Limited service hotels continue to grow in Asia
Over the last twenty years, limited service hotels have expanded its footprint to all major regions in the world. Rising demand from growing tourist markets is the primary reason, but changes to the hotel ownership and operational models have also accelerated capital investment into the sector.
Starting from a notion that the room experience is key to travelers, limited service hotels have stripped out many traditional amenities that characterized full service hotels. This modification lowers investment outlay and operational cost, which leads to an investment product that generate stable income returns and an on-par to slightly higher risk-adjusted total return versus other commercial real estate assets.
The Asian in-bound tourist arrivals have seen explosive growth, growing from 100 million arrivals in 2000 to more than 220 million in 2015. As the region continues to develop, the UN World Tourist Organization expects inbound tourists to grow to 300 million by 2020 and 500 million by 2050. In the airlines sector, low cost carriers (LCC) have increased their seat capacity from less than 20 million seats in 2003 to over 170 million seats in 2014. The growth in the LCC market suggests that the travellers’ market has diversified and grown deeper. This provides a larger and thus more stable market for the hotel industry.
In many gateway cities, including Hong Kong, Singapore, Tokyo and others, hotel occupancy has remained above 85%, and in some cases above 90%, in the years since the Global Financial Crisis. As 85% is typically seen as full occupancy for hotels, the currently observed high occupancy has led to double digit revenue growth in the last five years. With traveller arrivals expected to increase by another 50% in the next five years, many gateway markets remain undersupplied, even factoring in the current pipeline.
Hotels were once seen by institutional investors as being higher risk than office or retail assets, but several factors have lowered risks that used to be inherent to hotel investments. First, the segregation of hotel ownership and operations started in 1993 has shifted hotel operations to hotel brands. Freed from the operational burden, owners can now focus on investment strategies such as buy-and-hold, renovation, and development.
Second, revenue management systems, driven by artificial intelligence, allow hotel chains to manage occupancy, average daily rates, and RevPAR in real time. This allows a better revenue optimization than the previous model driven by fragmented, local managements.
Third, the lower operational cost of the limited service hotel model has lowered the seasonality nature of hotel markets. Most hotel markets, saved for the largest metropoles, have strong and weak seasons. Operational cost, especially that for full service hotels, can potentially create a material risk, if the strong season is not strong enough to compensate for the operational cost for the full year.
Because limited service hotels offer only a selected few amenities, more floor area is typically used for rooms. Together with the fact that limited service hotels typically carry smaller rooms, the per room floor area is typically between one third and a half lower for limited services hotel.
The economy on amenities also reduces the staff requirement. According to our analysis, the number of staff at a similar-sized limited service hotel can be less than one-third of the staff number at a full service hotel. On the income statement, this typically translates to a 20 percentage point increase in Gross Operating Profit Margin (GOP Margin).
A higher GOP Margin lowers the breakeven RevPAR and breakeven occupancy of a limited service hotel. A limited service hotel also manages better the seasonality issue identified above, as the overall cost during off season is lower than that of a full service hotel. In fact, a similar-sized limited service hotel typically has a breakeven occupancy that is about 30 to 40%, versus over 60% for a full service hotel.
Hotels, in most markets that Admiral covers, yield between 100 to 300 bps higher than office or retail assets. For example, in Hong Kong, retail assets typically yield at around 3%, while hotels yield at about 5%. We have also observed similar capital value increases between general office, retail and hotel assets. On a risk-adjusted basis, hotels are on par to slightly better than other forms of commercial real estate.
We believe that hotels can be best compared to logistics assets two or three decades ago. Logistics assets saw a similar cycle, when investors were initially concerned with its long term investment value. However, once the ownership and operational models matured, logistics assets saw a one-time, secular value appreciation in multiple markets. This tightened the yield gap between logistics and office assets, and now in many markets, especially those with an active REIT market, logistics cap rates are on par with office or retail cap rates. We see hotels, more specifically limited service hotels, as having similar potential.
Victor Yeung is chief investment officer at Admiral Investment