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By Chris Evans and Claudine Vickery, London

Hotel investment across Western Europe continues to reflect the cyclical state of national economies, while uncertainty remains high as to how global investment may eventually change the industry. As a result, Arthur Andersen conducted a survey among existing and potential investors to create a profile of the hotel investment climate throughout Europe. The survey follows on the heels of a number of similar studies by Arthur Andersen in the highly active U.S. hotel market.

Survey findings paint a portrait of a relatively unsophisticated investment base, yet with a strong prognosis for the future as a Pan - European hotel sector eventually emerges under the twin market forces of globalisation and consolidation. Most respondents reported that they invested on an opportunistic basis and sought properties with "upside" potential, which may justify higher prices, rather than a stable earnings stream. This lack of sophistication was particularly surprising against the current backdrop of consolidation within the industry, but may result in part from the current lack of a truly pan - European hotel market.

The European hotel market business cycle in 1996 reveals an industry in quite dramatically different phases of a business cycle marked by downturn, slump, recovery and growth. In 1997, most countries evidenced an upturn in the cycle but were clearly experiencing very different rates of recovery and growth. The existence of the cycle and the differing positions of the national markets on this cycle have given rise to differences in the level of interest in Europe's constituent national markets among hotel investors over the past 24 months. In recognition of this fact, we have focused our summary of survey results on three of the most important markets in Europe:
the United Kingdom, France and Germany. Each occupies a different position in the business cycle.
 

The United Kingdom

Investment Overview

London drives the U.K. hotel industry, which is generally believed to be at, or close to. the peak of the cycle, but with little downside risk in the short to medium-term. Some acquisitions have been made at particularly high prices. For example, the Hyde Park Hotel was acquired by Mandarin Oriental for £86 million ($136 million) at an approximate price per room of £457,000 ($73 1,000). The Barclay Brothers purchased the Ritz for £75 million ($120 million) at an approximate price per room of £681,000 ($930,000). Nevertheless, many would-be investors have been unable to justify the current prices being asked, and much of the interest among investors remains frustrated.

Institutional investment in the sector has been driven by the availability of stock in hotel companies and not by interest in acquiring hotel assets. During 1996, over £700 million of capital was raised by private hotel companies coming to the London Stock Exchange. Most of this activity was concentrated at the mid-market level. The availability of quoted hotel companies in which to invest provides liquidity and risk management through geographic. management and market-level spread. Investment in quoted stock is therefore a desirable method of investing in the U.K. industry.

Key Points of the Survey

Despite the UK's position at the top of the business cycle and the preference for opportunities with a clear upside potential, there was strong interest in this hotel investment market. In London, the current level of earnings and resultant high prices were a deterrent to deal completion, but only served to heighten the levels of interest. in hotel investment opportunities. Provincial markets have also been experiencing strong market conditions, hut price levels have not been so inflated as to deter investment. As a result, a significant number of transactions have been completed outside London during the past 24 months. Examples of such transactions include the Cameron House Hotel and Estate, which was sold to De Vere hotels for £311,000 ($408,000) per room, and the Colchester Mill Hotel, which was sold to Allied Hotels for £135,000 ($216,000) per room.

There are a number of regeneration projects underway in London, notably Paddington Basin (a 15-minute express link to Heathrow is expected to be completed in 1998), Battersea Power Station, the Great Eastern Railway Station (Liverpool Street) and Greenwich (the focus for the Millennium celebrations). This has given rise to a number of newbuild opportunities outside the traditional four- five-star hotel destinations in central and west London. The London Tourist Board has estimated that there are around 3,100 rooms at all levels currently under construction. Of these, only 30 percent are at the four and five star levels.

While domestic hotel companies have been able to exploit these new development opportunities, overseas chains and investors have been understandably reluctant to enter the UK market outside the established and proven hotel locations. However, there is strong interest. particularly on the part of US-based professional investors, in the UK. Many Real Estate Investment Trusts (REITs) and private companies, which have been so acquisitive in the United States in recent years, regard gaining a presence in the United Kingdom as crucial to their international expansion plans.

In terms of investment appraisal techniques, discounted cashflow approaches such as Internal Rate of Return (IRR) and Net Present Value (NPV) were widely used. Where an IRR was calculated and a hurdle rate applied, that rate appeared to be somewhat arbitrary in calculation. Where an NPV approach was used, few investors attempted to calculate a weighted average cost of capital or to establish a risk adjusted rate specific to the transaction under review.

A number of the banks and investment agencies surveyed took a comparatively simplistic approach to hotel investment. For example, respondents tended to use a single valuation method rather than using a range of methods to provide an indicative range of values. Discounted cashflow methods were not widely used, and where they were used, discount factors tended to be based on judgement rather than on cost of capital plus a risk premium appropriate to the location. Current earnings multiples appeared to be the favoured valuation method, rather than an assessment of earnings potential.

France

Investment Overview

The French hotel industry has continued to suffer from the chronic overbuilding of the late 1980s and the early part of this decade. Not surprisingly, overcapacity has combined with flat domestic demand for hotel accommodations to suppress provincial operating performance. Hotel owners in provincial France, who include many of the country's most important banks, have been unwilling to wait for profit improvement and instead, they have become sellers rather than investors in, or lenders to the industry in the past two to three years.

The economic profile produced by these conditions has greatly influenced the availability of equity capital and loan finance to fund acquisitions. Most of the capital invested in the French hotel sector in the past 24 months has been provided by private, international sources.

There has however, been a discernible up-turn in demand as measured by REVPAR in both Paris and the French provincial markets in 1997. Most industry commentators believe that this will continue through 1998. giving rise to more interest in investment in the sector.

Key Points of  the Survey

Against the background of these general trends, the contrast between both the characteristics and the conditions of the Paris market on the one hand and the French provincial markets on the other, needs to be highlighted. Market performance tn both the capital and the provinces has been poor largely due to the crisis in the domestic economy. However, in Paris, the effect of the Franc Fort (strong Franc) policy combined with, at many hotels, insufficient flexibility with regard to room rates, has led to perceptions of high prices and has deterred many foreign visitors. This has exacerbated the effects of the recession in the domestic economy.

Even so, Paris remains the second most important city in Europe for hotel investors, after London. Parisian hotels available on the market in the past year have attracted global interest among "strategic" or single-asset purchasers. The deals that have taken place have been made at what many commentators would consider "uneconomically" high prices, particularly by reference to earnings, both historic and projected. Nevertheless, there appears to be strong belief in the upside potential following refurbishment, particularly at the so called palace hotels which have changed hands. These hotels have included: the Meurice (terms not disclosed), acquired by the Brunei Investment Agency; the Plaza Athennee, acquired by Prince Jefri (£45 million or $72 million, equivalent to £213,000 or $341,000 per room); and the George V acquired by Prince Al Waleed bin Talal (£104 million or $166 million, equivalent to £424,000 or $679,000 per room).

Outside of Paris, the most notable aspect of hotel investment activity in the past 24 months has been the acquisition of portfolios of hotels, loans and hotel businesses by professional opportunistic investors. As a result of default on the part of borrowers, the French banks and institutional investors have become reluctant owners of hotel companies and hotel real estate. These financial institutions have displayed a willingness to make provisions and accept write-offs against the face value of their exposure. This has provided certain categories of investor with the opportunity to acquire properties at what might he considered "firesale" prices. Normally, such investors are seeking to acquire businesses, at "reasonable" multiples, which offer significant upside potential via a combination of better management, branding and good timing from a market perspective. Such investors, while not technically venture capitalists, share similar characteristics in that they seek high internal rates of return and a clear exit route, either by way of a trade, sale or flotation.

Germany

Investment Overview

German hotels have traditionally been financed under structures involving an owner's leasing of the asset to an operator, with payment typically calculated as a percentage of total capital costs. In effect, the operator underwrites the cost of ownership through the lease payments. The major investors in hotel real estate have been the banks and the open ended property funds such as DCI and Fundus. Many of the banks remain unwilling owners, but the weak performance of other commercial property markets has limited their ability to find alternative investment opportunities. Since the German equity markets are relatively undeveloped, there has been little opportunity to raise funds through public share ownership, as has occurred in the United Kingdom.

Operating conditions have been flat through to mid-1997, but the slight improvement in rates originally noted in 1996 is now beginning to gather steam. Against the prevailing background of lease financing and adverse market conditions, there has been little interest on the part of international investors in acquiring real estate at the prices being asked. Equally, there has been little or no interest on the part of operators in entering into leases that assume all of ownership risks. There has been a certain reluctance on the part of the banks and institutional owners to acknowledge the poor market conditions and operating performances. In turn, they have been unwilling to sell at below the face value of the debt or at a discount to book value. This has largely meant a standoff between potential purchasers and sellers in Germany during the last four years or so.

Key Points of the Survey

Due to the sophisticated debt markets and the relatively undeveloped equity markets in Germany, the cost of debt (approximately 6-8 percent) is higher than the cost of equity (typically 5-6 percent). This is clearly not the case in the more developed U.K. equity markets, where gearing up projects allows a company to reduce its weighted average cost of capital and thus to increase the appropriate investment opportunities. Our survey showed that industry rarely uses a discounted cashflow approach to evaluate hotel investment opportunities, but rather employs an earnings multiple approach based on a capitalisation rate of between 6 and 8.5 percent for a stabilised year.

Another inhibitor of hotel investment activity is the use of the Sachwert method in valuing real estate. This is often described as "bricks and sticks," since it calculates the value of the individual materials used to construct the property at cost. The method addresses physical replacement cost, but not earnings and/or realisable value. The Sachwert method is fundamentally at odds with the appraisal techniques now used by sophisticated purchasers.

Conclusions

Our survey suggests that there is still a notable absence of a sophisticated class of professional hotel owners in Europe. However, strong interest in the European hotel industry is clearly evident among U.S.-based opportunistic investors, some REITs and special purpose hotel investment companies in addition to the interest of strategic investors in individual "trophy" hotels referred to above.

The historic absence of both a network of professional hotel owners, and also a truly integrated pan - European hotel industry,  together with the diverse hotel market conditions in the constituent countries of Western Europe has dictated that the characteristics of hotel investment in the sector varies widely from country to country.

Furthermore, there is strong evidence to suggest that this will change over the next few years. While there is still an absence of pan-European hotel companies, industry consolidation on a global scale continues apace, being driver by the huge volumes of capital now available, primarily in the U.S. The headline grabbing deals involving, for example, Interstate, Renaissance, Westin, ITT Sheraton and Ritz Carlton are far reaching in their effect. Also of significance is the apparently strong interest on the part of the REITS, particularly those with paired-share status, in national hotel companies in Europe and also the new breed of professional hotel owners and asset managers best represented by Strategic Hotel Capital, Inc.

We believe that the tidal wave of new capital being formed in the United States will move rapidly to Europe during the next few years. The combination of corporate and individual hotel asset deals beginning to "dry-up" in the US, the excellent returns which investors in the sector have achieved in recent years, the consolidation of ownership of the industry globally and the availability of a portfolio of risk-profiles between European countries is beginning to whet the appetite of many US-based investors, in some instances for the first time ever.

This will give rise to the emergence of a more professional approach to acquisitions of, and investment in, hotels and hotel companies on a pan - European basis than has hitherto existed. It may, in some countries, fundamentally alter the nature of institutional investment in the sector. For example, instead of individual hotels in Germany being owned by investment pension funds and insurance companies, with returns being based on an annuity (calculated by reference to project costs), we may see those same institutions investing in the professional hotel owners.  It is hypothesised that this will provide those investing institutions with higher rates of return as a result of their ability to asset manage the subject investment. In the UK it is likely that US investors, particularly the REITS, will drive consolidation in the sector, possibly via acquisition of interest in publicly held hotel companies.

Whatever the precise effects of this unprecedented level of interest in the European hotel sector, we are confident that the by-products will include greater homogeneity of ownership, more professional investment analysis, more involvement on the part of asset managers, and a greater acknowledgment of the fundamental difference between ownership and management of hotel real estate. We further believe that brands will become an increasingly important component of the industry and that some hitherto national brands will disappear as a pan - European industry inevitably emerges as part of global consolidation.
 

©Arthur Andersen