Print Preview : Another Look: Hotels vs. office in an investment portfolio

Another Look: Hotels vs. office in an investment portfolio
Hotels are like a creme brulee, rich, delicious, but not everyone likes them; however, perhaps more investors should acquire the taste for mixing them into real estate investment portfolios, according to the latest edition of Hotel Topics published by Jones Lang LaSalle Hotels. In the report, the firm examines the relationship of hotels to office in the market cycle and explains the volatility in hotel earnings, underscoring the significant opportunistic play available to investors at certain points in the cycle.

Currently, hotel allocation, if it exists at all, represents a tiny but growing share of institutional portfolios, explained Melinda McKay, Senior Vice President of Jones Lang LaSalle Hotels and author of the report. Institutional investors typically allocate either zero or a range of 5% to 10% of a fund to real estate, with the hotel allocation often dropping off the chart given the `creme-brulee` effect. Actually, investors should grasp the risks, learn to time the market and take another look at hotels as an investment vehicle.

UNIVERSE OF OPPORTUNITY - The hotel sector has a tremendous diversity of investment options, ranging from economy to luxury in the almost 14 million rooms worldwide. An additional layer to this mix includes brand and management company, which act as a point of differentiation between asset types, dictating performance and therefore investment return.

Hotels can be offered under a variety of different investment structures, although the sale-leasback structure is widening the appeal of hotel investment to institutional investors given its bond-like characteristics. According to Arthur Adler, Managing Director and CEO-Americas of Jones Lang LaSalle Hotels, A gradual merging of the lease and management structure risk spectrums is predicted, to the extent that the guaranteed management contract and the turnover lease will offer similar investment return volatility characteristics.

HOTELS ATTRACT PREMIUM RETURNS - Hotels are often considered a higher risk investment class than office, and, in turn, investors seek a premium. And they get it. Throughout the United States, over the decade to first quarter 2003, hotels achieved an average quarterly premium to office of 378 basis points in rolling four quarter total returns. The equivilant premium in income returns was 217 basis points. This high income yield should represent a flag for pension funds, as an aging population drives the trend of payouts exceeding contributions, thereby rendering current income returns an increasingly important consideration, noted McKay.

Yet this return premium comes at the price of volatility. The income return range over the past decade measured 637 basis points, as compared with office at 160 basis points. Interestingly, such volatility has been greatly reduced across Europe through the sale-leasback investment structure.

The real message that less risk sensitive investors will take from this is the value and significance of timing in hotel investments, added McKay.

LOW RETURN CORRELATIONS SPELL DIVERSIFICATION - The greatest portfolio diversification benefit comes from inclusion of assets that have low or negative correlation with the other asset classes within the portfolio. Private hotels have a low correlation with bonds, public real estate and to a lesser extent private real estate. On the other hand, public hotels have a low correlation with stocks and private real estate, while both private and public real estate have low correlations with stocks and bonds. This suggests that the returns of the respective asset classes do not move together indicating an opportunity to diversify risk and volatility. Private hotel returns are somewhat correlated with stocks, not surprising given that returns in both sectors are intimately linked with economic changes and sentiment vacillation.

Worldwide, hotel ownership under a lease structure is akin to bond style covenant driven investments which should have a low correlation against stocks, included McKay.

ATTRACTIVE VALUES RELATIVE TO OFFICE AND TREASURIES - Hotel yields are at a 10 year high relative to Treasuries and remain competitively priced in comparison to office in the United States. This implies that hotel values remain very reasonable relative to earnings, providing additional protection from the downside risks associated with economic slowdowns, as well as possible room for growth as investors compare this sector`s prospects relative to other investments going forward. Also, hotels consistently trade at a higher cap rate premium to office and treasuries. At a current 700 basis point premium to Treasuries, even accounting for risk factors, hotels represent a strong value proposition, said Adler.

ARE HOTELS A PREDICTOR OF OFFICE MARKET CYCLE POSITIONS? - Cycles are critically important in the real estate investing business. Hotels are rarely a `stabilized` asset - they are either on their way up or way down, stated Adler. While in a broad operational sense, office and hotels differ (due to rate variations), there appears a causal link in their respective cycle positions.

This suggests that hotels can act as a barometer of office market performance, given their quick reaction to economic climate. It also serves to demonstrate that hotels play an important role in balancing investment performance in a mixed real estate portfolio.

Recently in the United States, hotels appear to have assumed a `leader` effect in relation to the office cycle position. Using three of the largest U.S. hotel markets as a proxy: Chicago, Los Angeles and New York; the report identified that hotels exhibited a `lagged` cycle position as compared to office in 1990. However, this pattern began to change in 1995 when the markets appeared closely aligned. As we approached the new millenium, the `leader` effect of hotels became evident, with 2000 indicating an earlier peak than office. This was reaffirmed in the current position (2003), with hotels demonstrating an advanced trough to office.

HOTELS` ROLE IN A DIVERSIFIED REAL ESTATE PORTFOLIO - Hotels play an important yield-rich role in a diversified real estate portfolio. For investors who are not solely focused on the lodging sector, hotels traditionally fit into an `opportunistic` investment strategy, where there are no set expectations on income, but the total return on the investment would be in the upper teens or above.

For a more opportunistic strategy in North America and Europe, LaSalle Investment Management suggests up to a 10% portfolio weighting to hotels, with a smaller percentage for Asia Pacific, advised McKay.

THE FUTURE ROLE OF HOTELS - Hotel investment no longer sits on the fringes of the investment domain, an asset class once only for the venture-capitalists or highly specialized outfits. Accelerated maturation has formed a central component of this sea-change, as investors become more experienced, capital markets more disciplined and the demand supply balance less unbalanced.

There still remains a higher component of risk, with the hotel sector vulnerable to demand shocks such as terrorist attacks. Yet with a disciplined and specialized investment and/or asset manager, the impacts of such risks can be mitigated and returns maximized, concluded McKay. Vicky Karantzavelou - Tuesday, September 30, 2003