hotels around the country. Mr Ren said the evaluation results would come out in about 10 days. According to information from various travel websites in China, China Post's hotels are mainly two-star and three-star inns scattered in developed cities and tourist spots in remote counties. Some of the hotels in big cities are four-star. Still, a large number of China Post's small hotels are either in remote areas or have no ratings.
