Real Estate

Don't Fall in Love with Your Asset$!

By Jonathan B. Sebbane ~ Consulting and Valuation Analyst at HVS New York

Monday, 10th September 2007

Today in our industry, nothing is meant to last forever, and this is true of hotel ownership -

Industry trends in terms of corporate strategy, we clearly notice that most major hotel firms are gearing toward an asset-light approach to remain competitive.

From a global perspective, the hospitality industry has seen an exceptional level of transaction activity, changes in hotel ownership, and new management structures over the last five years. One of the main factors that stimulated these key trends is probably the split between hotel ownership and hotel operations. Indeed, publicly quoted hotel operating companies are selling owned properties and concentrating on core business as they continue to recover from real estate cycles. This strategy allows them to lighten their balance sheet, gather capital to finance international growth, and execute share buy-backs, thereby increasing their share price.

According to Steve Rushmore, President and Founder of HVS, 2006 was a "Good Time to Own Hotels in the United States" as hotel values continued their rapid growth and both occupancies and room rates escalated and capitalization rates declined. HVS research indicates that in 2006 there were 249 hotel transactions valued at more than $10 million, up from 237 in 2005, with the average price per room rising to $203,000 from $160,000. The HVS 2006 U.S. Major Hotel Transactions Survey also shows that in 2006, the ten largest sales by price per room reflected an average of $874,000. Moreover, of the sales tracked by HVS, 17 had a price per room greater than $450,000, with the largest portfolio sale being Host Hotels & Resort's acquisition of 33 hotels for $4.1 billion.

In 2006, public companies, including hotel operators, continued to be net sellers. Large hotel companies, such as Marriott International, InterContinental Hotels Group (IHG), and Hilton Hotels Corporation, continued to sell assets in order to raise capital and meet stock market expectations.

As a matter of fact, companies in favor of a separation between "bricks and brain" pointed out that the stock market is more likely to better value hotel companies with less ownership than those involved in real estate. According to Mark Abramson, former Senior Managing Director at New York-based investment bank Bear Stearns & Co., Inc., the need to divest real estate was understandable since the public equity market was not rewarding hotel companies for the value created in these assets to the same degree that private equity and hotel REIT investors were willing to provide.

Nevertheless, questions remain: Should public equity markets own hotel companies? For how long will these companies be listed on a major exchange? We should now examine both buyers' and sellers' (hotel operating companies) value drivers and focus on the potential pitfalls of asset-light strategy for hotel companies over the long term.

Selling the Family Jewels

In 1993, Marriott Corporation decided to split up its hotel business by creating two different entities: Host Marriott (now Host Hotels & Resorts) as the largest REIT owner of luxury and upper upscale properties, and Marriott International. The objective was to manage and franchise hotels and operate the management services and distribution businesses[1]. At that time, most hotel chains still believed that one way to grow was to add real estate to their "collection." Nowadays, the hotel industry has changed, and major players have made concerted moves, focusing on the higher-margin operating business.

However, the gains from the sale of these core assets are one-off, and it could take years or even decades to recreate a portfolio of owned properties of the type that major hotel chains have recently sold. In 2006, public lodging companies dominated the seller side, demonstrating the asset-light trend, enabling each stakeholder to focus on core skills. As noted by Gisle Sarheim, Vice President at HVS, New York, "while the traditional 'own/operate' model has proven successful for small private hotel companies, it has become a hurdle for larger public lodging companies."

However, over the long term, one of the major risks for hotel groups applying asset-light strategy might be the loss of control of their assets. By taking a hotel operating firm private, investment vehicles such as private equity firms could take over control of management agreements, hotel chains' only bargaining power, and unencumbered properties. Recent transactions include the sales of the famous Hilton Metropole and Hilton Birmingham Metropole for GBP 417 million. According to Robert M. La Forgia, Executive Vice President and Chief Financial Officer of Hilton Hotels Corporation, Hilton's asset sale program has delivered more than $2 billion in proceeds since early 2005.

In addition, he added that consistent with Hilton's strategy to grow the managed and franchised business and reduce hotel ownership, the company intends to place additional hotels on the market; for example, Hilton recently agreed to sell ten properties throughout Continental Europe to Morgan Stanley Real Estate Fund for approximately $770 million. As many hotel chains aligned with the asset-light approach, Hilton Hotels Corporation used the proceeds from sales to pay down debt and lighten its balance sheet. Such transactions usually allow hotel chains to regain large amounts of money to capitalize on opportunities and soften debt as a means of improving debt/equity ratios, earnings multiples, and returns on investment.

In fact, major listed hotel chains require a constant flow of capital to meet equity market expectations and maintain a solid credit rating. This is the case with Marriott International, Inc., which focuses on management and franchise contracts, investing where expected returns exceed the cost of capital, selecting real estate development or temporary ownership to enhance management agreements, and recycling capital as part of its investment philosophy[2].

Figure 1 - Debt/Equity Ratio for Major Hotel Chains as of January 2007

Source: Reuters as of January 2007.

As illustrated in Figure 1, most hotel chains have debt/equity ratios below the lodging industry level, except Hilton Hotels Corporation, which completed a leveraged acquisition of Hilton