by Mary Lou Jay
Diversifying your portfolio by investing in other properties can be a good strategy to reduce risks and increase returns. The key is finding the right property, and there are many factors that go into that decision. Here, we explore some steps to accomplish this goal.
Consider Your Options
You can confine your search for an investment property to the geographic area you know and to hotels – either similar to what you already own or those that offer a different level of service. You also can branch out into other types of properties and/or locations. There are advantages and downsides to each approach.
Hotel owners often prefer to buy other hotels as investments because they already understand the demands of the industry. “I find that the best investment strategy is to stick with the real estate that you deeply understand,” said H. Keith Thompson, principal, Avison Young. “Many times, investing outside of your skill set is the recipe for failure.”
Hotels have a greater expense load than other asset classes, such as apartments, and they are much more complex to operate, especially if they have a restaurant component. But that complexity offers a unique opportunity for people who know what they’re doing. “There’s a lot more room to create value-added strategies,” said Brian Holstein, principal with US Hotel Advisors.
And there are plenty of opportunities for diversification within this market. “I believe investors should own franchise brands across all franchisors,” Thompson said. “When market cycles happen, it’s sound investment strategy to have hotels from top tier, mid-market and even economy. It is called ‘averaging down and across,’ which basically means to spread the risk across many platforms instead of just one.”
If you’re accustomed to running a limited-service hotel, however, taking on a full-service venue with food and beverage, group meetings, and catering can be challenging, especially as labor costs continue to rise. Partnering with someone who already has experience in owning a full-service hotel or in running a hotel restaurant may improve the odds of making the investment a success.
Diversification into other types of properties like apartments can be a great option as long as investors don’t get in over their heads, and they’re decreasing the risks in their portfolios, Holstein said. “One should only dabble in non-hospitality if they feel they fully understand the different operating dynamics. One way to get around this is to begin by hiring an experienced management company that specializes in that asset class.”
Some investors interested in other geographic regions may consider investing in a non-hotel property like an apartment building to get a feel for the area before purchasing a hotel. But Derek Olson, senior vice president at CHMWarnick, said this doesn’t really provide the information that a hotel investor would need. Apartment renters are residents of an area, where hotel guests are more likely tied to area businesses and the room needs they generate.
Do Your Homework
When you own multiple properties in the same market, you can enjoy the synergies of shared resources and local management. But investing in a hotel in a different region can be a good strategy, as long as the investor has researched and is comfortable with the area and doesn’t stretch resources too thin.
“Many multi-property hotel owners have investments that span different states,” Thompson said. “We believe the strategy is sound because it offers the investor the opportunity to diversify outside of one market. It spreads the risk/reward across different demand-generating markets and usually allows for a greater portfolio yield.”
“It helps to diversify an investment portfolio, which can be beneficial in a downturn and ease demand-driver concentration issues,” Holstein added. “But absentee ownership can lead to underperformance unless you have a good management company to run your operation.”
Hotel market data from companies like STR Global can provide a general picture of how a metro area is performing. “That’s a good start,” Olsen said, “but you really need to reach out to the industry experts – the appraisers, the operators who have hotels in that market, the brokers – to see what hotels in a specific area are trading at from a price-per-room and a cap-rate standpoint.” He recommends benchmarking the performance of the property you’re considering against comparable hotels in your own portfolio.
Olsen said there are four major factors that potential investors should consider before purchasing. “The biggest factor is the supply coming into the market; more than anything else, that can have a negative impact going forward. In a lot of these markets, if you have one new hotel, that could be a 15- to 20-percent increase in the competitive supply,” he said.
Investors should research any new demand generators for the market, such as companies moving in or out of an area. “You also need to evaluate the location of the hotel relative to the demand generators in the area,” Olsen added.
Finally, investors need to consider the capital they’ll need above and beyond the purchase price. A change in ownership often means a change in brand, and a property improvement plan (PIP) to upgrade to brand standards. “A lot of times, that PIP can result in a significant expense, so you really have to understand what the brands are going to require,” Olsen said.
But data shouldn’t be the ultimate determining factor when making an investment, whether local or out of town, according to Thompson. “The decision should be based on the comfort level of the investor to the segment, brand, and investment size. In summary, it doesn’t matter how good the deal is if investing in it will cause financial stress. The investment needs to be comfortable, measurable, and achievable.”
Adopt Risk-Reducing Strategies
The first step in maximizing returns and limiting risks on your investment is to have a deep understanding of where its upside and downside risks are, according to Thompson. That varies with every market, location, and brand.
Olsen said the best and most important way to limit risk is to do extensive due diligence and make sure the underwriting is accurate. For example, investors need to know if the property taxes and/or insurance will go up when the sale goes through, or if the hotel pays a ground rent that will reset every few years. Unless a new owner has accounted for these increased expenses, returns could be lower than anticipated.
Financing the investment with a loan that utilizes the proper amount of leverage and structure is another tool for maximizing returns and limiting risk, according to Holstein. “You want to borrow enough money so that you can spread your equity out among numerous assets, which creates diversification. For instance, if you have $10 million of equity to invest, borrowing at 66 percent loan-to-cost enables you to buy three $10 million hotels instead of one. The leverage will amplify your returns, but you want to make sure you don’t borrow too much because leverage works both ways and will amplify losses as well.”
Investors also can limit risks by taking out a non-recourse loan, which shields a borrower’s other assets (such as a home) in the event of a loan default. One downside with this type of loan, however, is that it heavily penalizes prepayment.
Finally, make sure you choose a hotel that is appropriately positioned within its competitive market, Olsen said. “It’s important when you buy the property that you develop a revenue management strategy that will maximize the room nights and the rates from the different demand channels.”