_Greater diversification of institutional hotel investment - way forward to counter Brexit headwinds

While hotel property is increasingly considered a mainstream asset class with institutional investors rapidly increasing their allocation of funds into the sector, it remains a relatively underutilised and untapped asset class.

This is despite alternative investments being increasingly explored to help solve institutional investors' need for greater portfolio diversification and increasing requirement to grow income and manage risk in the face of Brexit headwinds.

In 2017, institutional investment in the UK hotel market totalled approximately £1.4 billion, of which over 87% of institutional capital was invested in hotel transactions secured with either a fixed, variable, ground, long lease, or development fixed lease interest.

Of the remaining 13% of institutional investment, approximately 8.5% came from overseas institutional investors, investing in property sold free and clear of the existing management.

The robust demand for fixed lease hotel investments backed with strong covenants, combined with the versatility and strong performance of these assets, as well as a shortage of existing stock suitable for fixed lease due to the long-term cycle of these assets being held, have collectively resulted in the rising phenomenon of yield compression, whereby the growth potential and security of the income stream is perceived to be stronger.

With the majority of the UK fixed lease hotel market confined to two main operators, Whitbread and Travelodge, our research estimates that the fixed lease market represents approximately a 17% share of the total UK hotel supply, with the growth of bedroom stock rising year-on-year by 5.5% per annum, over the past three years.

Meanwhile, the top six hotel operators represent some 37% of total UK hotel supply, equivalent of 65% of the total UK branded hotel stock.

Armed with the tools to manage the risks associated with alternative asset classes, the opportunity for institutional investors to further diversify their portfolio within the hotel property market is significant.

The future of hotel investment by institutional investors is at the turning point of change, where a broad base of fixed lease hotel assets will be complemented with a strong pipeline of investment, with good yield potential and capital growth in operational assets.

The implementation of a well-defined and thorough operational due diligence process will be essential in order to confidently assess the potential rewards or pitfalls of a hotel operating business.

In addition, specialist hotel asset managers will be increasingly deployed in order to maximise returns and to protect and enhance asset values over time.

Larger, full-service properties in strategic locations with strong, year-round demand generators are most likely to be targeted, with the global hotel brand franchisers likely to become big winners as institutions tap into their distribution platforms and technological expertise.

Identifying under-performing assets suitable for development and repositioning is likely to be another route for investment, offering the greatest potential for income growth. 

With a growing number of operators keen to take on a lease structure, hybrid leases are also expected to be increasingly used by institutional investors as a means of increasing the income potential through sharing the risk linked to the performance of the hotel.

Likewise, hybrid hotel management agreements, reflecting greater alignment of risk and reduce some of the disadvantages of the owner, are likely to become much more the norm.

The yield arbitrage between fixed lease hotel assets and hotels sold as going concerns is significant – broadly 300 bps. For institutional investors already cognisant of the hotel market, significant opportunity exists to seek out alternative routes to hotel investment.

Through strategic partnerships and changes in the risk profile between the institutional owner and operator, the foundations will be laid for higher risk adjusted returns, with a growing slice of institutional funds allocated to selective hotel operating businesses.

Knight Frank’s award winning hotels team provides a discreet and efficient consultancy service advising on the full spectrum of hotel and leisure assets.