The Northwest Quadrant is the place to create increased shareholder value and the place to be seen!  No, we’re not talking about buying hotels in North West Australia, even though hotels in Broome, Port Headland, and Karratha may have important roles in a diversified portfolio. What we’re talking about is the desirable place to be in risk and return space: the domain where hotel investors enjoy the highest returns with a minimum of risk.

Most hotel investors,  regardless of whether they are seeking “core”, “core plus”, “value-added” or “opportunistic” type returns, long to be in the Northwest Quadrant!  While the boundaries of North West Australia are ill-defined, the boundaries of the Northwest Quadrant are anything but imprecise. The upper boundary is set by the efficient frontier, the frontier which describes the highest returns associated with a given level of risk. The best performing hotel portfolios in the country are found in the Northwest Quadrant.  By adding strategic hotels and or disposing of current assets that impede improved portfolio performance, investors can move to the “winners” corner and create increased shareholder value through effective portfolio management.

The goal of most hotel investors is to earn the highest possible return for a given level of risk. For most risk-averse investors, an investment with higher returns but lower variability is preferred to one with lower return and higher variability. Clearly, most investors prefer to be located in the Northwest Quadrant as illustrated in Exhibit 1. 

Exhibit 1: The North West Quadrant and the Four Corners of the Hotel Investment Universe

Now by harnessing the power of Modern Portfolio Theory (MPT), hotel investors can find the combination of markets and hotels that achieve the highest levels of return with a minimum of risk. By constructing an efficient frontier1, investors can identify a range of optimal2 hotel portfolios depending on their risk appetite.

The efficient frontier is an extremely powerful benchmark as it allows investors to evaluate whether they can do better by either fine-tuning or strategically repositioning their portfolios. It enables investors to identify the incremental investments that will improve their portfolio’s performance and the current hotels that are a drag on increased risk-adjusted returns. It can therefore help to identify additional markets and or hotels for a portfolio, identify hotels for disposition, and assess the portfolio implications of these transactions.

Exhibit 2: The Efficient Frontier and Directional Opportunities

Exhibit 2 illustrates an efficient frontier and the current position of a portfolio in risk and return space. The current portfolio has a return of 9% and a risk of 5% giving a risk-adjusted return of 1.8%.  The portfolio’s risk-adjusted return can be improved by changing its mix of assets. By adding several hotels and selling several others that were impediments to increased performance,  an investor can move a portfolio in the north-west direction closer to the efficient frontier.  The repositioned portfolio now has a return of 12%, an increase of 300 basis points over the old portfolio. The new portfolio has a risk of 3.5%, a decline of 150 basis points compared with the old portfolio giving it a risk-adjusted return of 3.43% as illustrated in Exhibit 3.

Exhibit 3: Hotel Portfolio Impact Statement

Source: Hotel Investment Strategies, LLC

While the new portfolio is clearly more desirable than the old portfolio, it remains a significant distance from the efficient frontier.  Just how much is this inefficiency costing the investor? The investor can now calculate the opportunity cost of the portfolio’s location by measuring the basis point spread between the efficient frontier and the portfolio at a constant level of risk. In this case, the opportunity cost of the new portfolio’s position is 500 basis points at 3.5% constant risk.

While a portfolio’s current position can change in one of five ways with the addition or deletion of hotel properties, the objective should be to move the portfolio in the north-west direction. Movements to the northeast or southwest may be advantageous, depending on the investor’s tolerance for risk.

1. An efficient frontier describes the highest attainable returns associated with each level of risk.

2. The term ‘optimal’ refers to the statistical process used to design efficient portfolios.