Those of you who’ve been following me for a while have noticed that I absolutely hate hotels in every way shape and form (search @therealestateG6 and “hotel” or “hospitality” on Twitter and you’ll see I was talking about hotels and even predicted the NYC hotel market decline far before coronavirus ever hit). It’s about time I laid it all out and told you why.
Let’s start at the top. Hotels aren’t even really a real estate investment. They’re an entire business on top of the real estate. It’s probably easiest to look at this by comparing to other forms of real estate.
To make it simple, we’ll compare to multifamily.
“Leases” – For a multifamily building, you typically sign year long leases with your tenants. For a hotel, these “leases” (hotel stays) are only a few days. This makes hotels an absolute nightmare both because the management becomes far more time intensive and because your revenues could drop off a cliff tomorrow and there’s nothing you can do about it. On the management side, since the leases are day-to-day, you have to build out revenue and forecasting systems to predict the revenue not only for the next few months, but for something as close as the next few days! This is absolutely insane. These systems are also incredibly complex and take a ton of time to get right
With multi, since the leases are a year long and the expenses are more consistent, you can build a budget at the beginning of the year and be relatively certain (absent an absolute crisis) that it will be accurate. With hotels, you have no idea what is going to happen. Do you have a hotel near Madison Square Garden? Did the New York Rangers not make the playoffs? Congratulations, your YTD revenue is now down 20% from last year (when tons of people traveled to their playoff games), through zero fault of your own. Have fun explaining to your investors that you’re not going to be able to make distributions this year because Chris Kreider couldn’t figure out his slapshot.
Did a new hotel open up across the street? Congratulations, you’re now in a rate-cutting war with your neighbor. New hotels typically enter the market with below market rates (rates are simply the amount you charge for a room night). That means they start off being unprofitable to build their business to eventually be profitable. Since hotels are essentially price takers, your hotel has to match the rates of the new hotel otherwise you won’t get any business. While being unprofitable for a short amount of time was budgeted in the business plan for the new hotel, it certainly wasn’t budgeted in your business plan. Now imagine that three new hotels open up in one year in your relative proximity (this is entirely possible and regularly happens in markets like NYC). That’s 3 months of the year minimum where your rates absolutely crater, which is easily enough to ruin the P&L for the entire year.
Did Sally cancel her bachelorette party because she had a falling out with her maid of honor? Congratulations, those 15 rooms she had reserved are now vacant. Good luck filling them on short notice to make up for the lost revenue.
You get the idea. The common theme here is that none of these events are controllable or even your fault. You’re putting your money into an asset you literally cannot control.
The fact that the “leases” are so short-term leaves you incredibly vulnerable to the forces of the market, which is catastrophic for a real estate business. It also means that you have a very short-period of time to react to negative events. If your revenue drops, then you have to try to “flex” or decrease your expenses immediately to account for that, otherwise your P&L will suffer. This is incredibly difficult to do effectively. Lastly, it means that your management personnel must have an intimate knowledge of the market so they’ll know how certain events (such as a team missing the playoffs or a new hotel opening) will impact both the hotel and the market.
None of these items mentioned above matter for multi since the leases are all longer-term. There’s no quick adjusting necessary because everyone is locked in on a one-year lease (yes they can bail on it but then you can take their security deposit). Events going on in the market (playoff games) don’t matter at all. Supply increases, while dangerous long-term, do not affect the property in the short-term since it takes a while for tenants to move and find another building. The manager can even sit there and be absolutely clueless about what’s going on in the market and it won’t matter. The headache of short-term leases in the hotel market absolutely cannot be overstated.
Staff/Management Personnel – For a multifamily building, you need one manager on site to run the building (depending on how large the building is, there could be more or even less) and maybe one repair man to run the repair process (you could just have a contractor on call as well). A lot of times these people aren’t even on site at all times and work at the property part-time, or even manage several buildings at once. Hotels, on the other hand often need hundreds (and I mean hundreds) of people to run. You have general managers, assistant general managers, front desk managers, sales people, housekeeping staff, revenue managers, etc. So instead of managing a physical building (which is easy), you end up having to manage people (which is both difficult and time consuming). And the type of people you’re managing are all low-skilled, minimum wage workers. It’s like herding cats. You’ll be dealing with sexual harassment claims, employee fights and just general nonsense. And the whole time, you’ll be thinking to yourself “I didn’t sign up for this, all I wanted to do was buy some real estate”.
Role staff is performing on-site – Now, equally important to the number and quality of staff is the role the staff is performing on site. In a multifamily building, the staff is not performing any essential functions at all. Maybe the staff is collecting rent checks, responding to tenant demands, executing small repairs and helping to lease up the building. These are all extremely simple tasks that anyone can perform. And if one of those tasks is not done, it becomes extremely obvious and is relatively easy to correct. For a hotel, your staff is single-handedly running a siloed business within a building. This business is not small either. Yearly revenue for major city hotels with a couple hundred rooms regularly runs into the tens of millions. Since this business is so big, you’d expect the guy at the top of it (usually a “CEO” for most businesses, but for hotels a “general manager”) to be extremely competent. You’d be mistaken. Unless the hotel is absolutely massive, even top end general managers in large cities top out at $150k-$250k. This is roughly the same salary as an investment banking analyst, except that this is the “cream of the crop” of the hotel business at the top of their careers. Needless to say, you will not be getting top tier talent to run your business, since no one who is talented would be willing to max out at $250k in their career. To make matters worse, a CEO typically has some sort of significant equity incentive. This is not the case with hotels. The GM has essentially no equity interest in the property and it’s extremely hard to make them truly care about the property/business the same way a CEO would. Just to really hammer this point in, usually when you buy a multifamily property, the upper level management of the private equity firm (all very competent, making $1MM+) make the decisions that determine the return profile of the asset for your investors. Instead, with a hotel, you’re leaving your investor’s money in the hands of a decidedly less competent person who only makes $150k. You’re doing a disservice to your investors.
Minimum wage exposure – Most of your workforce will be making minimum wage. What does this mean? It means you have massive minimum wage exposure. This may not seem like a big deal, but trust me, it is. Say the state raises the minimum wage from $12 to $15. Only a measly $3 dollar raise right? Shouldn’t be a problem. Wrong. Most of your workforce now costs 25% more. And your revenue stayed flat. You’re in big trouble. Hotel margins are bad enough as it is, but artificially increasing your salary costs (which states will continue to do), will only make them worse. Multifamily buildings do not have this problem as there is minimal staff (if any) and salaries only make up a small percentage of the expenses.
Food & beverage outlets – While we’re on the topic of margins, the only business with worse margins (and a worse business model) than hotels is food and beverage. Naturally, that means that hotels contain food and beverage outlets as well.
As an aside, just to make sure everyone understands this – With hotels, you have the physical building itself you have to manage, you have the business of a hotel you need to manage and you have a restaurant (most of the time several) you have to manage. This is at least 2-3x the amount of work it takes to run a multifamily property. The amount of time wasted managing hotels is nothing short of incredible. Something very few firms take into account is opportunity cost. With all the time you’re wasting managing a hotel, you could buy 2-3 more multifamily buildings, deploy 2-3 times the equity and make 2-3 times more money.
Back to the food and beverage detail – Restaurants take an incredible amount of time and effort to run. But guess what? They’re often “loss-leaders” for the property. This means that hotel operators are often willing take losses on food and beverage outlets that they know will be unprofitable so they can attempt to “drive rate” (increase the room rate) at the hotel. Yes, this should be the stupidest thing you’ve ever heard. To make matters even worse, if you’re operating under a flag or a brand (ex Hilton), you’re often required to run the food and beverage outlets (even though the brand knows it’s unprofitable for you to run) because they’re part of the “brand standards” the flag requires for its customers. The whole situation is so braindead that it’s incredible hotels have even survived for this long. Most hotel investors have wisened up recently and figured out that leasing out the F&B to restaurant operators is easier, but it’s still a horrible process and the operators blow out constantly.
Needless to say, running a food and beverage outlet is not something you need to worry about when operating a multifamily building.
Brands – Speaking of brands, the brand contracts are straight up highway robbery. Contracts sometimes last 20-30 years (no idea why you’d ever sign a contract for that long), with extremely expensive breakage fees and little to no recourse if the brand doesn’t produce revenue/room nights for you. On top of that, they charge a ridiculous amount of fees (can end up being as high as ~10% of revenue all in) and come with the aforementioned insanely restrictive brand standards. The brand standards are nearly always are at odds with hotel performance (as in the case of the food and beverage) and often make you too slow moving in a field where changes occur on a day to day basis, which is obviously not ideal. You can operate the property yourself as a boutique hotel, but then the time spent on management increases enormously.
Once again, needless to say, this is not an issue you need to worry about when operating a multifamily building.
Evolution – The entire hotel experience is moving towards “experiential” type concepts (think Airbnb-type concepts on the extreme end and “boutique” brand concepts on the more basic end). This means you have to continually evolve to stay ahead. This type of evolution – sometimes occurring in the span of months or days (remember, you have no contractual income, so if consumer preferences change on Tuesday, you have to make the switch by Wednesday) is unheard of in the multifamily sector since your contractual income is in place for a year.
The Worst Risk-Adjusted Investment of All Time
Now let’s think about all the reasons why hotels are a bad investment (and markedly worse than multifamily in nearly every aspect).
If you had to guess, what do you think the appropriate spread in returns would be above multifamily? Say multifamily traded at a 4.5% cap rate, what do you think hotels should trade for? An extra 500 basis points? Maybe even more?
You’d be wrong. The spread vs other asset classes is a literal joke. People buy these hunks of junk for a ~100-300 bps spread from multifamily buildings. The worst part is they then tout it as a good “risk-adjusted” investment. Couldn’t be further from the truth.
In return for ridiculous risk and a massive management headache you pick up a few hundred measly basis points tops. To make matters worse, the main reason you’d want a higher cap rate is to have a higher cash on cash return. Unfortunately, cash on cash returns are not hotels’ strong suit. The whole point of a high cash on cash return is that it is supposed to be relatively consistent. Due to the factors mentioned above, as well as how events vary wildly year to year and the inherent seasonal nature of the business, the high cap rate rarely translates to a high cash on cash, and if it does, it varies so widely year to year (one year up, on year down, etc), that the variability makes it extremely undesirable. The next common argument people will throw at you is that hotels are only designed to be flipped. This doesn’t make sense either. You can flip an office building or multifamily building as well and it’s way less risky. And the cap rate doesn’t matter on a flip either (so no advantage for hotels having a higher cap rate), since (holding all assumptions equal) you’d sell for the same cap rate you bought it for. A 50% increase in NOI at a 7% cap rate yields you the same returns as a 50% increase in NOI at a 5% cap rate.
So, in summary, hotels are worse for both cash on cash-focused investing and IRR-focused investing, which basically means they’re worse for all types of investing.
So when people come to you and say “I don’t know what you’re talking about, I made a ton of money on this hotel flip”, believe them. They probably did. But, they could have taken way less risk and made the same (if not more) by flipping a safer form of real estate. As hotel owners have found out from corona virus, risk-adjusted returns matter.