Today’s investment landscape—characterized by persistent inflation, climbing interest rates, supply chain issues, and geopolitical tensions—presents many challenges for individual investors. There are, however, pockets of opportunity if you know where to look. 

The hospitality real estate sector is arguably one of the most compelling investment opportunities in our current environment. Here we explore why the present moment is favorable for hotel investments. We also walk through three considerations for identifying the right hospitality investments for your portfolio.

Framing the conversation: The role of private real estate investments

In recent years, the ability of a traditional 60/40 portfolio to deliver on the promise of reliable diversification and steady growth has come under pressure—in fact, this classic portfolio blend may no longer be enough to meet many individuals’ long-term investment goals. As such, more individual investors are re-thinking their asset allocation approach and choosing to add alternative investments to their portfolios. 

In the broadest sense, the term “alternative” applies to any investment that’s an alternative to traditional, publicly traded stocks and bonds. The alternatives landscape encompasses a wide range of assets, strategies, and investment vehicles, including real estate and private equity investments. Alternatives can help lower portfolio volatility, enhance returns, and broaden diversification. As alternative investment accessibility and transparency have greatly improved, many experts now consider alternatives to be an essential part of a well-constructed portfolio.

In paying greater attention to alternatives and private investments, individuals are following in the footsteps of savvy institutional investors. Top-performing institutions have been long-time allocators to private investment strategies—and have substantial outperformance to show for it:

• Research by Cambridge Associates shows endowments and foundations in the top quartile of performance had one thing in common—a minimum allocation of 15% to private investments.
• Top decile performers have steadily increased their private market allocations over the past 20 years, often pushing well beyond the 15% mark to reach allocations greater than 40%¹.

Within the realm of alternative investments, private real estate plays a particularly important role, delivering diversification benefits while providing steady income and the potential for capital appreciation—so it’s no surprise to see elite endowments target, on average, an allocation of nearly 5% to private real estate².

There’s never been a better time to invest in hotels

Among the various segments within private real estate, hospitality stands out as an especially compelling opportunity in the current environment. The sector is underpinned by a combination of advantageous characteristics and a favorable supply-demand dynamic.

Uniquely strong protection against inflation

As US inflation reaches multi-decade highs, investors are rightly seeking shelter from the storm. Income-producing real estate is widely reputed to offer some degree of protection from inflation, based on the principle that property owners can hike rents to keep pace with changes in consumer prices. As shown below, the benchmark NCREIF ODCE US real estate index has posted its highest average returns when inflation is high and rising.

Source: J.P. Morgan Asset Management Guide to Alternatives® 2Q 2022, NCREIF, BLS. “High” inflation is defined as any year-over-year headline CPI reading above the historical median, while “low” inflation is defined as any year-over-year headline CPI reading below the historical median. The median year-over-year headline CPI for period between 1978 to 2021 is 2.89%. Data is based on availability as of May 31, 2022.

The extent to which a given real estate investment can protect against inflation is closely linked to its ability to adjust rents in step with inflation. Because hotel rates can be changed day-by-day, they can respond to inflation on a nearly continuous basis. This compares favorably to other types of real estate where lease terms are much longer—for example, one-year residential lease terms or five-year office leases that may or may not have index-linked provisions to adjust for inflation.

Historically, the hotel industry has proven its ability to grow during times of high inflation. From 1972 to 1982, for example, the US consumer price index climbed at an 8.7% compound annual growth rate. During the same period, US hotel industry net operating income grew at a rate of more than 12%, significantly outpacing inflation³.

An attractive combination of cash flow and capital appreciation

A hotel investment typically derives a large percentage of its value from its operations—the day-in and day-out business of renting rooms and running a successful lodging enterprise—while also offering the capital appreciation traditionally associated with land, buildings, and real estate assets. Taken together, these factors enable many hospitality investments to offer a relatively balanced risk-return profile. For many individuals, this is a welcome contrast to the array of real estate investments promoting sky-high returns based on precariously optimistic assumptions about future asset prices.

Strong demand for travel in a post-pandemic world

The depths of the COVID-19 pandemic presented the hospitality sector with a range of serious challenges. Today, a robust recovery is well under way—in fact, it’s on the verge of breaking into a new phase. It seems the pandemic had at least one silver lining, providing a clear reminder that we love to travel and experience the world firsthand.

“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

For investors, the current moment presents an opportune entry point: Demand for travel is expected to reach historic levels in 2023 as business travel ramps up to join remarkably high demand in the leisure sector. Industry experts have recently upgraded their timelines for full recovery in the US hotel sector, forecasting nominal revenue per available room (RevPAR) to surpass 2019 levels in 2022. As shown below, the outlook for several top-line performance indicators in the US hotel market is quite positive.

Source: STR, CoStar Group, June 2022. https://str.com/press-release/str-te-upgrade-forecast-full-us-revpar-recovery-2022 

Constrained supply pipeline favors existing owners

The pandemic weighed heavily on the operating fundamentals of the hospitality industry, dampening appetite for new hotel development. As shown below, the number of hotel rooms under construction declined steeply into 1Q 2022. The pipeline is expected to shrink even further as rising interest rates present an additional headwind to development projects and supply chain issues persist. The current dynamic of growing demand and constrained supply supports existing hotel owners, creating a favorable environment for outperformance.

Source: STR, CoStar Group, April 2022. https://str.com/press-release/us-pipeline-march-2022

Hospitality investment considerations

While the overall backdrop for the hospitality sector is favorable, real estate is an inherently granular asset class, and each hotel investment has a unique risk-reward profile. Investors and their advisors should carefully assess the factors that influence an investment’s potential success. For hotels, three particularly important factors are:

Property characteristics

Hotels are primarily categorized by location, the “flag” or brand affiliation, and services or amenities offered. Full-service hotels, for example, feature a long list of on-site amenities, such as restaurants, meeting rooms, spas, and shops, while select-service hotels offer a trimmer selection of amenities—perhaps a fitness center and meeting rooms.

A hotel’s characteristics can indicate, at least partially, what type of risk-reward profile it may have as an investment. However, it’s important to recognize that five-star luxury doesn’t necessarily mean five-star returns. Select-service hotels, for example, have demonstrated resilience through downturns and typically have more predictable operating performance than full-service hotels. Extended stay hotels benefit from demand from traveling healthcare workers, long-term consultants, and families that need more space. Similarly, secondary and tertiary markets may not be as “hot” than coastal urban centers but often benefit from more stable demand.

Sponsor and business plan

Manager selection is a critical factor in achieving long-term investment success—especially when investing in alternatives, such as private hospitality real estate. Consider this: Over the 10-year period ending 4Q 2021, the dispersion between top quartile and bottom quartile annual returns for private US non-core real estate managers was nearly 14 percentage points. For public global large cap equity managers, the spread separating top and bottom quartile managers was less than two points⁴.

When evaluating hospitality investment managers, investors should focus on the sponsor’s overall strength and vision. The best sponsors are disciplined and appropriately conservative in crafting their underwriting assumptions. They draw on deep experience in identifying and executing the right business plan for the right market. In terms of assessing a sponsor’s vision, the goal is to accurately evaluate the amount of risk baked into the business plan—for example, the extent to which returns are reliant on upside at exit vs. significant cash flow.

Hotel management practices and operational efficiency

Given the operational intensity of hotels, management practices have a significant influence on the overall success of an investment. The right management can minimize risks and maximize returns—so investors should pay careful attention. 

Many property owners partner with external management and operations experts. In these scenarios, bigger is often better: Large, experienced management companies are typically better positioned to offer asset owners and investors the scale, support, and deep operational knowledge necessary to generate attractive returns.

Operational excellence: Key areas of focus

Closing thoughts

Amid today’s challenging investment landscape, hotels present a compelling opportunity. Hospitality investments are uniquely able to keep pace—even thrive—during periods of elevated inflation while offering a balanced blend of cash flow and capital appreciation. Furthermore, the current dynamic of growing demand amid constrained supply creates a healthy runway for investment performance. For many individuals, now may be an exceptionally opportune time to add hospitality investments to a well-diversified portfolio.

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

References

1. Cambridge Associates, “Private Investing for Private Investors: Life Can Be Better After 40(%)”, Feburary 2019. https://www.cambridgeassociates.com/insight/private-investing-for-private-investors-life-can-be-better-after-40/ 

2.  NACUBO-TIAA Study of Endowments, Fiscal Year 2021 Asset Allocations for U.S. Higher Education Endowments and Affiliated Foundations, total endowment size >$1bn, February 2022. Data represents asset allocations as of June 30, 2021. https://www.nacubo.org/-/media/Nacubo/Documents/research/2021-NTSE-Asset-Allocations–REVISED-February-18-2022.ashx?la=en&hash=461EAB247180B408D4975C1230F211EC404A88AB

3. CBRE, “A New Horizon: The Case for an Inflationary Bull Market in Hotel Real Estate”, May 2022. https://www.cbre.com/insights/articles/a-new-horizon-the-case-for-an-inflationary-bull-market-in-hotel-real-estate

4.  J.P. Morgan Asset Management Guide to Alternatives® 2Q 2022, Lipper, NCREIF. Data is based on availability as of May 31, 2022.