A growing number of high-net-worth individuals are considering investments in hospitality real estate—understandably so, given the favorable tailwinds supporting the sector. If a financial advisor, family member, or personal acquaintance presents you with an opportunity to invest in a hotel deal, how can you assess whether it may be a good fit for your portfolio?

For new and seasoned investors alike, a clear analytical framework is a great starting place. Here we present a seven-part blueprint to help you build a solid assessment.

 

1. Market demand

Key question: What are the fundamental drivers of demand for the hotel?

Supply-demand dynamics are important determinants of success for any investment. When evaluating demand for potential hotel investment, your primary goal is to understand which drivers attract patrons to the area.

Consider the current situation and the future trajectory of major demand factors, such as:

• Tourism and leisure travel attractions
• Travel infrastructure, e.g., airports, highways, cruise ship terminals
• Large employers
• Universities
• Medical centers
• Convention centers
• Sports teams
• Military and government facilities

For example, A hotel you’re assessing is located near a forthcoming convention center, which should draw commercial guests and groups to the area for trade shows and other events. The convention center supplements the steady year-round demand the property enjoys from a nearby college, where guests include prospective students, families visiting current students, and other academics. This blend of demand drivers may increase your confidence in the hotel’s ability to generate revenue consistently.

On the other hand, you may discover that a particular hotel is in an area where several major employers have recently shut their doors, suggesting shrinking demand from business travelers—and a cloudier picture for the investment’s return potential.

 

2. Market supply

Key question: To what extent will new supply increase competition?

The best-performing hotel investments are typically those in markets with high barriers to entry and minimal competitive supply. The less competition for customers, the better for revenues and asset value. As such, you’ll want to understand what competition a hotel currently faces and what new developments are in the pipeline.

Quantifying supply can take legwork. You’ll want to understand which factors may limit supply, including legal and regulatory hurdles, geographic barriers, political issues, and economic constraints, such as high construction costs. Franchise disclosure documents can be a helpful resource for identifying approved developments in an area. To identify projects that are planned but not yet formally approved or disclosed, savvy investors rely on third-party researchers and databases as well as relationships with key players who have an ear to the ground. Experts can also help you understand if a market is near or beyond its saturation point—or if demand is strong enough that new supply is expected to be readily absorbed.

For example, The market for potential investment is experiencing a favorable decline in supply, perhaps driven by zoning headwinds and a trend toward converting hotels to other uses. Alternatively, you might find that a given hotel market has added new supply at a rate that far exceeds the national average, prompting you to ask follow-up questions about absorption and the future pipeline.

 

3. Sensitivity to macro changes

Key question: To what extent is the hotel insulated from macroeconomic headwinds?

Macro factors—such as interest rates, inflation, and recession—all impact a hotel’s operating environment and investment performance. That said, some markets and brands are more insulated from macro headwinds than others.

Consider a hotel’s diversity of demand as a starting point: Hotels with the ability to attract multiple demand segments are typically better insulated. Sensitivity of demand is also important, as it speaks to how quickly bookings may be impacted by a deteriorating economic environment.

For example: Say you’re considering a suburban hotel that caters to customers visiting the nearby headquarters of a mid-size firm as well as families attending regional events at a local sports complex. While revenue from business travelers may quickly decline in a recession, this could be partially offset by steady demand from amateur sporting events, which are more likely to continue in a variety of economic environments.

Similarly, you might find that an extended-stay hotel is relatively well-insulated. Demand is likely driven by guests participating in large-scale projects with long-term backing, suggesting cancellations are less likely to spike during an economic hiccup.

 

4. Segment and brand selection

Key questions: How will the choice of hotel brand and type impact investment performance? Are the segment and brand well suited for the market?

Key drivers of hospitality investment performance include margins, operating income, market share, and competitive differentiation. These factors are heavily impacted by the hotel type (segment) and brand—and the corresponding suitability of these factors for the chosen market.

Different hotels offer different services, cost different amounts to build and manage, and attract different customer segments. As part of your initial assessment, aim to understand how a given hotel is situated within the following categories:

By assessing the “goodness of fit,” you’ll better understand the investment’s risk profile and potential upside.

For example: When comparing investments, you might find that a hotel in the select service segment has a lower operating cost structure and better margins than a luxury hotel with specialized on-site food, beverage, and spa amenities.

“The outlook for hotel performance remains positive. Even as the economy faces headwinds of higher interest rates, volatile financial markets, and inflation, lodging demand and room rates are being buoyed by strong household finances and the return of business travel.”

Aran Ryan, director of lodging analytics at Tourism Economics

5. Cost basis

Key question: What kind of downside protection is incorporated into the deal?

An investment with an attractive cost basis creates a measure of downside protection and a solid foundation for upside value creation.

For example: When assessing a hospitality deal with a higher cost basis—perhaps the asset was acquired at or above replacement value—you may find it will require more cash flow from operations or an aggressive sale price to reach the target return. Furthermore, you may determine the exit price will be difficult to achieve unless there is a large shift in the market.

 

6. Renovation and/or CAPEX needs

Key question: What are the capital requirements to remain competitive and optimize asset value?

Capital expenditure (CAPEX) is an important part of the overall strategy to maximize investor returns. Active management of CAPEX can maintain the hotel’s competitiveness, avert deferred maintenance, and increase asset value.

Aim to understand the capital requirements due to necessity—as determined by the asset’s age and condition—as well as any brand-mandated updates.

For example, A given investment’s business plan may call for lobbies and guest rooms to be updated every five to seven years and for the pool to be resurfaced immediately. In some instances, these expenditures may be easily managed and achieve a favorable return. In other situations, such outlays may pose a challenge to cash flow or be viewed as sub-optimal uses of capital.

 

7. Balance of return components

Key question: What is the anticipated return profile?

Longer-term investments are typically designed to make the most of operating skill and strive to maximize long-term net operating income. Short-term strategies are usually predicated on market timing and leverage, with returns maximized by a well-executed sale; sponsors typically focus less on property cash flows. Tax consequences are a larger factor with short-term strategies.

Begin by evaluating the investment’s targeted balance between cash flow from operations and capital appreciation. You’ll need to evaluate the deal’s strategic goals, intended holding period, and exit strategy.

For example, A given deal may pursue a “value add” strategy, whereby the sponsor intends to renovate the property and then sell it immediately after completing the upgrades. Some investors may find this business plan skews the return profile too heavily toward capital appreciation and short-term gains. Such investors may prefer the risk-return profile of a longer-term investment designed to capture cash flows from a property that’s steadily ramping up and expected to command a material rate premium above the broader market.

 

Forming the basis of your assessment

Where can you get the information needed to answer the questions raised in this framework? Important items to gather include:

• Details about sources and uses of capital for the offering
• Details about the business plan and sponsor’s strategy for optimizing value
• Performance assumptions
• Sponsor’s track record
• Information about the sponsor’s leadership team

A high-quality sponsor should readily provide you with documents clearly featuring these items.

As with any investment, it’s wise to draw on a team of experts, including financial, tax, and legal advisors. They can help guide your investment analysis, identify areas that require more in-depth due diligence, and help you track down any missing information.

Two of the country’s leading hospitality owners/developers/operators have created the Jali platform to provide access to institutional quality hotel investment opportunities.  To learn more, visit jali.co