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[#PAFh19] “One of the themes of our investment strategy […] is to be careful not to pile up these different levels of leverage”

Charles Du Breuil, Executive Director, Morgan Stanley Real Estate Investing at the Paris Asset Forum >hospitality.

Where are we in the hotelier en est-on dans le hotel business cycle?

Among all the investment opportunities that we are studying between 2009 and 2011, RevPAR levels were down. What was remarkable is there were two factors that amplified this drop: operational leverage and financial leverage.

10 years have gone by and the environment has changed dramatically. However, when it comes to looking at new investments, it is important to keep in mind that because of leverage levels, things can change very quickly in the hotel industry, in either direction.

It is important to put this issue of leverage into perspective by looking at where we are in the current operational cycle. Let us focus on three major European markets: Germany, the United Kingdom and France.

We therefore compared the 2001 - 2008 cycle with the current cycle using the performance data provided for Olakala_destination. First observation, the current cycle is much longer than the previous one, which lasted 7 years. The current cycle is in its 11th year, it is difficult to predict the reversal although we can see that RevPAR growth has slowed in recent months. It is nevertheless reasonable to think that we are closer to the end than to the beginning. Looking at the absolute performance of RevPARs, performance is well above the peaks of the previous cycle. In Europe on average, we are 21% above the peak of the previous cycle for RevPAR. This is not a surprise given that historically in Europe supply is more constrained than demand, so it is logical that performance should improve. We therefore look at the relative performance of RevPAR. This growth differential (+21% of RevPAR) is slightly higher than the increase recorded in the previous cycle compared to the prior period. The 2008 RevPAR was 18% higher than the 2001 RevPAR.

This average obviously contains very heterogeneous situations from one country to the next and from one market to the next. Looking at the data on a scale of the three selected markets, Germany is probably the most advanced country in the cycle. In 2019, RevPAR is 39% higher than the 2008 peak, while in 2008 it was only 14% higher than the 2001 peak.

The United Kingdom is in a situation quite similar to the one in which it was at the time of the last reversal. RevPAR is 28% above the peak on average in 2008 and it was also +28% in 2008 compared to 2001.

France is less advanced in the cycle than its neighbours. RevPAR is on average 17% above the 2008 peak whereas in 2008 it was 21% above the 2001 peak. In theory, therefore, there are still growth prospects on the French market, unlike its European neighbours. This delay can also be explained by the impact of the terrorist attacks on the growth rate of RevPAR in France.

What is the impact of the levels of leverage on hotel performances in case of reversal?

When RevPAR drops, operational leverage acts as a multiplier of investment performance. For example, for a hotel with 60% fixed costs, if its RevPAR falls by 21% (as was the case in Spain and the Netherlands in 2009), this 21% drop in turnover will automatically reduce EBIDTA by 40%. It therefore appears that the fact of having 60% of fixed costs has doubled the impact of the decline in revenue on EBIDTA.

If we add to this operational leverage - intrinsic to the hotel industry - a significant financial leverage, then the multiplier effect can be colossal. This is exactly what happened in 2009 as mentioned above and continued to have an impact in 2010 and 2011.

Where are we in the financial cycle?

Is the level of debt today similar to that of 2005-2007, which corresponds to when the last valuation peaks were reached? Today we are in a much healthier hotel financing environment than in 2005-2007. At the time, private equity funds investing in hotels regularly set up acquisition structures with nearly 80% LTV. This creates extremely low debt service coverage ratios by default at the time of acquisition.

Currently, leverage levels for "basic" hotel acquisition financing rarely exceed 65%. This reflects both greater caution on exercised by investors and a change in these investors' profiles. There is now a larger proportion of investors who have a long-term strategy and therefore need less leverage to achieve their investment objectives.

In 2007, private equity funds represented 44% of the volumes invested in hotels in Europe, in 2018, they represented only 21%. At the same time, the share of "long-term" investors increased by 60%. Reassuring signals in the event of a reversal: less leverage, cost of debt that has fallen sharply.
The banks' margin level has not changed much, it remains similar to the margin level observed during the previous peak. The base rate is 0 or even negative in some cases, which has resulted in halving of the cost of financing. That is, less funding and cheaper funding.

There are transactions in the United Kingdom that have recently emerged with very high effective leverage following the sale of land to Freehold funds as part of sell & lease-back. Selling the land against a fixed liability, which can represent 10 to 16% of EBITDA, allows the investor to significantly reduce the amount of equity capital to invest during the transaction, but it works exactly like financial debt.

Real estate lever

This data may have a different weight depending on the market concerned. If we come back to the example of a hotel with 60% fixed costs as an owner, we sign a lease with a coverage ratio that is low and a tenant whose credit is recent or moderately established. Rent is an additional fixed cost for an asset class that already has significant fixed costs and cyclical income.
When the market turns around, how much can the RevPAR be reduced so that the tenant can continue to pay his rent? This is the central question for us when we invest. This question is all the more central with the increase in the number of sandwich leases in recent years.

For investments in walls, in the long term we prefer a reasonable guaranteed minimum rent with a relatively large variable rather than attempt to multiply the immediate return by a high fixed amount. Two advantages: protect the hotel owner as much as possible downside and above all as an investor to participate more in the upside and, with the tenant, in the creation of value.

Why is this class of assets attractive?

What we like about this asset class, especially when comparing it with other real estate asset classes, is its long-term growth prospects and the fact that it benefits from secular trends that are positive. If we compare the evolution of overnight stays with the increase in the number of rooms in Europe over the last 10 years, we can see that the number of overnight stays has increased almost twice as fast as the number of rooms. We know that the number of travellers will continue to increase by 2% per year until 2030. While structural supply constraints persist in Europe, we believe that long-term investment prospects are very positive.
To be able to achieve this performance in the long term, it is necessary to be able to retain assets when there is a turnaround, which is why one of the guiding principles of our investment strategy in this asset class is to be careful not to stack these different levels of leverage together.

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