Identifying individual hotels that are underpriced (expected abnormal or excess risk-adjusted returns) in an economic sense is difficult to achieve. Unless a hotel investor has access to information that is not widely known, or is contemplating the purchase of a hotel where the information set differs significantly from that used for market valuations, it is unlikely that an investor will be able to consistently acquire underpriced hotels.
Without a formal framework of market equilibrium it is doubtful weather investors can consistently identify underpriced hotels, other than by chance! Merely placing bets on hotels which are expected to rise in value in the future is no guarantee of abnormal returns. Hotels which are “expensive” or “cheap” say nothing about whether they are underpriced or overpriced.
A good investment strategy, should, therefore, try to improve the probability of achieving abnormal returns in all phases of a hotel’s market cycle and an investors ownership cycle. A hotel which is cheap does not necessarily imply that it is underpriced. This distinction is important as the terms underpriced and cheap may well be confused in the marketplace. Although a cheap hotel may well be worth buying, any subsequent increase in value may only offer compensation for its risk and not contribute to abnormal performance.
By using our Equilibrium Hotel Pricing Model we help clients identify underpriced hotel assets throughout Australia. It should be noted that our model is a model of the capital market, not of the space market.
Please Feel Free to Subscribe to Our Australian Posts at the end of this Post.
The “Ideal” Hotel Investment
In these unprecedented times , it is easy for hotel investors to overlook the most important cornerstone of the capital markets: that expected returns are (and should be) greater for more risky assets as illustrated in Exhibit 1.
Exhibit 1: Financial Economics 101: Risk and Return
Hotel investors commonly believe, implicitly if not explicitly, that they are getting a higher expected return without assuming greater risk. If a hotel investor wants a higher return, the investor must generally accept more risk. The extra return for a given level of risk is the ‘risk premium’ that is necessary to induce investors to invest their money in a hotel whose cash flows are less certain. The risk premium is also defined as that part of the hotel’s total return that reflects the level of risk over and above the risk-free rate of return which an investor could obtain from a guaranteed investment, such as an Australian Government 10-Year Bond.
Now the analysis of return necessitates the analysis of risk. Both must be quantified before tradeoffs between risk and return can be made. An “ideal” hotel investment is one from which the investor expects a high rate of return, relative to the level of risk and is found above the linear equilibrium pricing line illustrated in Exhibit 1. Clearly, every hotel investor is interested in investments with a weak – and therefore favorable – relationship between the expected rate of return and the expected level of risk.
A common misconception is that higher risk equals greater return. The risk/return tradeoff means that with higher risk there is a possibility of higher returns, but it doesn’t guarantee them! The risk/return tradeoff is therefore the balance between the desire for the lowest possible risk and the highest possible return.
Now in order to identify hotels likely to deliver high risk-adjusted returns or positive “alpha” (most bang for the buck), investors need some idea about what hotel values and expected returns should be in equilibrium. Without a theory and accompanying model of market equilibrium, it is doubtful whether investors can identify underpriced hotels, other than by chance. Intuition and Discounted Cash Flow (DCF) analysis alone, do not cut it when seeking positive “alpha” is the goal.
Equilibrium Hotel Pricing Model
Our Equilibrium Hotel Pricing Model is based on the single index model. The model is used to determine an appropriate required rate of return and thus the price of a hotel, if that hotel asset is to be added to an already well-diversified portfolio, given the hotel’s systematic risk. The model takes into account the hotel’s sensitivity to systematic risk (also known as non-diversifiable risk or market risk or beta (β) in the financial industry), as well as the expected return of the market and the expected return of a risk-free asset such as a government bond.
The model prices individual hotels, markets or portfolios and enables us to calculate the return-to-risk ratio for any hotel or market in relation to the overall market’s return-to-risk ratio. Therefore, when the expected rate of return for any hotel is adjusted by its beta coefficient, β, the return-to-risk ratio for any individual hotel in the market is equal to the market’s return-to-risk ratio. This is calculated by the equation in the accompanying box below and illustrated in Exhibit 2.
The expected return on a hotel is therefore a function of the risk-free rate of return and a risk premium, which is related to its prospective market risk beta, β. The risk-free rate of return compensates investors only for the time value of money. The difference between the risk-free rate of return and the expected return on a hotel investment is the expected risk premium which is proportional to the amount of risk in the asset.
Exhibit 2: Reasonable Expected Hotel Returns in Equilibrium
In a pricing framework, however, it is not total risk that is important. The relevant risk is systematic or non-diversifiable risk. Systematic risk is an appropriate measure of risk to use for pricing hotel assets because it determines the correct opportunity cost of capital. The opportunity cost of capital is determined by reference to the return on assets carrying equal risk. Systematic risk, or beta, is a measure of covariance between the market portfolio and the specific market or hotel.
Exhibit 3: Selection of Underpriced Hotels
The expected rate of return an investor chooses to value a hotel should reflect the contribution the property makes to a well diversified portfolio. Investors should not be willing to pay a premium for bearing risk that can be expunged by diversification.
Our equilibrium hotel pricing model forecasts the shape of the linear equilibrium pricing line by:
- forecasting the expected return on the market portfolio of interest to an investor (e.g. luxury, full-service or limited-service hotels, etc.)
- forecasting the risk of individual hotel markets and assets (market variance and covariance between an individual hotel market/asset and market portfolio to derive prospective betas), and
- estimating the expected return for individual markets and hotels (risk-free rate, expected risk premium and prospective beta).
Our equilibrium hotel pricing model is therefore a model of the expected risk premium required by hotel investors and is a model of the capital market, not of the space market.
Practical Uses for the Equilibrium Hotel Pricing Model
By quantifying how the capital market prices risk at either the individual hotel or market level, we can help investors to :
- understand what are reasonable expected returns on different types of hotels in different markets as illustrated in Exhibit 2.
- identify markets or individual hotels that are currently mispriced as illustrated in Exhibit 3, and
- adjust portfolio returns to reflect the amount of risk in a portfolio by changing the portfolio mix of assets as illustrated in Exhibit 4.
Exhibit 4: Adjusted Portfolio Returns to Reflect Portfolio Risk
Many hotel investors set only one hurdle return requirement and face the danger of overpaying for an asset that is exposed to higher levels of risk. This is caused by the common practice of purchasing hotel assets based on current “market determined” cap rates. These cap rates in turn are driven by what investors are currently paying for hotel assets and is partly a function of how much capital is chasing hotel deals. By using the outputs of our model to check the reasonableness of these market derived returns, we help our clients determine what asset values and expected returns should be in equilibrium.
The second application involves identifying assets that are currently under, over or fairly priced on a risk-adjusted basis and can be used in buy, hold and sell analyses. We therefore help investors determine if potential hotel acquisitions are likely to return high risk-adjusted or positive “alpha” returns. The outputs of our model are also used to help investors identify overpriced hotels for potential disposition as these properties are unlikely to offer returns commensurate with their embedded risks.
Targeting individual hotels that are mispriced on a risk-adjusted basis is difficult to achieve. Unless a hotel investor has access to information that is not widely known, or is planning the acquisition of a hotel where the information set differs significantly from that used in market valuations, it is unlikely that he or she will be able to consistently acquire underpriced hotels or dispose of overpriced hotels. Merely punting on hotels which are expected to rise in value in the future is no guarantee of positive alpha.
Hotels that are “expensive” or “inexpensive” say nothing about whether they are underpriced or overpriced. A hotel which is inexpensive to buy does not necessarily imply that it is underpriced in an economic sense. This distinction is important as the terms “underpriced” and “inexpensive” may well be confused in the marketplace. Although an inexpensive hotel may well be worth buying any subsequent increase in value may only offer compensation for its risk and not contribute to abnormal performance.
Based on detailed research, we believe that investors find it difficult to distinguish between the relative amount of risk in one hotel type or location and that in another. If this is the case they will not require significantly or persistently different going-in IRRs or cap rates across different hotel types and locations.
In a marketplace characterized by a heterogeneous hotel product, relative pricing inefficiencies and mispriced assets, better-than-average returns are available to better-than-average hotel investment decision-makers. We arm our clients with independent and unbiased advice so that they can become, not only better-than-average, but the best hotel investment decision makers in the business with the highest probability of success.
Subscribe to Our Australian Posts