As the industry recovery continues to gain momentum, opportunities for investors abound. Whether it’s a full-service property in New York, San Francisco or Miami, a select service hotel in Pittsburgh or Raleigh, North Carolina, or a limited-service asset in Frisco, Texas, or Pueblo, Colorado, there is no shortage of capital waiting to get off the sidelines and back in the game.
With real estate investment trusts, sovereign funds and institutional capital chasing deals in the major markets, yields are being driven down to the range of 3% to 5%. The situation is quite different in the secondary markets, where capitalization rates are ranging from 8.5% up to as high as 12%. As a result, with interest rates remaining at historic low levels, cash-on-cash yield investing in secondary markets can be lucrative with the appropriate level of leverage.
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| Aik Hong Tan |
With that said, to be successful, an investor must pay special attention to specific issues that are unique to any secondary-market deal.
Demand
First and foremost, as with deals of any kind, careful study and understanding of demand generators in the market are crucial. The number and nature of demand drivers in secondary markets tends to be fewer and more targeted than in major markets such as New York or Los Angeles.
It is important to understand the dynamics that draw travelers to the area. Sometimes it can be a single landmark such as a college or military base. In these cases, it is essential to realize that even one single event, like the closure of the military base, can have a major impact on demand.
In other cases, factors such as the construction or major refurbishment of a factory might bring new, short-term demand to the market, causing occupancy and average daily rate to increase but only temporarily.
The key to successful investments in secondary markets is the existence of diverse and sustainable demand generators. Examples might include a strong corporate base, a major university or popular attractions that draw leisure travelers on a consistent basis.
One example of such a market is Burlington, Vermont. GE, IBM and Ben & Jerry’s ice cream have a major corporate presence there. The University of Vermont and Lake Champlain also attract weekend travelers from New England as well as Canada. With the exception of a slight decline during the depth of the recession in 2009, the revenue per available room in the Burlington market has increased consistently by 4% to 5% annually from 2007 to 2012.
Supply
Even though barriers to entry in secondary markets are not as high as in major markets, careful consideration needs to be given to key variables. At the top of that list is location as it pertains to potential new supply. For example, it is better to be in the downtown or core center of a secondary market rather than at a highway location in the outer ring. Why? It is harder to build in the urban center due to infill and permitting constraints, and because supply is limited in those areas, it poses a distinct advantage if a hotel can be acquired in the urban center.
Buying at significant value below replacement costs is also a good strategy as it provides a significant cost advantage over a new-build hotel. Securing affiliation with top brands including Marriott International and Hilton Worldwide with a reasonable area of protection under the franchise agreement also works to mitigate against new supply entering the market.
Exit strategy
Exit strategies for hotels in secondary markets must be developed strategically and evaluated carefully. One question to ask is whether the current brand will be available to the next buyer. This depends, in large part, on the age of the asset. A select-service hotel with a major flag might sound like a great opportunity. However, it might not be such a good deal if the property is 40 years old and is unlikely to retain that same flag when the owner attempts to sell it three or four years later. As a result, the value of the hotel will be compromised greatly.
It is also important to project how and why the value of the asset will increase by the time the hotel would be sold. In major markets, supply constraints and scarcity of land drive a natural appreciation of real estate prices over time. This is not the case in secondary markets, where real estate values are more subject to a range of variables.
The most critical factor is how cash flow of the hotel would grow. To be successful, a buyer in a secondary market must clearly develop and implement a plan to increase the cash flow of the property between the time of acquisition and the time of sale. Some strategies to accomplish this could include an upgrade of the brand as well as more focused and sophisticated management than the previous owner.
Conclusion
New York’s Times Square and Main Street’s town square each offer opportunities for the hotel investor. Those who are most successful are the ones who understand the dynamics and distinct differences between the two market types and who are able to identify and capitalize on the factors that drive customer demand, influence supply and have an effective exit strategy.
Aik Hong Tan serves as a principal of Greenwood Hospitality Group. In this role, Mr. Tan is actively engaged in the financial and investment disciplines and growth strategies of the company. During his career, Mr. Tan has overseen a number of major initiatives including development of mixed-use real estate projects, issuance of bonds to international financial institutions, disposition strategies for power related companies, oversight of e-commerce/GDS and purchasing disciplines in the hospitality arena. Mr. Tan earned a Master of Business Administration degree and Bachelor of Accountancy from the National University of Singapore, and is a member of the Institute of Certified Public Accountants of Singapore. He currently serves on the Executive Board to the School of Hospitality, Restaurant & Tourism Management at the University of Denver.
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