Hotels as an alternate investment class, how hotel performance compares to other core real estate

Our next presenter is Glenn Boltwood, CEO and co-founder at Serene Capital.

Glenn has over 25 years experience in the real estate investment management and property industries.

His presentation topic today is hotels as an alternative investment class, how a hotel performs compared to other core real estate.

Welcome to the presentation, Glenn.

Thanks very much, Angelina.

And thanks everyone for tuning in today.

I thought I'd start off by talking about hospitality spend.

And hospitality spending includes accommodation hotels, as well as spending in cafes and restaurants.

And as you can see on the slide here with the red dotted line, hospitality has been one of the fastest growing consumer segments since December 2018, up until now.

And that growth is continuing to happen.

The other interesting thing about hotels when we compare them against other forms of commercial real estate is that hotels are a good hedge against inflation.

The slide here shows the last time we had major inflation back in the 1980s.

And as you can see, in every state and territory in Australia, average room rates far outpaced inflation at that point in time.

If we move to more recent experience, what we're seeing today with inflation

STR have stated that capital city hotel average room rates have grown over 30% since 2019.

So again, well outpacing current inflation levels.

It's interesting to understand not only how hotels perform against other commercial real estate from a performance perspective, but also from a risk perspective.

And as many of you on this podcast will understand,

that generally speaking, the higher you go up in quality in office, generally it's considered the lower volatility, because during difficult leasing times, there's generally a flight to quality.

Interestingly though, with hotels, it's actually the inverse relationship.

The higher the quality of hotel you go up, the more volatile the income stream.

And we saw this very much in the global financial crisis where five star hotels

actually suffered more than four and a half star hotels.

In that period of time, corporates who travelled to these hotels were afraid to stay in five star hotels and stayed so paid a higher average room rate in four star hotels because they didn't want to be seen to be living it up when they were making significant redundancies at the time.

Another important thing when we compare hotels to other forms of real estate

is talking about yields.

And many of you will understand about cap rates and yields, but it's important to note that when a headline yield is, I guess advertised at say 7.5% for a hotel, it means very different things to a 7.5% yielding offers.

And so what I'm trying to show here is what the true yield is, what you actually get paid.

In a hotel, a 7.5% yield

actually equates to an 8.14% yield.

And the reason being is hotels have a sinking fund, which is actually subtracted from the actual real yield, which funds capital expenditure.

In the face office yields, we don't have this.

In addition, there's a bit of smoke and mirrors in the office markets, because the face yield assumes that firstly, the property is fully leased.

But secondly,

it excludes major material items that can affect the true underlying yield, such things as incentives and in Sydney CBD at the moment, these can range anywhere from around 35 to 40% plus of your gross face rent, which you actually don't get necessarily if it's provided in a form of abatement.

In addition, there's leasing commissions and also office doesn't allow for a vacancy factor.

So in this analysis, I've assumed

a modest 10% vacancy over the long term.

When you take that all into account, the true yield that an investor is getting over the long term actually only equates around about 3.65% versus the headline 7.5%.

So what this means is really in hotels, if you're targeting a 10% total return, the majority of your return is driven by income, generally about 80%.

Whereas if you're looking at offers,

then you need a significant amount more capital growth to actually generate a 10% return on a like for like face yield.

So you really need to think about apples with apples as opposed to apples with oranges.

The other thing that's different between other forms of core real estate like offers, retail, industrial versus hotels is that core real estate, the top 20 owners generally control about 80% of the stock or ownership in major markets.

And so generally what you'll find, which is what we saw in 2019,

was that all these big parties were chasing the same types of real estate at the same time, which meant that yields in office and industrial went down as tight as 4% or for prime industrial sub 4%.

And now we're seeing when all these parties can't buy real estate today, that we're seeing a dramatic shift in the investment markets with cap rates or yields softening materially, creating a massive amount of volatility in pricing.

With hotels,

There's very few hotel owners that own more than one hotel.

It's quite a fragmented ownership.

And most of these hotel owners are unwilling hotel owners.

There were developers who got convinced to build a hotel as part of a scheme.

And when they went to sell it on completion, they realised they couldn't even get their money back.

And so have had to hold onto these hotels.

And generally as a result, we find that because these owners don't act and have different drivers,

we can actually buy value right throughout different market cycles.

It's important to understand that hotels have different risk premiums as well, depending on where they're located.

And so unlike office, retail or industrial, where you might go into a single asset syndicate, I wouldn't advise that in hotels, you definitely want a portfolio to manage diversification and volatility.

If we look at leisure hotels, which we don't invest in, such as Cairns, generally you might only have three different demand drivers, domestic leisure, international leisure, and meetings and conferencing business.

If one of those segments isn't performing well, it's very hard for the other two to then make up.

And so you're under that difference.

And so you have a lot more volatility in income streams in those hotels.

Whereas if you actually go to a more corporate infrastructure focused hotels, generally speaking, they might have eight or nine different demand drivers.

And so when one of those is not firing, the other seven or eight can generally offset that through growth.

And therefore you find that you have a lot less volatility in that income stream.

So what is Serene Capital's approach to reducing volatility in hotels?

Well, firstly, we've developed a strategy that's really designed or was designed to withstand a global financial crisis type event.

We saw in the GFC that markets that had a lot of exposure to international demand sources, such as international leisure or corporate, suffered significantly during the GFC, the likes of Sydney and Melbourne.

Whereas those domestic marksman, Canberra Perth, actually didn't really miss a beat during the global financial crisis.

And so our portfolio was really designed about around a domestic focus portfolio.

In addition, as we spoke on the previous slide, diversification is key in terms of not only multiple demand drivers, but geographic locations.

A lot of investors, especially offshore investors, they come to Australia and they say, we want to be in Sydney, Melbourne, whether that be hotels, office, retail, industrial.

The reality of it is Sydney and Melbourne are 90% correlated.

So if you're invested in Sydney, you're effectively already invested in Melbourne.

So going into both markets doesn't actually create too much diversification.

The other thing we focus on to withstand that GFC type event

is hotels that have what we call sticky demand drivers or demand drivers that don't run through economic cycles or actually improve during a recession, such as government.

So heavily invested in assets underpinned by defence, where spend is only going one way in the next 10 to 20 years, health, major infrastructure projects, heavy industrial and education sources.

And we find that during these periods,

of economic uncertainty, these demand sources are fairly stable in terms of their travel patterns.

High yield and the majority of the income being driven by, or total return being driven by income return is very important for us.

We're not banking on cap rate compression.

We want to actually deliver 75 to 80% of the return out of income alone.

And then very importantly, we like to buy assets

generally below and well below replacement cost.

And the reason for this is that if supply does come in, they generally, those parties will need a much higher return to actually generate a profit.

So as a result, they need to charge higher rem rates, and then we can bring our assets up underneath them and get some income growth.

Now with hotels, I mentioned before that they're not as institutionalised as some of the other core real estate segments.

And therefore these returns in blue are actually our hotel fund returns, because there is no index for hotels.

And the orange returns are the MSCI index, which is a mixture of wholesale, retail, commercial offers, industrial and diversified funds.

And you can see that over the last nine years, since this fund was established,

that we've outperformed the core real estate markets, despite having to go through two years worth of COVID restrictions.

I'll stop here, but brief snapshot on our fund.

We have applications closing end of March.

If you want more information, please contact us or visit us on our website, www.serenecapital.com.au.

Here is our disclaimer and otherwise, thank you very much.

Thank you for your presentation, Glenn.

Do you have time for a few questions?

Yes, certainly do Angelina.

Thank you.

Generally, travel has been considered as a questionary spend in nature.

Why is hotel accommodation continuing to grow despite high interest rate and inflation?

Look, there's a few structural tailwinds for hotels at the moment.

And the first one really started back in 2009, just post the global financial crisis.

what we saw was a massive shift from consumer spending away from goods retail into experience and services retail.

And at the time, and I still do, I really put that down to the mass uptake of social media.

Everyone already had their Louis Vuitton handbags or their flat screen TVs.

So to get the likes they wanted, they needed new and novel experiences.

And that really allowed travel to take off globally.

The second structural head tailwind at the moment is around, especially in Melbourne and Sydney, work from home.

Many people are still working from home two to three days a week.

And so there's no escape now from work when we go home.

And so what we're finding is that more people are actually taking longer and longer holidays to get away from home and have that mental break.

And then the third thing is the younger generation.

This illusion about cost of housing, a lot of the younger generation are choosing to experience life and travel as opposed to buy a house.

Is demand for hotel accommodation more valuable than other core real estate sectors?

Look, we did a lot of study a while ago on this, and what we saw was that from 1989 up until now,

There's only been two times where demand for the top 10 markets in Australia has actually declined.

One was in the GFC, where total demand in that year only declined by 1.2%, which is nominal compared to office or industrial declines over time or retail spend.

And then more recently in COVID.

And that wasn't so much a demand decline, it was more the fact that the governments wouldn't allow us to travel and borders were shut.

So from that perspective, despite major demand shocks, such as we had bird flu, we've had other economic crisis, demand has generally been fairly stable and continued to grow over that 30 to 40 year period.

Thank you, Glenn.

No worries.

Thanks, Angelina.

Really appreciate your time.