Buying after a down-market cycle is always safer than jumping in at the top of the bubble after a long run up. Hotel revenues hit a historic low in 2020 due to COVID, and commercial property value is based on how much income they make. With signs of recovery from pent-up travel demand and the expectation of continued improvement in the industry, there should be some great buys possible in the next year with some interesting upside to your investment. Per CoStar in a recent article, “people are moving travel and experience up into their hierarchy of needs versus doing anything else with their money.” And hotel executives are generally confident in the demand’s resiliency and industry’s ability to weather another downturn should one occur.

Hotel companies tend to be fairly resilient overall during economic turmoil because demand never usually drops off too severely for too long, not counting pandemics. Certain geographies may be more vulnerable than others, particularly those that have struggled the most to recover from the scars of the past couple of years.

The hotel industry adapted and grew more resilient and innovative during the recent crisis. We all lived through and observed it, COVID changed human behavior around the world. The hotel industry had to quickly adapt to provide people peace of mind and instill travel confidence again in order to win guests back. They marketed “staycations” with food and beverage offerings to locals and established partnerships with hospitals to accommodate healthcare workers. They embraced the concept of working from home, encouraging business travelers to work from their top line rooms while taking advantage of packages including room service and a health or fitness plan. Revenue managers were forced to evaluate which strategies and marketing techniques really drive income. Discounts, for example, did not result in greater occupancy, but rather a stronger focus on client communication resulted in incredible understanding by clients, resulting in return business. Hotel owners were required to reimagine what a socially distanced, safe stay would really look like for customers. This led to an unprecedented degree of versatility, reduced contact, and increased technology and convenience being implemented in every space possible. Finally, hotels reacted quickly to the decrease in expected travelers by cutting internal expenses wherever possible.

Now that hotels across the US have risen to the challenge of facing the COVID pandemic by implementing these sweeping adaptations, they are a fresh and relevant lean running machine, ready to weather whatever is on the horizon. The performance of a hotel is not linked to the stock market or other real estate trends, making them an appealing investment right now.

A hotel is more than a potentially profitable piece of real estate. It is an actively functioning (24 hours a day, 7 days a week) operating business with a real estate component. Hotels derive most of their value from the proven ability to generate cash and the potential to increase income. In fact, the hotel’s robust operational nature is one of the primary reasons you want a hotel as part of your real estate portfolio. Hotel investment differs in a few ways from the Big Four commercial real estate asset classes: multifamily, office, industrial, and retail. The biggest difference is the operational element, which adds risk and uncertainty, but it also offers a slew of additional perks that can make hotel investing more appealing. Below are just some of the reasons you should consider it.

High Return From Operating Cash Flow

The number one reason that most people invest in a hotel is the high yield return that’s associated with this type of real estate investment. The return mostly comes from the operating cash flow. The core source of revenue from hotels is through the nightly stays and day-to-day operations. Every night is another chance to boost income. The opportunity comes in optimizing each additional night’s net earnings per room sold. It is important to have an experienced management team in place.

Sticky Expenses

There are three separate expense categories under the USALI standard hotel financial statement: Departmental, Undistributed, and Fixed. The profit lines that follow each of these represent varying levels of control over them.

Departmental expenses are the costs necessary to provide services for the guest. This category includes costs to service the rooms and provide food & beverage. The majority of these costs are related to labor more than outside goods and services. Undistributed expenses are related to the cost of operating the hotel, such as management, maintenance, general and administrative, and sales-related expenses. These expenses relate to outside goods and services more than labor. Fixed expenses are costs incurred regardless of occupancy and revenue, such as property taxes, site fees, and energy bills.

As you can see, these expenses become more fixed as you move down the financial statement. Some expenses are very sticky and set by outside market forces, like wages and utilities, but most are open for negotiation. This is one of the greatest reasons to invest in hotels. You can negotiate a great deal with suppliers to keep expenses at one price level, while revenue increases on a separate track. As revenue improves, the cost to service the hotel doesn’t increase dramatically. This provides for a healthy increasing profit.

Tax Benefits

Real estate ownership is one of the most tax-efficient methods of investing available. The top three advantages of property ownership in commercial real estate are depreciation, equity growth, and tax-deferred exchange. This applies to all direct real estate investments, but hotels take these three advantages to another level.

Depreciation means the decrease in value over time due to use, wear and tear or obsolescence. As a result, United States tax law allows real estate investors to reduce their taxable income by applying a depreciation expense schedule over a defined timeframe. Hotel investments are unique since they incorporate real, personal, and intangible property. Therefore, investors benefit from more tax laws that may accelerate the depreciation.

Equity growth is important for a variety of reasons, but the most significant tax benefit comes in recapitalizing your investment. Cash equity pulled out from a debt refinance is not subject to federal income tax. Even small improvement of hotel’s operations can boost cash flow and add tremendous value, which is accessible tax-free in this way.

Finally, 1031 exchange is a powerful tool used by so many successful real estate investors. With this tool, you defer capital gains taxes by immediately rolling your funds into another “like-kind” piece of investment real estate. This can increase your income potential and possibly centralize operations into a single, larger-scale property.

Cost Segregation

Hotel investments consist of three major categories for tax purposes: building, FF&E (furniture, fixtures and equipment) and goodwill. The first two – building and FF&E – are physical assets. Goodwill is the intangible value attributed to customer loyalty, employee relations, and other intangible factors that make the hotel successful.

Each of the physical assets have different depreciation schedules. Some sub-categories even have their own depreciation schedules depending on government policy aimed at increasing specific investments. Therefore, a hotel’s operational and capital-intensive nature allow them to take advantage of multiple bonus depreciation policies not available to multifamily, office, industrial, and retail real estate. Cost segregation is a tax deferral strategy that frontloads depreciation deductions into the early years of ownership, which is an important aspect of increasing after-tax income.

Value-Add Potential

The core source of revenue from hotels is through the nightly stays and day-to-day operations. However, one benefit of owning hotels is the flexibility to offer value-adds to increase your income and therefore the property value. These are the areas of value enhancement in a hotel:

• Renovation – Expectations for hotel interiors, style, and amenities are always changing. In many instances, these are purely aesthetic modifications, but having a management team in place that is committed to keeping up with current trends and design will ensure a steady source of income over the long term.

• Operations – Hotel management is a people operation. Customer loyalty and employee engagement have a major influence on the ability of an organization to increase revenue and minimize costs. Many of these enhancements are free or inexpensive, but their discovery and implementation are crucial.

• Contract Positioning – Hotels need a wide range of sales and service contracts with quality operating partners to ensure quality operations. The brand licensing agreement and certain important maintenance agreements might have a significant influence on revenue and profitability.

An excellent investment manager balances the influence of each of these factors while also determining where each hotel requires the most attention. Even the tiniest value-add feature may improve a hotel’s income, allowing investors to profit from value while multiplying cash flow.

The Experience

Owning a hotel or having access via part ownership brings a different reward from that of investing in office or multifamily real estate. You can experience it! You can visit and experience a stay in a hotel of which you are part owner. The ability to welcome your family and friends into a hospitality environment is very rewarding. You spent time building your investment portfolio and carefully selecting real estate investments that support your financial goals, and with hotel, you can share an experience in one of your investments with the people you love.

In conclusion, since overall hotel revenues are still recovering after the historic low over the pandemic and commercial property value is based on how much income they make, hotel real estate can be a great opportunity with interesting upside to the investment. It will be important to be selective about the quality and location of the target asset, and look at how the hotel performed during the pandemic. With consumer confidence in travel back, domestic leisure travel is surging. But as you are aware, investing money in anything, including the stock market and real estate, always involves risk and it is best to look at each asset type and the risks associated with that particular investment. At Bluefox, we believe that hard assets, in particular real estate, is best.

Let’s connect to see how Bluefox Ventures can help you diversify your portfolio by investing in alternative assets like real estate.

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