How to Measure Risk in Hotel Investing
By: John Wijtenburg
Tags: Commercial Real Estate, Real Estate Investments, Investing, Risk, Hotel

How to Measure Risk in Hotel Investing

Commercial real estate (CRE) investments are risky. Of course, with CRE, you have the benefit of a physical asset backing the investment — unlike most public securities.

That said, the business plan and sponsor may add or subtract risk depending on the approach.

Risk Levels

CRE investors measure risk on a spectrum from Core to Opportunistic.

Core — stable cash flow and little to no deferred maintenance

— stable cash flow and little to no deferred maintenance Core Plus — stable asset with potential value enhancement from minor tweaks to operation or property

— stable asset with potential value enhancement from minor tweaks to operation or property Value Add — unstable asset with value enhancement from operational turnaround or renovation

— unstable asset with value enhancement from operational turnaround or renovation Opportunistic — defunct operation or non-existent property with value creation in construction or rebuilding operations

Hotels generally fall in the Core Plus to Opportunistic risk spectrum for a variety of reasons.

To start, every hotel will come with a brand-mandated change of ownership property improvement plan (PIP). This requires the new owner to make capital improvements to bring the hotel to current brand standards.

Additionally, hotel investments are more like an operating business with a real estate component than the other way around. This comes with a variety of risks associated with the strength of your operator.

As you would expect, the higher risk should accompany a higher return on investment.

Identifying Risk

Real estate investments trade within an opaque and illiquid market, which is in stark contrast to how public markets operate. Therefore, measuring risk is much more difficult than how you would approach a typical public equity or debt investment.

Hotel investment risks fall into three broad categories:

Operations — risks associated with the operation of the hotel. These are associated with both top line production and how much of that flows to the bottom. It also includes the general liability risks that are readily apparent and insured against. Property — risks associated with the condition of the property. These may include useful life of mechanical systems, quality of the building envelope, and binary risks associated with renovations (i.e. whether the work gets done). Property risks also include the natural disasters and other clear risk factors that you insure against. Market — risks associated with macroeconomic conditions. They may appear in the operation, property, or capitalization of the asset. This is a catch-all for everything out of the sponsor’s control. However, an astute sponsor will identify them and establish appropriate mitigation measures to address these risks.

This framework will give you an eye for what to look for in an investment’s offering documents. A private placement memorandum identifies these in a comprehensive legal way. However, you should look for indications of each throughout the presentation and discussions with the sponsor.

Evaluating Risk

Very few risks are easily quantified.

In many cases, you have to look to your gut for direction on how to evaluate risk. However, you should also rely on the sponsor to answer questions related to how she intends to address the three areas identified above, especially for items within her control.

Let’s look at an example.

Courtyard by Marriott in Fort Lauderdale, Florida. It is, currently, not getting its fair share of bookings and the average daily rate is just below market average. The sponsor established an operational turnaround plan, and the PIP is expected to cost $20,000 per room.

This is clearly a value add deal because of the scope of the renovation and the need to catch up to the market. Therefore, I would expect the investment returns at the project level to be >20% IRR and >2.0x multiple.

The most glaring risks center around the operator’s ability to close the gap with the market. A renovation will probably have a big impact, but it must combine with a robust revenue strategy that includes corporate groups and airline contracts.

Courtyard is a strong brand, especially with business transient guests, so that doesn’t present a major challenge. Still, it’s important to evaluate the competitive set and proposed new supply to ensure you’re not splitting that distribution channel with a Residence Inn, full-service Marriott, or some other Marriott-branded property in the market.

About the Author

John Wijtenburg is a hotel investor and blogger at Hotel Investor Toolbox. You can connect with him at LinkedIn, Instagram, and Twitter.