What drives investment in luxury hotel assets? Is it the perception that this asset class is more stable and therefore could provide a more consistent level of return? Is it because luxury hotel assets can deliver higher returns than other investments? Or is it that the desirability and scarcity value together evoke an emotional attachment that ultimately entices investors?

There are clear links between economic activity/prosperity and visitation on a luxury hotel’s performance, and ultimately on the decision to invest in these assets. But these are not the only reasons. There is evidence to suggest that luxury hotel assets do not necessarily deliver the highest returns when compared to, say, other property investments. However, there may be other elements, such as desirability and status, that could well be influencing factors.

The economics of it all

Global economic conditions have been buoyant over recent years, with sustained levels of economic growth combined with periods of relatively low inflation and interest rates. Globalisation and the relaxation of business restrictions in countries like China and India, together with high oil prices, have effectively given rise to the phenomenon of sovereign wealth funds, and together with low cost airlines have all contributed to increased economic activity on a global scale. It is therefore no surprise that the UK has benefited from this, given its position as one of the leading economies in the world with a truly global financial capital in London.

The economy has been generally buoyant, as evidenced by strong global growth in GDP, an increase in wealth especially among the middle classes, and an increase in global travel. As inflation continues to remain at relatively low levels and with the freedom of capital as it is, this has led to a culture where arguably higher risk takers can be rewarded especially in the short to medium term. It was only following wider geo-political events such as 9/11, the Iraq war and July 7 bombings, that the returns from investing in the stock market were less than those of savings accounts.

Invariably, economic growth implies higher levels of business activity. This in turn has created jobs, and with employment comes higher levels of disposable income – especially in periods of relatively low interest rates. In other words, households are encouraged to spend.

Hotels are ultimately dependent on the level of visitation that a country receives, whether it is for business or pleasure, nationally or internationally. Global and in particular UK overseas visitation has been at buoyant levels in recent years. This could be attributed to the advent of low cost airlines together with increasing globalisation. In addition, as net wealth has increased, in the ‘cash rich time poor’ society that we live in, it is not surprising that the ‘short-break’ phenomenon continues to thrive.

Visitation is somewhat influenced by wider geo-political events, evidenced by the slight downturn in the UK in 2001 and in global performance in 2002. However, evidence suggests that the underlying market fundamentals remain strong and as such visitation bounced back in the latter years. Overall global tourism grew by a compound annual growth rate (CAGR) of 4.3% between 1997 and 2006 compared to 3.2% for overseas visitors to the UK over the corresponding period as domestic travel remained at 1997 levels.

Measures of UK luxury hotel performance

In the following table we set out the performance of luxury hotels in London – defined as hotels with a five-star rating – between 1997 and 2006, identifying key performance indicators (KPI).

As illustrated above, UK luxury hotels have performed consistently well over the years as rooms yield increased by a CAGR of 2.2% between 1996 and 2006. Although this demonstrates strong market fundamentals, it also indicates the influence external factors can have on hotel performance, such as wider geo-political events, as highlighted on the next page.

Economic relationship

It can be argued that in most instances the economic prosperity of a country will have some impact on the lifestyle, disposable income and therefore the level of visitation. The following diagram should reveal any clear links between economic growth and visitation to the UK.

The above graphs suggest there is some degree of correlation between UK GDP growth (economic activity), and visitation. However, this relationship strengthens when compared to global growth. Correlation between UK GDP growth and overseas visitation is negative, with global GDP having a higher correlation to overseas visitation to the UK. This suggests that the UK is influenced, at least to some degree, by changes in global economic activity.

It is not surprising that there is some positive correlation between local economic activity and changes in domestic visitation. In addition, world economic activity also influences patterns of domestic travel, especially given the UK’s influence and exposure to global economic activity. However, I believe that the low correlation could be influenced by external factors that are not necessarily related to economic activity.

Hotel performance relationship

It could be further argued that, by extension, economic prosperity and a stable investment climate should be an impetus for growth in a hotel’s performance. In the following diagram we explore this relationship, posing the question ‘Is a hotel’s performance (in this case measured by % change in rooms yield) impacted by changes in the economic environment?’

From the scatter diagram and the derivation of correlation co-efficient above, we can infer that economic activity does influence a luxury hotel’s ability to improve its rooms yield and therefore profitability. However, it is not the only factor. We can further test this relationship by looking at the link between visitor numbers and hotel performance. This is in effect an acid test of our findings above.

Although there appears to be some correlation between overseas arrivals and growth in hotel performance, there is a slightly negative relationship with domestic visitors. This is not surprising given, generally, the higher propensity of overseas visitors that stay in luxury properties when compared to the more price sensitive domestic market. However, it does reinforce the fact that hotel performance is ultimately influenced by geo-political events.

Conclusion - What therefore drives investment in luxury hotel assets in the UK?

We have illustrated that, although economic activity influences visitation and therefore hotel performance, these are not necessarily the only factors. This is particularly true in situations where the market dynamics are shifted following external ‘unique/one-off’ factors such as geo-political events.

Below we look at the level of returns hotels have delivered in the past – measured by property yields – and compare this to other property and equity returns over the corresponding period. It should be noted that returns are defined, for the purposes of this report, as changes in capital value.

The graph above clearly shows that property returns have been on the rise in recent years following a downturn between 2000 and 2003. This reflects the impact of wider geo-political factors and also highlights the resilience of the markets as average returns continue to increase in the following years.

Clearly, over time, funds in savings accounts will have accrued the lowest level of return as savings rates offered by banks are more or less between 25 and 75 basis points over and above the base rates. Although this may appeal to a risk averse investor, clearly the willingness to take risk has demonstrated that it can deliver higher returns, at least in most instances, given the right market conditions.

Following the events of 9/11 hotel yields have gained steady ground, being at competitive levels since 2003, making this type of investment a true asset class. Previous apprehension, due to what was perceived as a cyclical asset and lack of information, were the key drivers in under investment in this type of property in the early years. However, with the ‘divorce of the bricks from the brains’, i.e. separating the property ownership from the operation, this has led to renewed interest throughout the sector.

This is particularly evident in the luxury hotel sector in the UK where yields have been at relatively good levels. Admittedly the relative lack of new supply has had some impact on this sector in terms of increasing its scarcity value. However, is it the best asset class to be investing in? Evidence, as set out above, clearly indicates this is not the case as investments in retail, office, care and equity have typically outperformed this asset class. We have established a link between economic activity and visitation on a luxury hotel’s performance, but these can arguably be considered not strong enough to fully influence this decision. This therefore suggests that there are other seemingly invisible factors that do influence investment in luxury hotels.

The cachet that is attached to luxury hotels and their appeal to a certain social demographic give us an indication that there must also be some sort of emotive element associated with investment in these types of properties. Although this could very well be strategic, it could also be derived from its potential to be a ‘status symbol’; thus, one might even consider using the term ‘trophy asset’ when referring to prime properties in this asset class. Perhaps this is best illustrated by examples of recent trades in the UK, including the Four Seasons Park Lane, London; The Savoy, London; Bovey Castle, Dartmoor, and Westin Turnberry Hotel, Scotland.

As such, it could be said that although the expected returns do have some impact, it is perhaps also the desirability, and associated scarcity value, that may ultimately influence the drive for investment in a luxury hotel asset.

In addendum: The impact of the current economic crisis on luxury hotel assets

It is clear that the current economic crisis will threaten hotel fundamentals at all levels although this impact, given recent performance data, seems to be delayed. Traditionally luxury hotel assets tend to weather economic downturns better than their counterparts of a lower standard, with perhaps, the exception of budget properties. This is clearly highlighted in the long term trends above with the rooms yield of luxury properties not fully tracking (correlated with) GDP performance. It can therefore be said that whilst the performance of luxury hotels’ is not fully insulated from the dynamics of the wider economy, any influence tends to be softened by other factors unique to their target market and positioning.

The impact on yields tends to be more difficult to fully gauge as during periods of economic downturn a lower number of transactions tend to take place (as is evident in the comparatively slow transactions market in recent times). Yields, in line with the market, can be expected to be spread outwards albeit at a lower rate compared to say mid-market properties. However, the breath of this spread will be determined and ultimately is narrower should the hotel be located in say a key location benefitting from the reassurances a strong brand offers. Indeed in cases where the asset is a recognised trophy asset, evidence suggests that yields tend to remain on the low side, a recent example of which being the Grosvenor House Hotel, London which is attracting bids in excess of £700m. Once again a clear illustration that perhaps the motive in acquiring luxury hotel assets, even in turbulent times, is a combination of not only financial returns but also desirability.

Download a PDF which shows the graphs in more detail.

If you have any questions about this article, please contact Govinda Singh.