The hotel investment sales market is beginning to reaccelerate.
The volume of conversations between owners, buyers and brokers is increasing. The discussions are translating into action as financial firms increasingly are receiving requests for acquisition financing.
Asset sales activity benefits the hotel industry for all the reasons I highlighted in my previous article. Fresh investment dollars into assets at valuations reflecting the current environment will also usher in the beginning of a new lodging cycle. Every prior cycle can be characterized by certain trends. What will come to characterize the industry’s next cycle?
The select-service hotel segment was established in the 1980s. The hotel franchising model broke out in the 1990s, as did the increased flow of institutional capital through the establishment of lodging real estate investment trusts. Private equity capital entered the space in earnest in the first decade of the 2000s, and third-party management companies grew to manage their assets. Franchise companies began to merge in the 2010s and, at the same time, establish new brands and product categories such as lifestyle and soft brands. Consolidation has continued into 2020s with mergers amongst third-party management companies. The lodging sector has evolved from an emerging industry to what now feels like an industry that’s in a phase of maturation. The coming years in the hotel sector will certainly include new developments but also a reconfiguration of legacy dynamics.
One key theme of the next cycle may be the relationship between the three primary economic participants in the hotel industry: owners, brands and managers. As the brand companies have largely consolidated and the management company landscape is currently in the process of doing the same, it would reason that consolidation of hotel ownership may occur during the next lodging cycle. Scale to combat scale. This dynamic has happened in other industries.
In today’s hotel industry, the natural consolidators — real estate investment trusts and institutional investors — have yet to find conviction in deploying equity capital. Sentiment amongst lodging REIT investors is evident in weak REIT stock prices. Large financial buyers are investing in hotels at muted levels. While spending at hotels nearly has become a staple of consumer spending in the United States, the profitability of hotel ownership has experienced sustained headwinds. Market forces may drive a reallocation of revenue amongst the three primary industry participants.
Hotel brands have been the principal beneficiary. With a business model that has very low marginal cost, the industry’s growth has resulted in significant gains in brand company profitability. Their success is reflected in their stock price. Management company compensation also is largely tied to overall industry revenue growth. While their expense structure is more intensive than the brand companies, it’s certainly less so than the underlying hotels they manage. Both market participants benefit from economies of scale — in the case of the brand company, both economies of scale and economies of scope. The benefits of that scale have not resulted in lower prices for their common client: the hotel owner. Perhaps that will change in the face of continued margin pressure for hotel owners.
Certain brand companies have already adjusted loyalty fee-related expenses. Royalty fees are sacrosanct to hotel brand companies. I do not foresee a reduction in that P&L line item but there are many other fees and expenses that can be adjusted for the benefit of owners. Management companies for their part pass through many fees and expenses outside the base management fee. Perhaps hotel owners may experience some relief on those expenses, or maybe the broader relationship evolves from a fee-for-service model to more of a risk sharing with a lower base fee and greater incentive payment. It’s counterintuitive but both brand companies and management companies are incentivized to look out for the profitability of hotel owners.
There are at least two high-level outcomes if there’s no change from the current expense regime. One outcome is that hotel assets experience only marginal increases in value. That would likely put downward pressure on new hotel construction. This would adversely affect the growth prospects of both brand and management companies — a dynamic that currently exists. A second impact is based on the Jeff Bezos philosophy that “your margin is my opportunity.” In the case of brand companies, does a new entrant join the space with a lower-cost — not lower-quality — offering? There’s already one player who’s very successfully created and scaled a brand company that’s announced he’s doing it again. In the case of management companies, do hotel owners acquire operating businesses to keep the manager’s profit for themselves?
Market forces will ultimately determine the “right” structure and economic distribution amongst the parties. Whatever the outcome, consumers will continue to spend on hotels, and the hotel industry will continue to evolve.
Ankur Shah is the chief financial officer of Access Point Financial, a $3 billion hotel-focused real estate credit firm.
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