Hotel investors are confronted with two types of risk when constructing diversified portfolios; systematic and unsystematic. Systematic risk (also known as market risk) is the part of total risk that cannot be eliminated or reduced, no matter how well an investor attempts to diversify. It is the volatility due to national fluctuations and all hotels have some systematic risk. The greater the systematic risk of a hotel, the greater the return investors will expect from the hotel. No matter how much total risk a hotel has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that hotel.
Unsystematic risk (also known as specific risk), on the other hand, is the risk due to the idiosyncratic fluctuations unique to an MSA or hotel. It is the proportion of total risk that is not associated with contemporaneous fluctuations in national performance and while it cannot be eliminated entirely, it can be reduced through diversification. Exhibit 1 ranks the top 25 U.S. hotels markets from highest to lowest systematic risk assuming 8-year holding periods.
Exhibit 1: : Historical Systematic and Unsystematic Risk Measured by Annual RevPAR Growth for the Top 25 U.S. Hotels Markets with an 8-Year Holding Periods Ending 1995-2018
With a shorter holding period of six years, systematic risk increased in all markets except for New Orleans, Minneapolis, Atlanta, Detroit and St Louis as illustrated below.
Exhibit 2: : A Comparison of Historical Systematic Risk Measured by Annual RevPAR Growth for the Top 25 U.S. Hotels Markets with 6-Year and 8-Year Holding Periods.
Beyond markets, the analysis to identify the proportion of systematic and unsystematic risk should be undertaken at the tract and the competitive set level to help determine the expected return (and the risk premium) on a prospective hotel investment.
It should be noted that the price of a hotel is determined by its contribution to a diversified portfolio. Investors are not willing to pay a premium for bearing risk that can be diversified away. The expected rate of return an investor chooses to value a hotel should reflect the contribution that the property makes to a well-diversified portfolio.