Perspectives
A room with a view
ME PoV Fall 2017 issue
Despite falling revenues in the Gulf Cooperation Council (GCC) region’s hotel sector, the overall number of hotel projects announced continues to rise. What is driving this investment and what is the market outlook for the hotel sector in the region?
As there is a limited market for the acquisition of trading hotels in the GCC region (known as the secondary market), the majority of investment in the GCC is in the development of new hotels. This has led to an increasing number of new hotels being developed in Dubai, despite recent falling revenues and overall performance in the sector.
Strong comparative global returns
Despite falling occupancy and room rates, certain markets in the Middle East continue to present an attractive investment opportunity on a global comparative basis. In 2016, gross operating profit across the region averaged around 40 percent. Hotels in the region achieved an average Revenue per available room (RevPAR) of US$115–a fall of around nine percent from the previous year. Globally, this is second only to Caribbean hotels that achieved an average RevPAR of US$135.
Investment drivers
While the hotel industry in the GCC looks to attract international interest, investment remains primarily driven by local investors–with the exception of investment by Indian nationals. Some international investors seem deterred by issues related to the region’s legal and regulatory environment and currency risks.
From a local investor perspective, key motivations include longer-term investment, portfolio diversification, income returns and status through brand association. In a region where cash is king, hotels can be used to generate a higher amount of income yield/continuous cash compared to other assets, which can be further invested into other businesses. Another key factor is the regional push for economic diversification, with tourism being at the forefront of the agenda. The introduction of the White Land tax in Saudi Arabia (a 2.5 percent tax on undeveloped land plots exceeding 5,000 square meters within city limits) has also spurred hotel investment in the country, as hotels are generally able to generate a higher income return compared to other real estate assets.
A room with a view
Which markets and why?
While geo-political issues affect the region as a whole, market transparency, tourism economics and infrastructure vary across key markets and play a major role in attracting investment.
The United Arab Emirates (UAE), in particular, remains the most attractive market in this regard, with a strong tourism demand forecast. The Saudi market has strong fundamentals in terms of population and religious tourism demand, but is constrained by a limited, albeit developing, investment market.
This is evidenced by the level of upcoming supply in planning or under construction with the majority being in the UAE and Saudi Arabia. Oman has also seen increased hotel investment interest in Muscat, Salalah and new destinations such as Sohar and Duqm.
Financing trends and access to capital
One way to look at the hotel investment market is through the capital structure. The financing structure for hotels in the region previously adopted the typical equity and bank debt sources.
We have seen a shift in the way developers are raising non-debt finance. Due to tightening bank liquidity, developers are turning to alternative sources of finance such as mezzanine funds for last mile funding. Investment firms dominate the mezzanine financing landscape—with a rise in the formation of capital in the mezzanine and junior debt space in the UAE recently.
Developers are also turning to alternative sources of finances such as the condo hotel model and Real Estate Investment Trusts or Funds (REITs/REIFs) structures to fund hotel development and investment. These structures provide several advantages both to the developer and investor markets. Both structures have a clear legal framework and allow for smaller investments from a wider pool of investors, solving the challenge of sourcing large investors.
The bank perspective
From a debt perspective, the market is facing stricter terms and increased due diligence. Banks are no longer taking pure construction risk based on feasibility studies, even if the numbers appear attractive. Their criteria are shifting more towards the profile of the investor/developer. Liquidity is generally available for qualifying investors who have a development track record and alternative sources of free cash that they could use to service project debt until the project is able to generate cash.
In general, banks are no longer willing to finance the cost of land and typically require investors to include the land as a portion of their equity contribution. A typical offer for the major markets (such as the UAE and Saudi Arabia) would include a Loan To Value (LTV) ratio of 60-70 percent on hard construction costs only, at a cost of 5.5-6 percent (Eibor1 + margin.) Loan tenure generally ranges between 2-3 years of construction, plus 7-8 years of amortization, with a 20-30 percent balloon payment.
Local banks that have advanced leveraged finance capabilities on sophisticated structured financing deals will sometimes work with alternative lenders who, generally, play a role during construction.
Market outlook
Within the Middle East, Sovereign Wealth Funds (SWF) and government-related developers are likely to continue driving hotel development in their respective local markets, while family businesses are likely to focus on key regional cities.
The largest issues deterring international investment are the legal and regulatory environment and currency risks. If these issues are addressed, the market could see a rise in activity within its secondary market and the development of a more mature real estate institutional investment environment.
In the meantime, developers continue to explore alternative funding structures, such as real estate investment trusts and funds, alternative debt, and the Condo Hotel model.
Bank debt will likely continue to be available for qualifying investors who have a development track record and alternative sources of free cash.
by Grant Salter, Director, Travel Hospitality and Leisure, Financial Advisory, Deloitte, Middle East
Endnotes
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