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Budget vs. Luxury Hotels


30 September 2010
The Inherent Differences from an Investor's Point of View

By Harmen de Jong, Consultant, PKF The Consulting House

Much has been said about the viability of the budget hotel market in Dubai and the wider MENA region.
But what are the differences between budget and luxury hotels and what market dynamics drive their
respective performance? The underlying fundamentals are either driven by the investor or the market as
illustrated in the exhibit below.

The following article describes the underlying market and investor driven fundamentals for each market
segment and aims to answer the question of what hotel investors should look for.

Composition of the MENA Lodging Market vs. Europe and the US

The most straightforward argument in favour of investing in a hotel is a perceived supply gap for a certain
type of hotel category in a market. In a maturing market, a common way to project a potential supply gap
is to compare the composition of existing lodging supply with more mature markets such as Europe and
the US. This argument is further illustrated by the following graphs.

The market share of existing budget hotels (Economy + Midscale w/o F&B) appears to increase as a
lodging market matures. Arguably, the budget hotel sector in the MENA region has room to grow until it
reaches supply levels of the luxury segment, potentially indicating a market gap and future opportunities.
In relative terms, Europe has more than three times as much as hotels that cater to the budget end of the
lodging market whilst the US, as the most mature market, contributes eight times more hotels in this
segment relative to its Middle Eastern counterpart.

Emerging vs. Mature Destinations

As lodging markets mature, they tend to experience a declining ratio of luxury properties compared to
other hotel categories. The history of many well established tourism destinations indicates that initial
marketing efforts and destination positioning were predominantly targeting the higher (upscale/luxury) end
of the market. Classic examples of such destinations, which subsequently catered to a wider spectrum of
travellers, are Egypt, the Spanish Riviera and many Austrian winter destinations. The following graphic
aims at positioning the maturity level of Dubai's lodging market among other global lodging destinations.
The main reason for new tourism destinations to initially cater to the higher end of the market is the
expectation that new destinations will attract touristic "explorers" and that these typically higher income
tourists spend more than their lower income equivalents. In many cases the strategy to develop the upscale
segment of the hotel sector in a new market first, is driven by a mandate which falls under the
responsibility of the Ministry of Tourism. Examples include Mozambique and Oman that position away
from mass (budget) tourism and almost exclusively cater and position themselves as a fresh adventurous
destination for the well-off to preserve natural resources. In short, the destination's position in the market
cycle is of significant relevance for investors that consider entering a lodging market.

Risk and Return Characteristics

A further characteristic, which differentiates budget and luxury hotel properties, is the respective return on
investment for either hotel type. The total financial return a real estate asset can achieve (holding period
return) is a function of the cash flows generated by its operations and the value appreciation of the
underlying real estate asset.

The difference between holding period returns from luxury and budget hotels is that budget hotels tend to
derive more value from operations (higher annual yield), given a leaner cost structure based on lower
capital investment, land cost and staff-to-room ratios. As a result, budget hotels generally achieve higher
operating returns, leaving more for the bottom-line. Luxury properties tend to derive more value from
property appreciation, as luxury hotels are often located in prime business or tourism areas and occupy
iconic landmark buildings. Such assets, especially if they are located in a market with high entry barriers,
tend to appreciate more in value than a budget hotel located in a suburban or industrial area. The following
graphs illustrate the difference in contribution of the value drivers between budget and luxury hotels.

Luxury hotels provide additional value benefits as the hotel brand and its perceived value can be extended
to other real estate components such as branded residences or offices. In Dubai, examples include private
residences by Armani, The Address and The Fairmont Palm Jumeirah, which all achieve significant sales
rate premiums over comparable non-branded properties located in the same area.

However, returns should never be analysed without taking into consideration associated risks. The cap rate
is a well accepted measure to compare the risk levels of real estate assets. Due to the lack of data in the
MENA region cap rates achieved in the US are presented in the table below.

Investors consider luxury hotels a less risky asset relative to budget hotels as entry barriers are usually
higher in the luxury segment. Studies show that luxury hotel properties are more often situated in resort or
urban locations. These locations are characterised by a lower number of available sites for hotel
development compared to development areas typical for budget hotels, typically in suburban locations,
along highways or in close proximity to airports.
along highways or in close proximity to airports.

Another reason why investors consider luxury hotels a less risky investment can be attributed to the higher
hurdle rates that are required to justify the increase in development costs for luxury hotels due to extensive
facilities and amenities such as meeting and function space and a variety of F&B outlets. A higher
feasibility hurdle rate requires higher occupancy levels and average rates before a newly proposed luxury
hotel development is economically justified.

Current Economic Environment

The current economic environment had a substantial impact on hotel investments in today's market. Loan
to value ratios have dropped compared to 2008 and due to the lower capital required for budget hotels
relative to luxury hotels, it is more likely that investors qualify for loans pertaining to budget hotels.

Looking at the demand side, it is common that corporate travel budgets are trimmed down during
recessionary periods. These changes are likely to favour budget hotels. Nevertheless, in general hotel
investors take a long term view as the useful life of hotels extends beyond the economic cycles of
recession and recovery.

Conclusion

Considering the property value appreciation component of the holding period return, luxury hotels tend to
be more substantial than budget hotels. Thus, investors in luxury properties may have to hold on to their
asset for a longer period of time to reap the full value potential. This is especially true when the luxury
hotel has been acquired at the height of a bull market. In addition, higher entry barriers inherent to the
luxury hotel segment provide existing hotels in that segment with a greater window to generate a return on
investment. Therefore, luxury hotels appear to be suitable for investors with a longer term horizon, such as
insurance companies and pension funds.

With respect to risk and return objectives, investments in budget hotels are sometimes considered riskier
than investments in the luxury segment not least as they have lower barriers to entry and thus
competition. This reflects in lower cap rates for luxury hotels. Consequently, budget hotels can have
frontloaded holding period returns and tend to be a better match for hotel investors with higher risk
tolerance and a shorter investment horizon.

Looking at the market related investment criteria in this article, Dubai provides a good example of budget
hotels currently being favoured over luxury hotels. The maturing nature of the destination, the perceived
oversupply of luxury properties and their difficulty to attract debt capital currently focuses investors
towards budget properties, not least as there is still a good market gap for branded supply as opposed to
non-branded properties which are the real victims of this market shift.

The author, Harmen de Jong is a Consultant with PKF The Consulting House, business advisors to the
hospitality and property sectors based in Dubai and operating under the oldest established brand name in
the industry. Their services are focused on the needs of owners, investors and developers of hotel and
tourism related real estate projects. Core services cover real estate strategy, fully fledged project
development management, business valuation, operator selection and feasibility & market studies. For
details please refer to www.pkf-tch.com.
© Zawya Select 2010
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