Institutional Investment in UK Hotels | By Robert Barnard, PKF UK

Historically, two key concerns of institutional investors were the inability to measure and benchmark hotel returns due to lack of transparency in information and the illiquid hotel transactions market which led to widely differing valuations. In the past few years, valuations have become more transparent and easier to benchmark as the market for hotel assets has become more liquid following greater separation of operation and ownership. Several hotel companies have divested assets to focus on management of operations and on the expansion of their brands. Assets are often acquired by investors including banks and private equity firms.

Although institutional investors have gained better understanding of the hotel market over the past decade as information became more transparent, there is still no official index to monitor returns from direct investment in hotels by institutions over an extended time frame. Capital and income returns from hotel assets remain difficult to measure on an industry-wide basis.

In 1989 PKF published a paper which analysed the investment return of eight provincial hotels. This report was updated in 1994 with a broader sample of 25 hotels in the UK (all outside London). The return on investment achieved by these samples outperformed the return achieved by property investments in the WM Company analysis of pension funds performance over the same time frames.

This year we have assembled a broader sample of 90 hotels in the UK, including 14 in London, with full financial data over the last 13 years (1992-2005). In line with the results from previous studies, the return on investment achieved by this more comprehensive sample was higher compared to the return achieved by pension funds investing in UK property over the same period.

From an investor's point of view, these findings should justify a closer look at hotels as an asset. In particular, UK life and pension funds should consider UK hotels as an integral part of their property portfolio.

Summary of Findings

Pension funds and insurance companies account for 84.0% of UK funds under management which in 2005 totalled £2.0 trillion. The majority of funds are invested in bonds and equities with property portfolios representing only 4.9% or £98.8 billion.

While the equity market historically provided access to the UK hotel industry, the demise of several listed UK hotel companies in the past few years through mergers and acquisitions has limited the range of investment vehicles, particularly for larger funds. Life and pension funds now channel investments via private equity and property funds and, more recently, via dedicated hotel funds. The development of the UK REIT market over the next few years should also provide an alternative investment route.

To illustrate the potential rate of return of investments in the hotel industry between 1992 and 2005, we have looked at the performance of 90 hotels representing nearly 18,500 rooms across the UK. We have adopted the same approach as in our previous study in order to calculate a return on a basis which would be appropriate to the needs of institutional investors. However, certain adjustments have been made, including provisions for a management fee and a reserve for normal renewals and replacements.

We then appraised investment performance using two methods:

• a simple income yield, calculated on a notional historic (1992) investment
• the internal rate of return (IRR) method, which takes into account the relative values of investment income over time, and reflects changes in the value of the asset.
• The table below summarises key results based on the broader sample of 90 hotels compared to the results of the previous PKF study which was based on 25 hotels.

Summary of investment returns

The simple income yield approach indicates an average annual nominal return of 13.2% over the 13-year (Period 2) compared to 17.5% over the previous 15-year period (Period 1). Nevertheless, with inflation averaging 7.2% in Period 1, real income yield in Period 2 was slightly higher at 10.9% compared to 10.3% in Period 1. Meanwhile the IRR in Period 2 at 10.1% is less than half the 20.5% in Period 1. Although this may seem a dramatic drop, it must be noted that average inflation was higher in Period 1 which necessitated higher return premium.

Based on an assumed initial capital outlay and exit multiples of eight times adjusted earnings, annualised capital return from hotel assets was at 3.1% in Period 2, taking total nominal return to 16.3%. This compares favourably to the 12.3% achieved by UK pension funds from property investments which include both capital and income. This result is noteworthy given the UK property market was particularly strong between 2000 and 2005 while, over the same period, hotel companies suffered from the impact of a series of geopolitical events including the 9/11 attacks, foot and mouth, SARS, the Iraq War and the London bombings.

Despite higher risks associated with the sector, hotel assets still provide better returns than other UK property over the longer term. Hotel companies are more adept at managing operations in an era of uncertainty so we expect future profits and investment return to remain high. The hotel transactions market is also more liquid with greater availability of larger assets/portfolios and more transparent valuations that has historically not been the case. With more funds looking to invest in hotel assets, we anticipate greater demand. And lastly, although outside the scope of this study, the diversification benefits of adding this asset type to the property portfolio should also be taken into account.

UK hoteliers experience further falls in March | PKF Reports Monday 27 April 2009