Last month, a hotel site at Club Street was sold in a public tender for $562.2 million. The site allows for roughly 240,000 square feet of development, which translates to $2,148.50 per square foot, a historically high price.
Hotels have long been a niche real estate sector. The lease structure, counted in days instead of in years like office or retail leases, means that hotel earnings are more volatile. In addition, the cost of running a hotel is much higher than the cost of running other forms of real estate. On an annual basis, the net operating income of a hotel ranges from 40 to 60 percent of total room revenue. This means that, if room revenue takes a sudden hit, the hotel operator can see operating loss, something typically not seen with other forms of real estate.
Hotels are also usually a rather small sector. Government data at the end of 2017 showed that there were 420 hotels, generating 67,084 rooms, for the whole of Singapore. Compare to “more than 1 million flats spread across 23 towns and 3 estates” (according to HDB’s website), the hotel stock needed in each city is vastly overshadowed by residential sites.
However, despite its niche status, hotels have become one of the fastest growing sectors in real estate over the last three decades. In Singapore, the number of hotel rooms grew from about 35,000 rooms in 2001 to over an estimated 70,000 rooms by 2021. Hong Kong’s total stock also grew from 42,000 rooms in 2002 to over 93,500 rooms by the end of 2018.
The most fundamental reason for this growth is the growth of tourism markets. According to the United Nations World Tourism Organization, between 2010 and 2017, tourist arrivals across Asia have grown by 63 percent. As a region, Asia Pacific has also grown from being 16 percent of the global total arrivals in 2000 to over 24 percent in 2017. As such, a continued growth in hotel supply is supported by the fundamentals.
However, beyond the fundamental support, a new form of operation has also stimulated the growth. Traditionally, hotels have been largely owned by the operators, and thus, the operators are exposed to the full cash flow risk we discussed above. This has led to less favorable financing terms as both equity and debt investors classify hotels as an operating business and not just a “real estate”.
In 1994, Marriott split itself into two entities. Host Marriott, a REIT, owns all the real estate assets, while Marriott International owns the brand and the operational know-how of the Marriott brands. The operator then operates the hotel on behalf of the real estate landlord. This allows investors to customize their risk-and-return profile by picking between the operator and the landlord. Many hospitality REITs, including the three that are listed in Singapore today, are pure landlords and do not operate the hotels directly.
Two and a half decades after the Marriott split, there are now three main operating models. The first is the traditional model, where the branded operator continues to own the real estate assets. This model is the most suitable to the premium brands, as the presence of such brands can improve the value of the immediate precinct. Thus, it is to the advantage of the brand to hold the real estate asset for its long term appreciation. As premium brands, the operator may also have more stringent requirements for its hotels and hence owning the assets directly gives the management more flexibility.
For the split model, the hotel landlord appoints the operator under a management contract. In the most conventional terms, the operator receives a management fee for managing the asset. They often include clauses for key performances indicators for the operator to meet. In return, the operator also gets a share of performance-based fee.
For REITs, however, the most common structure is through a lease. The operator will pay the REITs a rent, perhaps with an incentive rents to share the upside, and would be responsible for almost everything else. The advantage of this structure is it eases the ownership of the landlord, and it also provides income visibility to investors. The operator usually has the most flexibility in operation.
Overall, the changes to the operating model allow for more flexible financing strategies. Now the real estate landlord can seek capital from traditional real estate investors, and hotel assets can be valued as a type of commercial real estate (albeit still carrying a slightly higher cap rate than office or retail). The operators are now asset light and can expand their business as long as they can continue to secure new operating opportunities. This new model is perhaps one supporting reason of the rapid growth of the hotel sector all across Asia.
SIC2019: Dr Chan – I Foresee Shougang’s (HK: 697) Turnaround