Is your hotel portfolio well-positioned to create long-term shareholder value? If you answered “yes”, the portfolio is likely to be in the North-West Quadrant, the place to create increased shareholder value and the place to be seen! No, we’re not talking about holding hotels in the Pacific Northwest, even though hotels in Oregon and Washington State may have important roles in a diversified portfolio. What we’re taking 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 North-West Quadrant! While the boundaries of the Pacific Northwest are ill-defined, the boundaries of the North-West 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 North-West Quadrant, either by design or by good fortune! 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 return but lower variability is preferred to one with lower return and higher variability. Clearly most investors prefer to be located in the North-West Quadrant as illustrated in Exhibit 1.
Exhibit 1: The North-West Quadrant and the Four Corners of the Hotel Portfolio 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 appetite for risk.
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 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 are impediments to increased performance, an investor can move a portfolio in the direction of the north-west quadrant 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 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.
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.
Exhibit 3: Hotel Portfolio Impact Statement
|Portfolio Expected Return||Portfolio Standard Deviation||Return Per Unit of Risk|
1. An efficient frontier describes the highest attainable returns associated with each level of risk. Three crucial inputs; expected return for each hotel, risk or volatility of each return and the cross correlations among the returns is needed to locate the efficient frontier using for a mean-variance portfolio analysis.
2.The term ‘optimal’ refers to the statistical process used to design efficient portfolios.